Geneva (Kanaga Raja) — The uneasy calm that had reigned in the financial markets in late 2015 gave way to a turbulent start this year, witnessing one of the worst stock market sell-offs since the 2008 financial crisis, the Bank for International Settlements (BIS) said on 6 March.
In its latest Quarterly Review of March 2016, the Basel-based central bank of the world’s central banks said that markets at first focused on slowing growth in China and vulnerabilities in emerging market economies (EMEs) more broadly.
“Increased anxiety about global growth drove the price of oil and EME exchange rates sharply lower and fed a flight to safety into core bond markets. The turbulence spilled over to advanced economies (AEs), as flattening yield curves and widening credit spreads made investors ponder recessionary scenarios.”
In a second phase, the deteriorating global backdrop and central bank actions nurtured market expectations of further reductions in interest rates and fuelled concerns over bank profitability.
In late January, BIS noted, the Bank of Japan (BoJ) surprised markets with the introduction of negative interest rates, after the European Central Bank (ECB) had announced a possible review of its monetary policy stance and the Federal Reserve issued stress test guidance allowing for negative interest rates.
On the back of poor bank earnings results, banks’ equity prices fell well below the broader market, especially in Japan and the euro area.
Credit spreads widened to a point where markets fretted about a first-time cancellation of coupon payments on contingent convertible bonds (CoCos) at major global banks.
“Underlying some of the turbulence was market participants’ growing concern over the dwindling options for policy support in the face of the weakening growth outlook. With fiscal space tight and structural policies largely dormant, central bank measures were seen to be approaching their limits,” said BIS.
In some on-the-record remarks on 4 March on the eve of the launch of the Quarterly Review, Mr Claudio Borio, Head of the BIS’s Monetary and Economic Department, said: “The tension between the markets’ tranquillity and the underlying economic vulnerabilities had to be resolved at some point. In the recent quarter, we may have been witnessing the beginning of its resolution.”
He said that the new year greeted investors with one of the worst sell-offs on record. Investors had just breathed a sigh of relief following what had turned out to be an uneventful, if historic, 25 basis point increase in the federal funds target range in mid-December – the first hike since the overnight rate had been pushed to zero seven years earlier, marking the longest post-war phase of immobility.
Just two weeks later, markets tumbled. As in the summer, the trigger was China, as signs of a slowdown there hinted at broader emerging market weakness.
Equity prices took a dive worldwide, volatilities soared, credit spreads widened, emerging market currencies fell, especially vis-a-vis the US dollar, and the oil price sank to new lows, below the troughs reached during the Great Recession.
In turn, these developments fed pessimism about other economies, notably the United States, thus spreading gloom further.
According to Mr Borio, this was only the first phase of the turbulence. A second, briefer but perhaps more worrying episode in the first half of February focused on the health of global banks.
Their valuations, which had been under pressure for quite some time, plunged to new lows while their credit default swap (CDS) spreads rose.
Price-to-book ratios hovered around levels not seen since the most acute phase of the crisis. Disappointing global growth prospects and earnings announcements added to jurisdiction-specific worries, such as stubbornly high non-performing loans and regulatory-driven concerns about coupon suspensions for contingent convertible bonds (CoCos) in the euro area.
“But the main source of anxiety was the vision of a future with even lower interest rates, well beyond the horizon, that could cripple banks’ margins, profitability and resilience,” he said.
Anxiety grew and spread following the Bank of Japan’s decision to adopt negative policy rates. At its peak, more than US$6.5 trillion worth of sovereign paper was trading at negative yields – stretching once more the boundaries of the unthinkable. Only more recently have markets regained a certain composure, he added.
“Against the backdrop of a long-term, crisis-exacerbated decline in productivity growth, the stock of global debt has continued to rise and the room for policy manoeuvre has continued to narrow – a set of factors that might be termed the ‘ugly three’.”
Mr Borio further said that the latest turbulence has hammered home the message that central banks have been overburdened for far too long post-crisis, even as fiscal space has been dwindling and structural measures lacking.
