Statement on Monetary Policy – August 2007 International and Foreign Exchange Markets

International financial markets

Bond yields

Since the last Statement there have been some sharp movements in government bond yields. In May and June, yields on US government debt rose markedly as investors became less pessimistic about the US economic outlook. Consequently, the rise was mainly evident in real yields with inflation expectations little changed (Graph 16). By mid June yields had risen by more than 60 basis points on the same period a month earlier to be at their highest since early 2002. This was the sharpest rise in yields since 2004, although much larger movements were recorded in the 1990s. At that point, the yield curve sloped upwards for the first time since June 2006.

Over the second half of June and into July, however, bond market sentiment changed significantly. The catalyst was the adverse news involving the US sub-prime mortgage market.

The underlying deterioration in the US sub-prime market was not in itself news. The delinquency rate on sub-prime mortgages has been rising for some time, from a rate of around 6 per cent in mid 2005 to about 14 per cent in early 2007. Much of this deterioration is attributable to the poor quality of loans that were originated in 2005 and especially 2006 – a period in which there was strong competition among mortgage lenders and a significant relaxation of lending standards. Many of the loans were adjustable-rate mortgages on which the interest paid in the first couple of years is relatively low, but is then subsequently adjusted upwards by as much as 500 basis points. As the interest rates on a large number of the poorer-quality 2006 vintage mortgages still have to be reset, it is likely that sub-prime mortgage defaults still have a way to rise yet. This was acknowledged by Chairman Bernanke in his testimony before the US Senate Banking Committee in July, when he estimated that financial losses on the defaults could be in the range of US$50 to US$100 billion. Nevertheless, while these losses are sizeable, he indicated that the Federal Reserve does not believe that the sub-prime issues will lead to wider systemic problems or that they will significantly inhibit overall economic growth in the US.

The news that particularly unsettled credit markets was the announcement in mid June by US investment bank Bear Stearns that two of its hedge funds were facing financial difficulty through their exposure to the sub-prime mortgage market. Since then, several other hedge funds that invested heavily in products based on sub-prime mortgages have suffered financial distress, including in Australia (see below). Rather than any sudden unexpected deterioration in the sub-prime mortgage market itself, the problems experienced in these funds appears to relate more to their leverage and the illiquidity of sub-prime related debt markets in times of stress. Uncertainties over the market value of sub-prime debt and the failure of funds to report accurately initial trading losses eventually led creditors to make sizeable margin calls and even to seize collateral, some of which was sold into the market. This had the effect of moving market prices further against leveraged and cash-strapped funds.

In mid July, the concerns about sub-prime mortgage debt were further heightened by the actions of the major credit rating agencies. Standard & Poor's was first to announce that it was considering downgrading the credit ratings of around 600 classes of sub-prime residential mortgage-backed securities (RMBS). This was followed almost immediately by a decision from Moody's actually to cut the ratings of 400 largely speculative grade sub-prime RMBS. Over the following days there was a spate of further ratings downgrades to sub-prime RMBS and also to a large number of collateralised debt obligations made up from sub-prime RMBS. Moody's also announced that it would examine credit ratings on securities backed by ‘Alt-A’ loans whose risk characteristics fall between prime and sub-prime loans.

These events triggered a flight out of riskier credit markets and into higher-quality paper, notably US government bonds. As a result, yields on major market government debt fell and virtually all of the earlier increases were reversed. For example, the yields on 10-year US Treasury bonds which rose by more than 60 basis points in May/June, to a high of 5.3 per cent, subsequently fell by over 50 basis points to below 4¾ per cent.

Other major bond markets largely took their lead from events in the US (Graph 17). In Germany yields rose as high as 4¾ per cent before similarly falling back by 40 basis points, while in Japan yields rose to nearly 2 per cent before also declining. These swings in market sentiment since the last Statement have been associated with an increase in volatility, which for US government bonds reached its highest level since May 2004. Volatility in German and Japanese government debt also increased, but by less than that observed in US paper.

Heightened uncertainty in global credit markets also saw a widening of credit spreads for speculative-grade debt of around 130 basis points in July. Spreads are around their highs of recent years but are still well below the levels reached in the early part of the decade (Graph 18). Investor appetite for high-risk, high-yield debt has significantly diminished. This was illustrated by the difficulties that banks had in placing in the capital markets about US$20 billion worth of loans for two large private equity buy-outs involving Chrysler in the US and Alliance Boots in the UK. The concerns over credit quality also saw spreads on highly rated corporate debt increase to their highest level since 2003. This was partly driven by concerns over the potential exposure of banks to sub-prime debt markets. However, the concurrent decline in US Treasury yields has seen the level of yields on AAA-rated corporate debt actually decline.

The difficulties in the sub-prime market also generated some volatility in emerging market debt spreads. Spreads on emerging Asian and Latin American debt widened by around 50 basis points but still remain at low levels by historical standards, reflecting the strong fundamentals of these economies (Graph 19).

