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

International financial markets

Official interest rates

Most major central banks have tightened monetary policy settings over the past three months, or are expected to do so in the period ahead (Table 2, Graph 17). The notable exception has been the US Federal Reserve which has kept interest rates steady at 5¼ per cent since June last year. Over this period the Fed has clearly stated that inflation is its primary concern, but in contrast to the Fed's assessment about the balance of risks, financial markets have been more focused on the uncertain outlook for US growth. Markets continue to place a greater likelihood on the next move by the Fed being an easing rather than a tightening. Earlier in the year, general weakness in housing and concern over the rising rate of mortgage delinquencies in the sub-prime sector (see below) led markets to fully price in a rate cut by the middle of the year. However, ongoing strength in the US labour market and the limited spillover of the sub-prime problems have seen markets push back the expected timing of the rate cut until late in the year.

The European Central Bank (ECB) raised its policy rate at its March meeting and has subsequently stated that monetary conditions remain accommodative and has continued to emphasise the upside risks to inflation. Markets are currently expecting two further 25 basis point increases in European rates in the next six months. The Bank of Japan (BoJ) has also signalled its intention to continue to tighten monetary policy, albeit at a very gradual pace, following its second 25 basis points increase since it ended its zero interest rate policy in July last year. With Japanese inflation expected to fluctuate around zero in the near term, the market believes that the BoJ will not lift rates until later in the year.

Both the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ) have raised rates this year in response to increasing inflation pressures (Graph 18). The BoE has increased rates by 25 basis points to 5¼ per cent, and the RBNZ raised rates twice by 25 basis points from 7¼ per cent to 7¾ per cent. The markets expect the BoE to raise rates at least once more in the next six months. Policy rates in Sweden, Switzerland and Norway have also been increased this year from unusually low levels and the market expects further rate increases in each country. However, the Bank of Canada, which has left rates unchanged over the past year, is expected by markets to continue to maintain its policy rate at 4¼ per cent for the foreseeable future.

Monetary conditions continue to be tightened in China in an effort to curtail the growth in money and credit. Following several actions last year, in the first four months of 2007 the People's Bank of China (PBoC) has raised the reserve requirement for banks by 50 basis points on three occasions to 11 per cent and raised the official one-year lending and deposit rates by 27 basis points to 6.39 per cent and 2.79 per cent, respectively. Despite these measures, growth in the money supply has accelerated since late last year, remaining above the PBoC's target range.

Elsewhere in Asia, changes in monetary policy have been more varied. Monetary conditions continue to be tightened in India and Taiwan. In contrast, after cutting rates by a total of 375 basis points over its past nine meetings as inflation declined, Bank Indonesia left rates on hold in April at 9 per cent. In Thailand, monetary policy has been eased by 100 basis points in the past six months in an effort to boost domestic demand. Policy rates have also been reduced further in Brazil and Israel since the previous Statement.

Bond yields

There have been somewhat divergent trends in government bond yields among the major markets since the last Statement (Graph 19). In the US, there was initially a sharp increase in yields following strong employment data, which led market participants to wind back their expectations of a policy easing. However, subsequently softer inflation and housing data saw yields drift lower, with markets again focused on the possibility of an easing by the Fed later this year. German government bond yields were supported by strong economic data and comments from the ECB. Consequently, the interest rate differential between the US and Germany has continued to narrow, reflecting the relative growth prospects of the two countries. In Japan, yields on government debt are somewhat lower than at the time of the last Statement.

Spreads on emerging-market and low-grade US corporate debt temporarily rose as a result of the increase in risk aversion associated with equity market volatility in late February (Graph 20). Most affected were spreads on US low-grade ‘junk’ debt, which increased by 36 basis points over the first half of March. Subsequently, the market appears to have regained its appetite for risk and spreads on low-grade US corporate debt have fallen back to levels below those prevailing at the time of the previous Statement. Spreads on emerging-market debt have also unwound their sharp spike in late February to be back at historically low levels. Spreads on high-rated US corporate debt were only marginally affected by the changes in risk preference and have barely moved in recent months.