Despite exceptionally easy monetary conditions, in key jurisdictions growth has been disappointing and inflation has remained stubbornly low.
“Market participants have taken notice. And their confidence in central banks’ healing powers has – probably for the first time – been faltering. Policymakers too would do well to take notice,” he warned.
According to the BIS report, on 16 December, the Federal Reserve raised the target range for the federal funds rate, after eight years of monetary policy easing across the major currency areas.
Even after the increase, the US monetary policy stance remained highly accommodative: the increase in the federal funds target range was minimal – 25 basis points – and the stock of assets acquired over years of large- scale asset purchases was left unchanged.
The Federal Open Market Committee (FOMC) signalled that the shortfall of inflation below its 2% objective, and uncertainty surrounding economic conditions more broadly, were expected to warrant only gradual increases in the federal funds rate.
“Nonetheless, the decision marked a turning point in an era of extraordinary monetary accommodation,” said BIS.
It noted that when the first US rate hike eventually came, it hardly caused a stir. The onset of the tightening cycle had long been expected, starting as early as May 2013, when expectations of an eventual “tapering” of asset purchases had reverberated through global financial markets.
In the days before 16 December 2015, the futures-implied probability of a December lift-off was near 80%, reflecting confidence in the US economic outlook.
“Apart from temporary volatility around the announcement date, the yield curve barely moved. Equity markets traded sideways, as one source of uncertainty was resolved. However, other sources of uncertainty soon appeared, and have come to dominate the scene.”
FINANCIAL MARKETS BECOME UNSETTLED
According to the BIS report, the deterioration of global growth prospects unsettled financial markets from the start of the year.
The first phase of turbulence centred on anxiety over global growth in EMEs, and China in particular. China’s reported growth slowed to 6.9% in 2015, the lowest official rate since 1990. Consensus forecasts for 2016 had been falling continuously over the previous 12 months.
The softness in manufacturing had long been offset by a growing service sector, but in December the services PMI stood at its weakest level in 17 months.
Concerns about a slowdown in Chinese manufacturing spread to other EMEs, for which 2016 growth forecasts had been falling rapidly in the second half of 2015.
“Worries about manufacturing were not limited to Asia: the strength of the US dollar and low oil prices cast a pall over the outlook for US manufacturing, which weakened relative to the non-manufacturing sector. Indeed, the growth outlook for all major economic regions continued to deteriorate.”
Against this backdrop, said BIS, disappointing news from China triggered market turbulence on the very first trading day of the year.
As a closely watched manufacturing index pointed to renewed sectoral weakness, stock markets sold off in both advanced and emerging economies. As the Shanghai Composite plunged over 15% in the first two weeks of the year, major AE stock markets dropped by almost 10%.
During the first week alone, trading in China was halted twice in response to new market mechanisms that stop trading when losses reach a certain threshold, adding to market distress.
“Implied volatilities soared to peaks comparable to those observed in August 2015, and well above the subdued levels of the previous three years. But in contrast to that short-lived episode, the rout in early 2016 lasted for several weeks.”
BIS said that growing concern about the global economic outlook, in turn, led to further losses in commodity markets.
The prospect of weaker demand, on top of the supply glut that had become apparent over the past 18 months, hit crude oil markets hard.
Oil prices extended the slide of the second half of 2015, falling below $30 per barrel for several days before rebounding to slightly above that level.
Brent settled 70% below the average nominal price observed between mid-2010 and mid-2014, the peak of the long boom in commodity prices which spanned over a decade.
“In fact, current oil prices barely exceed the average nominal price levels of the five years preceding 2002, right before the onset of the commodity price boom.”
BIS said that the heavy debt burden of producers (especially US shale companies) may have exacerbated the price decline.
Lower oil prices reduce the cash flows from current production and raise the risk of illiquidity and possibly debt defaults.
“Firms facing such strains may have maintained or even raised production to preserve liquidity and reduce debt, thereby contributing to further price declines. These forces may have been at play in the US market, where the large drop in oil prices went hand in hand with continuous increases in oil inventories.”