Australian hedge funds and US sub-prime markets

A small number of Australian hedge funds that invest in lower-rated US corporate debt and asset-backed securities have been affected by the turbulence in global credit markets. One fund, which had a large exposure to US sub-prime loans, is being wound up. Several other funds have also recorded losses on their investments in sub-investment grade corporate debt and in structured debt. Some of these funds have suspended investor redemptions because of a lack of liquidity in the underlying securities.

These funds have, in aggregate, about A$1½ billion in funds under management, around 2 per cent of funds managed by Australian hedge funds. It is too early to tell if other funds have been significantly affected. Only 10 of the 200 Australian hedge funds predominantly invest in fixed income, but funds of hedge funds and global macro funds may have some exposure to sub-investment grade debt.

Official policy rates

Since the last Statement both the US Federal Reserve and the Bank of Japan have left their policy rates unchanged, while most other major central banks have tightened monetary policy (Table 3, Graphs 20 and 21). The Fed has left the federal funds rate unchanged at 5¼ per cent since June last year. Earlier in the year, financial markets had been expecting at least two reductions in the federal funds rate during the course of 2007 based on pessimistic assessments about the US economic outlook. But these expectations were unwound in May and June as market participants moved more into line with the Fed's view that there are more upside risks to inflation from tight labour markets than downside risks to the broader economy from the weak US housing market. Following the turbulence in credit markets, however, financial markets are currently again pricing in a policy easing in the US by the end of the year, despite the Fed reaffirming its concerns about inflation following its August meeting.

The Bank of Japan (BoJ) has kept its policy rate unchanged at ½ per cent for five consecutive monthly meetings. While it signalled its intention to tighten monetary policy further, this is expected to happen at a very gradual pace in line with developments in the economy and inflation. The market expects that the BoJ will lift rates by 25 basis points some time in the coming months.

The European Central Bank (ECB) raised its policy rate by 25 basis points to 4 per cent at its June meeting. The move had been widely anticipated and continued the gradual process of lifting euro area rates, which are now up by a cumulative 200 basis points since late 2005. With the ECB describing current conditions as remaining on the accommodative side and reiterating its inflation concerns, markets expect one further 25 basis point increase before year end.

Over the past three months, the Bank of England (BoE) has raised its policy rate twice by 25 basis points, from 5¼ per cent to 5¾ per cent. The BoE has now increased interest rates by a cumulative 125 basis points over the past year, reflecting concerns over medium-term inflationary pressures. Elsewhere in Europe, the central banks of Switzerland, Sweden and Norway each tightened policy by 25 basis points to 2½ per cent, 3½ per cent, and 4½ per cent, respectively.

Both the Reserve Bank of New Zealand (RBNZ) and the Bank of Canada (BoC) also raised rates over the past three months in response to increasing inflation pressures. The RBNZ twice raised rates by 25 basis points, in June and July, citing strong domestic demand, partly due to positive income effects from a marked increase in dairy prices, as one of its main concerns. The BoC also lifted its policy rate by 25 basis points to 4½ per cent in July. This was the first policy change since May 2006 and markets currently expect another tightening later this year.

Monetary conditions continued to be tightened in China in an effort by the authorities to rein in rapid growth in domestic liquidity. Since the last Statement, the People's Bank of China (PBoC) has raised the required reserves ratio for banks twice by a total of 100 basis points to 12 per cent (Graph 22). The PBoC also lifted the official one-year lending and deposit rates by around 50 basis points, to 6.84 per cent and 3.33 per cent, respectively. China's State Council also announced a cut in taxation on interest income from 20 per cent to 5 per cent in an attempt to divert savings into the banking sector and away from the domestic equity market.

Elsewhere in emerging markets, a number of central banks including those in Korea, Taiwan, and South Africa have raised their policy rates since the last Statement in response to rising inflationary pressures. The Reserve Bank of India raised its reserve requirement on banks. In contrast, Bank Indonesia has reduced rates three times by 25 basis points, from 9 per cent to 8¼ per cent, and the Bank of Thailand has cut rates twice, from 4 per cent to 3¼ per cent as inflation pressures in those countries have eased. Brazil's central bank has also cut rates twice by 50 basis points, from 12½ per cent to 11½ per cent.

Equities

Having recorded solid increases for much of the past three months, supported by the continued strength in the global economy, global equity markets declined sharply following the increased concern in credit markets (Graph 23, Table 4). Financial sector share prices have been most affected by the sub-prime fallout, with prices in that sector in the US falling by 8 per cent in July.

In contrast, share prices in emerging markets have generally continued to post very strong gains. Local currency-denominated China A shares have increased by around 20 per cent since the last Statement (Graph 24), despite continued speculation that the authorities may impose trading restrictions in an effort to cool the share market.

