Statement on Monetary Policy – August 2008 International and Foreign Exchange Markets

International financial markets have been primarily affected by two factors over the past three months: a further intensification of credit strains, particularly related to the health of the US financial system, and rising inflation. These factors have contributed to a significant decline in global equity markets, as well as greater expectations of policy rate increases in a number of economies, particularly in emerging markets.

Credit and money markets

The deterioration in the US housing sector and the poor performance of securities backed by residential mortgages continue to have a negative impact on the US financial system and global markets more generally. Delinquencies and foreclosures for both sub-prime and prime loans rose further in the first quarter of 2008 (Graph 11) and data released since the last Statement indicate that delinquency rates on US mortgages originated in 2007 are at a higher level than earlier vintages and are on an upward trend, suggesting that further rises are in prospect (Graph 12).

These problems have resulted in the failure of a number of smaller financial institutions in the United States recently. They have also contributed to the downgrading of the credit rating of several large financial institutions and the two largest monoline insurers, MBIA and Ambac. While some of the major financial institutions that have reported earnings for the June quarter have recorded somewhat better than expected earnings, they have all booked further credit-related write-downs. These write-downs have included greater provisions for loans originated by the institutions themselves rather than for greater exposure to structured products which had been the primary cause of write-downs in earlier quarters. To date, around US$500 billion has been written down by global financial institutions. Against this, around US$360 billion in new capital has been raised (Graph 13).

In the United States, speculation over the solvency of the two government-sponsored enterprises, Fannie Mae and Freddie Mac, led to heightened concerns about the stability of the financial system in early July. To quell fears over the viability of the agencies, US authorities announced a plan that involved an increase in the line of credit at the Treasury, access to Federal Reserve funds at the discount rate and authorisation for the Treasury to buy shares in both companies as a last resort to shore up their capital adequacy. Nonetheless, the Treasury Secretary reiterated that the agencies would remain in their current form as privately-owned corporations.

In late July, the Fed announced further changes to increase the flexibility of its liquidity operations (see Box A in the May 2008 Statement). These measures include: extending the Primary Dealer Credit Facility (PDCF) and the Term Securities Lending Facility (TSLF) to January 2009 from September 2008; introducing options on loans of Treasury securities under the TSLF of up to US$50 billion in addition to the current limit of US$200 billion; and extending the maximum maturity of its Term Auction Facility (TAF) loans to three months from the existing 28 days. Reflecting the changes to the TAF, the terms of the European Central Bank's (ECB) and the Swiss National Bank's US dollar auctions have been lengthened, and the Fed's swap line with the ECB has been increased to US$55 billion from US$50 billion.

The fragility of credit markets was reflected in another sharp run-up in credit default swap (CDS) premia to mid July (Graph 14). However, CDS premia remain lower than their peak at around the time of the Bear Stearns failure in March. Despite unsettled conditions in credit markets, risk premia in money markets have generally improved (Graph 15). The spreads on London Interbank Offered Rates (LIBOR) for the euro and pound sterling have narrowed noticeably since the last Statement.

Reflecting the credit turmoil, mortgage rates remain high in several major countries despite, in some cases, an easing in monetary policy. In both the United States and the United Kingdom, mortgage-related credit growth has slowed noticeably from its rapid expansion in 2007 (Graph 16). In the United States, housing credit has begun to contract outright. While it remains difficult to separate the extent to which the slowing in mortgage credit is attributable to supply-side factors or a decline in the demand for funds, both elements are likely to have played a role.

Monetary policy

Since the previous Statement, the focus of financial markets in developed economies has fluctuated between concerns about credit markets and growth prospects on the one hand and the risk of higher inflation outcomes driven by rising food and energy prices on the other. Accordingly, policy rate expectations have varied quite considerably. Inflation concerns have been even more prominent for emerging economies, where energy and food constitute a larger portion of consumer spending. As a result, central banks in many of these economies have raised interest rates during the period.

In the United States, the Federal Open Market Committee kept its policy rate unchanged at 2 per cent at its June and August meetings. The June meeting was the first at which rates were left on hold since September last year after cumulative reductions of 325 basis points. The statement accompanying that decision, and subsequent speeches, indicated that policy-makers were becoming more concerned about upside risks to inflation and inflation expectations amid diminishing downside risks to growth. The market's expectations for rate rises consequently increased, with as much as three increases by the end of 2008 being priced in at one point. These expectations were subsequently pared back substantially, such that one 25 basis point rate increase is currently expected over the next six months (Table 2, Graph 17).

The ECB raised its policy rate by 25 basis points at its July meeting, the first change to rates since June last year, as inflation in the euro area rose to its highest in over 10 years. However, market expectations for further rate increases have been scaled back recently so that no further change to the policy rate is expected for the next six months. Elsewhere in Europe, the central banks of Norway and Sweden raised their policy rates by 25 basis points, to 5¾ per cent and 4½ per cent respectively. In contrast, the Swiss National Bank left its policy rate unchanged at 2¾ per cent after judging that the current increase in inflation was likely to be transitory (Graph 18).

The Bank of Japan has kept its policy rate unchanged at ½ per cent since the previous Statement, and the market continues to expect the policy rate to remain unchanged in the coming months. The Bank of England also kept its policy rate unchanged at 5 per cent over the past three months, having cut rates by a cumulative 75 basis points since December last year. The market currently does not expect any change to the policy rate in the next six months. The Bank of Canada similarly kept its policy rate unchanged and the market currently expects one 25 basis point easing over the next half year.