BIS further said that in the midst of a global risk asset sell-off, a general flight to safety strengthened the US dollar.
Currencies of EMEs and commodity exporters tested new lows before finding support in mid-January at levels about 3% below year-end. Concerns about renminbi depreciation also stirred foreign exchange market volatility.
On 11 December 2015, the People’s Bank of China introduced the China Foreign Exchange Trade System (CFETS) reference basket, signalling a shift from a singular focus on the US dollar.
Between August 2015 and late January 2016, the renminbi depreciated by 6% against the US dollar, while staying broadly stable vis-a-vis the CFETS basket.
The country’s foreign exchange reserves dropped by more than $300 billion over the same period, at a seemingly accelerating pace that unnerved investors, BIS added.
“Expectations of further depreciation may have contributed to the sell-off in the domestic stock market, which in turn put further pressure on the currency. The combined impact of lower oil prices and a stronger US dollar has put substantial pressure on many EMEs at a time when the tide of global dollar liquidity appears to be turning.”
Global credit markets were also riled by turbulence. The low interest rate environment of the past few years had gone hand in hand with a search for yield that eased credit conditions, in particular for riskier borrowers.
As market turbulence spread, AE high-yield credit came under unusual pressure, after having been buffeted by increasing headwinds since mid-2014.
The widening of spreads was particularly sharp for US high-yield debt, which was weighed down by the under-performance of energy companies and fears of a rise in default rates.
By comparison, said BIS, the widening of corporate spreads was more moderate in Europe, with high-yield spreads halfway to their 2011 peaks.
The divergence between the investment grade spreads across the two regions coincided with the onset of the oil price plunge in mid-2014, possibly reflecting concerns over contagion from the oil sector to other parts of the US economy.
Sovereign credit spreads in EMEs also widened during the initial weeks of 2016, comfortably surpassing the heights recorded in 2011, said BIS.
According to the report, the monetary policy landscape across EMEs varied, reflecting the role played by commodities, exchange rates and other drivers of inflation.
Central banks in emerging Asia and Europe, whose economies mostly benefited from the commodity price plunge, kept their monetary policies unchanged despite substantial currency depreciation.
Commodity exporters, by contrast, tightened or signalled an inclination to tighten rates, as currency depreciation triggered strong inflationary pressures in spite of slowing economic activity. For most countries, however, the challenging global backdrop for exchange rates left limited space for monetary stimulus.
SECOND PHASE OF TURBULENCE
BIS further noted that the ongoing financial turbulence against a weakening global backdrop gave way to a second phase of turbulence, in which markets focused on the possibility that central banks could drive interest rates further into negative territory and, in the process, add to the persistent weakness in bank profitability.
As turbulence rippled through emerging and advanced financial markets, the resulting flight to safety helped flatten yield curves in core bond markets.
By late January, the term spread between the 10-year US Treasury bond and the three-month bill had dropped more than 50 basis points from the end of 2015 and the comparable spread for German bunds retreated by almost 40 basis points. In the past, flattening yield curves and widening credit spreads have often heralded weakness in economic activity.
“These developments sowed doubt among market participants about the positive outlook for the US economy, on which the Federal Reserve had predicted the December lift-off. External weakness, a strong dollar and widening credit spreads threatened to smother the recovery.”
With this new backdrop, said BIS, market expectations of future rate hikes declined to a point that became inconsistent with the prospect of three to four rate increases in 2016 implied by FOMC participants’ monetary policy assessments.
By early February, the probability of a rate hike in March had dropped from 50% to near zero, and even a June hike came to be regarded as unlikely. The turbulence led markets to price in a very gradual pace of tightening.
In contrast to expectations at the time of the December lift-off, by late January markets expected the federal funds rate to stay below 1% throughout 2017, and in February the expected pace of tightening fell even further.
“Policymakers in major AEs reacted to these developments with moves that were taken as pointing towards further accommodation.”