Exchange rates

The US dollar continued to depreciate against most major currencies since the last Statement (Table 5). On a trade-weighted basis, the nominal exchange rate is now around its lowest level in over 30 years, although the real exchange rate is currently around 10 per cent above its 1995 trough (Graph 25). The depreciation has been broad-based with the US dollar posting multi-decade lows against several major currencies including the Australian dollar (see below). The decline in sentiment has also been reflected in the total amount of speculative short positions against the US dollar, which had risen to their highest level since November 2004.

The major exception to the general appreciation against the US dollar was the Japanese yen which continued its trend depreciation in May and June, before more than reversing this in July as credit concerns contributed to US dollar depreciation (Graph 26). On a trade-weighted basis the yen remains at a multi-decade low. The depreciation of the yen in part has reflected the decline in the home bias of Japanese investors as households have gradually diversified their portfolios into foreign assets at a time when there is less offsetting portfolio equity inflow. Additionally, low interest rates in Japan have resulted in the yen being the primary funding currency for carry trades.

The New Zealand dollar appreciated strongly against the US dollar since the last Statement (Graph 27). The exchange rate has been buoyed by relatively high interest rates and rose further after the RBNZ unexpectedly raised official interest rates in early June. The central bank responded to the appreciation by intervening in currency markets to sell New Zealand dollars for the first time since the exchange rate was floated in 1985.

Most emerging market currencies have also appreciated against the US dollar in recent months. In particular, the Brazilian real, Thai baht, and Philippine peso rose strongly over the period. The Brazilian real was supported by improving economic fundamentals and a sovereign credit rating upgrade. The central bank has intervened in the currency market to limit upward pressure on the exchange rate.

The Chinese renminbi also appreciated further against the US dollar since the last Statement, with the pace of appreciation picking up in May and June to its fastest rate since the introduction of the new regime two years ago. In May, Chinese authorities announced a widening of the renminbi's daily trading band to 0.5 per cent from 0.3 per cent previously. This decision would, in principle, allow greater volatility and a faster rate of appreciation in the Chinese currency than before, although the limits of the earlier narrower band had not been utilised. Pricing in the non-deliverable forwards market indicates expectations for the renminbi to appreciate by a further 6 per cent against the US dollar over the next year.

Australian dollar

The Australian dollar has appreciated since the last Statement, rising above 88½ US cents for the first time since February 1989, before retracing some of its gains in late July (Graph 28, Table 6). The gains only partly reflected the general depreciation of the US dollar (see above), as the Australian dollar has appreciated against the currencies of most of its major trading partners, with the trade-weighted exchange rate rising above 70 for the first time since 1985. The exchange rate is well above its post-float average against the US dollar and a number of Asian currencies, as well as on a trade-weighted basis (Graph 29), but it is still below its average against currencies such as the euro/deutschemark, pound sterling and the New Zealand dollar.

The broad-based strength of the Australian dollar is attributable to a number of factors. The terms of trade have risen to their highest level in 50 years. Also, the strength of the economy and the resulting level of yields compared to other major economies have provided support for the local currency. Positive interest rate differentials have meant that Australia continues to attract substantial capital inflows (Graph 30). Portfolio debt inflows increased substantially in the March quarter (the latest period for which data are available), while bank and money market flows continue to account for the majority of net capital inflow in annual terms, despite a small net outflow in the first quarter of this year. Inflows of equity capital from abroad have more than offset equity outflows in the last two quarters.

Sustained appetite for carry trades has probably contributed to a significant proportion of the debt market inflows, and as a result the Australian dollar appreciated particularly strongly against the low-yielding Japanese yen in the period to late July. However, in the last days of July, the credit market concerns triggered a general unwinding of carry trades (see above), which in turn led the Australian dollar to depreciate sharply against the yen, US dollar and in trade-weighted terms, reversing a significant proportion of the earlier gains.

Reflecting the generally positive investor sentiment towards the local currency in recent months, net long speculative positions in Australian dollar futures on the Chicago Mercantile Exchange have generally been maintained at high levels relative to past years. This had also been reflected in Australian dollar risk reversals, which provide a measure of the market's expectations of the future direction of the exchange rate. Up until very recently, Australian dollar risk reversals had been rising, indicating a declining probability of a sizeable future depreciation (Graph 31). However, in recent days, risk reversals indicate that this sentiment has changed, with participants more concerned about the prospect of a sizeable depreciation of the Australian dollar. After declining for most of the period since the last Statement, Australian dollar volatility spiked higher at the end of July, and is now above post-float average levels (Graph 32).

With the Australian dollar reaching a multi-year high against the US dollar, the Reserve Bank continued its purchases of foreign exchange in recent months. Net purchases over the year to date have totalled $2¼ billion. Net reserves currently stand at around $33 billion, while the Bank's holdings of foreign exchange under swap agreements are around $471/2 billion.