Developments in the US sub-prime mortgage market^[1]

One of the most-publicised developments in financial markets in recent months has been those in the US sub-prime mortgage markets. Sub-prime mortgages are typically those where the borrower has an impaired credit history. The borrowers are therefore considered to have a higher risk of defaulting on their loan and face higher interest rates than prime borrowers. With variable interest rates at historical lows in 2003 and 2004, these loans were particularly attractive to marginal borrowers. In addition, these mortgages often had a two-year introductory (teaser) rate that reduced the borrowing rate to close to that of prime borrowers.

While low variable interest rates encouraged the initial rise in sub-prime lending, the surge in the share of the sub-prime mortgages in 2006 appears primarily to have reflected a loosening of credit standards to maintain loan volumes as demand from prime borrowers slowed. The combination of this decline in standards along with the rise in variable rates and the expiry of the two-year introductory discounts contributed to the marked rise in delinquency rates in the latter part of 2006 (Graph 21). It is noteworthy that the rise has occurred even though the unemployment rate remains low. Delinquency rates among prime borrowers and those with fixed-rate loans have remained little changed.

To date, more than 20 sub-prime lenders have closed. Other financial intermediaries with exposure to this market have also been affected, most notably the investment banks that have extended lines of credit to sub-prime mortgage lenders, have their own sub-prime lending subsidiaries or hold an investment position in related securities.

There are varying views as to the potential effect of these developments on the broader US economy. Three main risks have been identified: a generalised tightening in credit standards leading to a ‘credit crunch’; an overly aggressive regulatory response by state and federal agencies which could also cause a decrease in credit provision; and a deepening of the ongoing contraction in residential construction and stagnation in house prices. At this stage, the problems appear to be confined to the sub-prime market with little evidence of spillover to other areas. Moreover, a number of institutions are coming forward to buy the sub-prime loan books of some of the troubled lenders at a discount, regarding it as a reasonable buying opportunity.

Equities

Notwithstanding sharp declines in late February and early March following the sharp fall in Chinese share prices, global equity markets have posted modest net gains since the previous Statement (Graph 22, Table 3). Markets have been supported by the continued strength in the global economy as well as increased merger and acquisition activity. Larger gains have been recorded in European markets, where growth prospects are assessed to be far more favourable, than in the US, where developments in the sub-prime lending market and concerns about the housing sector more generally have weighed on some share prices.

In emerging markets, share prices in Asia and Latin America have also recorded net gains since the previous Statement (Graph 23), although this masks some large movements in both directions over the period. Emerging-market share prices were particularly affected by the volatility in late February, with some markets experiencing double-digit declines. However, most markets have recovered their losses and subsequently have continued to post gains. Most notably, China's local-currency-denominated A shares, which fell by 9 per cent on 27 February, have subsequently rebounded to be around 25 per cent above their peak recorded just prior to the drop.

In addition to the ongoing strength in the global economy, the rapid recovery in global markets may be partly attributable to the fact that there are few signs of significant misalignment in most equity markets. Price-to-earnings (P/E) ratios for major equity markets do not suggest any obvious overvaluations, with the S&P 500 and MSCI Europe P/E ratios close to their historical averages (Graph 24). However, it should be noted that the profit share is at historically high levels in most countries and earnings forecasts generally assume it will remain around these levels. Similarly, despite the sharp rise in prices among emerging Asian equity markets in recent years, the information available on P/E ratios also does not appear to be signalling any major imbalances (Graph 25). The exception to this may be the rapid increase in the P/E ratio in the Chinese stock markets since early 2006, where prices appear to be running ahead of fundamentals (Graph 26).

Exchange rates

The US dollar has depreciated against all major currencies in the period since the last Statement (Table 4). On a trade-weighted basis against the major currencies, the US dollar is at its lowest level in over 30 years, although in real terms it is still around 10 per cent above its historic low (Graph 27). The main factor weighing on the dollar over the period has been a reassessment of growth prospects in the US, with negative developments in the sub-prime lending market particularly affecting sentiment. In contrast, growth in the euro area has continued to be favourable, creating expectations that long- and short-term interest rate differentials with the US will continue to narrow. The appreciation in the euro against the US dollar has taken European currencies to their highest level against the dollar since late 1992.