At its January meeting, the FOMC acknowledged the global financial turbulence and possible repercussions on the US economy, but did not signal a change to the previous guidance. But on 28 January markets took note of the Fed’s announcement of the guidelines for the 2016 banking stress test, which asked banks to consider the potential impact of negative Treasury bill rates as part of a “severely adverse scenario”.
The BoJ surprised the markets on 29 January by introducing negative interest rates charged on the excess over required reserves and the balances accumulated by financial institutions under its quantitative and qualitative easing programme (QQE) and loan support programme, and thus joining the ECB and the Swiss National Bank in imposing negative rates on bank reserves.
The BoJ decision had an outsize effect on financial markets, said BIS, noting that Japanese government bond yields fell to record lows across the curve, with negative yields at all maturities out to 10 years.
And after a fleeting rebound in the Japanese stock market and a short-lived depreciation of the yen, Japanese banks’ stock prices fell sharply. This occurred even though the BoJ measure was designed to minimise the immediate impact on bank profitability.
As markets digested the implications of negative policy rates in Japan, they appeared to price in a further set of easing moves more generally. In a matter of days, the universe of sovereign bonds trading at negative yields expanded from $4 trillion to more than $6.5 trillion.
By early February, almost one quarter of the outstanding stock of sovereign bonds in the Merrill Lynch sovereign fixed income index were trading at negative yields. Among Japanese government bonds, that share exceeded 60%.
“As the universe of bonds yielding negative rates expanded, markets became increasingly aware of new constraints and trade-offs that might limit policy options.”
According to BIS, by some reports, the pool of euro-denominated debt yielding less than the ECB deposit rate (currently at -0.3%) surged by a third after the ECB’s policy meeting on 21 January.
“The rules governing the ECB’s asset purchase programme make such securities ineligible for future ECB purchases. If price dynamics continued to shrink the universe of eligible securities, the scope of the asset purchase programme would thus narrow, unless the deposit rate were pushed further into negative terrain – which, in turn, was seen as possibly eroding euro area banks’ future net interest margin.”
As stress reigned in financial markets and the global outlook deteriorated, tensions spread to the equity and debt obligations of major global banks. European bank shares had been trailing the broader market since mid-2015, but the gap widened in 2016. US banks also under-performed the S&P 500 index by
10% since early January, but Japanese banks plunged 15% vis-a-vis the Nikkei after the BoJ announcement.
Alongside falling share prices and widening credit default swap (CDS) spreads, the market for contingent convertible bonds (CoCos) of European banks took a remarkable dive.
“The limited impact on senior bank debt spreads suggests that the size or quality of capital buffers were not the primary concern even as CDS spreads widened. But the possibility that European banks might have to suspend dividend distributions and CoCo coupon payments set in motion a dynamic that reinforced the plunge in bank valuations across asset classes,” said BIS.
It added that these developments led market participants to focus on bank profitability. The doubts markets harbour about the prospects of European and Japanese banks, in particular, have long been reflected in the extent to which their share prices traded below their book value.
Price-to-book ratios slid further during the turmoil, but the persistent gap between European and Japanese banks vis-a-vis their US peers remained. Banks’ reluctance to pass negative rates on to depositors contributed to the gradual erosion in net interest income.
At the same time, concern over prospective bank earnings led market participants to look closely at the likely impact of an extended period of negative interest rates on bank profitability.
“Underlying some of the turbulence of the past few months was a growing perception in financial markets that central banks might be running out of effective policy options. Markets pushed out further into the future their expectations of a resumption of gradual normalisation by the Fed. And as the BoJ and ECB signalled their willingness to extend accommodation, markets showed greater concerns about the unintended consequences of negative policy rates.”
In the background, said BIS, growth remained disappointing and inflation stubbornly below targets. Markets had seemingly become uncertain of the backstop that had been supporting asset valuations for years.
“With other policies not taking up the baton following the financial crisis, the burden on central banks has been steadily growing, making their task increasingly challenging,” it concluded. – Published in SUNS #8196 dated 8 March 2016 via TWN