In contrast, the Reserve Bank of New Zealand (RBNZ) cut its policy rate by 25 basis points to 8 per cent in July. The RBNZ noted that the current reasonably tight policy settings have already restrained activity and inflation, and stated that it expects to lower the policy rate further. This has led the market to price in three more 25 basis point cuts in the next six months.

Inflation remains a primary concern in most emerging market economies, many of whom have raised interest rates since the previous Statement (Table 3). These include Brazil, Chile, Hungary, India, Indonesia, Israel, Mexico, the Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey. In addition, the central banks of China and India have raised their reserve requirements a number of times over the past three months as inflation in the two countries rose to multi-year highs.

Bond yields

Government bond yields for major economies have been volatile since the last Statement, reflecting the conflicting forces of heightened inflation concerns on the one hand and increased credit market tensions on the other.

US bond yields had increased in June by around 100 basis points from their trough in March, following comments from Fed officials highlighting further upside risks to inflation from high commodity and food prices (Graph 19). However, this trend was partially reversed as the focus shifted to credit market concerns. The yield curve in the United States has flattened since the last Statement, with yields on 2-year debt rising more sharply than longer-term yields. German government bond yields have also risen since the last Statement and have broadly followed similar trends to those in the United States. In contrast, Japanese yields were lower over the period.

While spreads on corporate debt moved broadly sideways throughout May and June, further credit market disturbances in July have seen investor appetite for high-yield debt diminish again. This has put upward pressure on spreads, although they remain below the peaks seen in March. Corporate yields have picked up as renewed volatility in credit markets has added to default risk, especially on sub-investment grade debt (Graph 20).

Corporate bond issuance in the United States was a little higher in the June quarter than it had been in the March quarter but remains at a low level. Issuance of mortgage-backed securities by non-agency issuers in the United States has remained very weak in the first half of 2008 (Graph 21). While the issuance by agencies has become more important over this period, it has only offset part of the slowing in overall issuance.

Spreads on US dollar denominated sovereign debt in emerging Asia, Europe and Latin America rose substantially in June and July, as rising inflation placed upward pressure on yields. East Asian local currency denominated bond yields have also risen, albeit from low levels (Graph 22). With inflation continuing to accelerate across the region, this has resulted in declining real interest rates.

Equities

Global equity markets have fallen considerably since the last Statement, with broad-based weakness across industries in both developed and emerging markets (Table 4). The financial sector suffered the largest declines amid further large write-downs and costly capital raisings, particularly in the United States and Europe (Graph 23). However, share prices in the industrial and consumer-related sectors also fell significantly, reflecting expectations of slower economic growth, high oil prices, and increasing interest rates. These pressures were most notable in east Asia, Europe and the United States.

Foreign exchange

The US dollar remained around the low levels prevailing at the time of the last Statement. On a real trade-weighted basis, the US dollar remains around the low reached in 1995, and in nominal terms is just above the three-decade low reached in March this year (Graph 24, Table 5). Over the past three months, the US dollar is little changed against the euro but has appreciated against the yen, reflecting the movements in policy rate expectations that occurred in the three areas (Graph 25).

The performance of emerging market currencies against the dollar was mixed. Several east Asian currencies depreciated sharply over the first half of the year as the inflation outlook deteriorated (Graph 26). Foreign exchange reserves have fallen in a number of countries, most notably in South Korea, indicating that monetary authorities in the region are actively intervening to support their currencies. In contrast, the Brazilian real and Mexican peso have appreciated against the dollar due to high commodity prices and several rate rises. The Chinese renminbi has also appreciated against the dollar.

There was speculation in June that the Vietnamese dong would be forced to devalue significantly. Much of this speculation was centred on the macroeconomic imbalances faced by Vietnam, including high inflation, negative real interest rates and a rapidly widening current account deficit. The government has taken some steps toward addressing these problems, including devaluing the currency by 2 per cent, widening its daily trading band and raising interest rates. These measures have helped improve sentiment toward the currency, with pricing in the non-deliverable forward market now indicating that the dong is expected to depreciate by around 15 per cent over the coming year, compared with 30 per cent a month ago.

Australian dollar

The Australian dollar has depreciated against most major currencies since the last Statement (Graph 27, Table 6). In mid July, the Australian dollar reached a post-float high against the US dollar of just over 98½ cents, boosted by the further rise in the terms of trade in Australia stemming from strong price increases for bulk commodity exports, including coking coal, thermal coal and iron ore. On a trade-weighted basis the dollar reached its highest level since February 1985 and is currently around 19 per cent above its long-run average. Since mid July the Australian dollar has depreciated as commodity prices have declined from their recent peaks and expectations for the future path of monetary policy in Australia have changed.

Australian dollar volatility has declined marginally since the last Statement. Despite this fall in daily volatility, intraday ranges have remained somewhat elevated, with the Australian dollar trading in a daily average range of slightly over 0.9 cents since the last Statement (Graph 28).

The strength of the local currency has been reflected in significant capital inflows, particularly in debt and money market instruments. It is also evident in net long speculative positions in Australian dollar futures at the Chicago Mercantile Exchange which have remained elevated since the previous Statement.

With the Australian dollar reaching historically high levels on a trade-weighted basis and against the US dollar in mid July, the Bank has continued to purchase foreign exchange since the last Statement. The Bank has made net foreign exchange purchases of around $620 million over this period, in line with the rate of increase over recent years, with net reserves increasing to around $36 billion.