Following higher-than-expected inflation data, the UK pound rose to its highest level against the US dollar since 1981 and remains near its recent 20-year high in trade-weighted terms. The New Zealand dollar has appreciated by 8 per cent against the US dollar since the last Statement to be at its highest since 1982, and the Canadian dollar has appreciated by 6 per cent.

The notable exception to the general appreciation against the US dollar has been the Japanese yen (Graph 28). Despite the recent revival in Japan's economic growth following a prolonged period of stagnation, several factors have tended to depress the yen. These include the fact that inflation and interest rates remain low in Japan. This has encouraged the continuation of capital outflows, both as a result of carry trades financed out of Japan, and overseas investment by Japanese households. While households' holdings of foreign portfolio assets amounted to only 3 per cent of their total financial assets in 2002, this share almost doubled to around 6 per cent as at the end of 2006. Over the past three months, volatility in the yen has been relatively high as the influence of these factors has fluctuated. In particular, as a result of the increased risk aversion that followed the share market falls in late February, carry trade positions were unwound and the yen appreciated sharply. However, as the market's risk appetite has risen again and share markets have recovered, carry trades have been re-established and the yen has reversed its earlier appreciation.

Emerging-market currencies have also generally appreciated against the US dollar since the last Statement. Although currencies such as the Korean won and Indonesian rupiah fell after the stock market declines of late February, they soon rose back in line with the recovery in these markets. The Thai baht has also appreciated over the period and is now above the level of December last year when the central bank imposed controls on short-term capital inflows.

The pace of appreciation in the Chinese renminbi against the US dollar appears to have slowed, with the currency little changed in recent months. Pricing in the non-deliverable forward market indicates expectations for the renminbi to appreciate by around 6 per cent against the US dollar over the next year. Given the broad-based depreciation of the US dollar, the renminbi has remained little changed in trade-weighted terms over the past 18 months.

To stem the appreciation of the renminbi the PBoC accumulated US$136 billion of foreign exchange reserves in the first quarter of 2007, with total reserves now exceeding US$1,200 billion. In recent months, China has announced plans for a new state investment agency to purchase around US$200 to US$300 billion in official foreign reserves from the central bank to invest in a wider range of assets. Authorities have indicated that one of the agency's initial investments might be in strategic resource companies and that it may operate on a mandate similar to GIC in Singapore.

Australian dollar

The Australian dollar has appreciated strongly since the last Statement, reaching a 17-year high of 83.92 cents against the US dollar and a 22-year high of 67.9 on a trade-weighted basis (Graphs 29 and 30, Table 5). A large part of the appreciation reflects the general US dollar depreciation (see above). Continued strength in base metals prices, particularly copper and nickel, has also helped underpin the appreciation. As noted in the chapter on ‘Domestic Economic Conditions’, Australia's terms of trade have risen to their highest level since the 1950s, significantly outpacing the appreciation of the exchange rate. Market expectations of a domestic interest rate increase have at times also supported the currency.

Capital flows into Australia remain strong (Graph 31). Large inflows have been recorded in bank and money market instruments and bonds, indicative of flows associated with carry trades. These flows have been encouraged by the relatively high yields in Australia. In recent years there has been a modest net outflow of equity capital as inflows of equity capital from abroad have been more than offset by equity capital outflows from both large direct investments by Australian companies and portfolio flows from Australian funds managers.

In line with the recent positive sentiment towards the Australian dollar, net long speculative positions in Australian dollar futures on the Chicago Mercantile Exchange remain at elevated levels, and only slightly below the peaks reached at the end of last year (Graph 32).

The Reserve Bank has been buying foreign exchange since 2002 to replenish sales made to support the Australian dollar between 1997 and 2001. With the Australian dollar at multi-year highs, the Bank has stepped up its purchases of foreign exchange in recent months. Net purchases over the year to date have totalled just over $1 billion. With revaluations following the appreciation partially offsetting recent purchases and earnings, net reserves currently stand at around $32 billion. The Bank's holdings of foreign exchange under swap agreements, which are used for domestic liquidity management purposes, increased to $49½ billion.

Footnote

See also ‘Box A: Developments in the US Sub-prime Mortgage Market’, RBA Financial Stability Review, March 2007, pp 23–25. [1]