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BIS Paper: Optimism evaporates

BIS Paper: Optimism evaporates

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Published by: AlternativeEconomics on Jun 04, 2012
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BIS Quarterly Review, June 2012
1
 
Optimism evaporates
1
 
Hopes for the global economic recovery and concerns about the euro areawere the two main competing themes in the marketplace in the period fromMarch to May. These two themes interacted throughout and were broadlyreflected across financial markets.Early in the period, following the ECB’s longer-term refinancingoperations, investor sentiment improved substantially. With bank fundingstrains reduced, the focus shifted to the strength of the global economy.Positive US economic news and the continued resilience of emerging marketgrowth helped raise hopes of a steady economic recovery. The renewedoptimism was particularly visible in equity and commodity markets. Fixedincome markets saw a compression in credit spreads, especially for banks andselected euro area sovereigns. It also resulted in a spurt of capital inflows toemerging markets.But by the middle of May, doubts had returned: doubts about euro areagrowth; doubts about the financial health of euro area sovereigns; doubts aboutbanks; doubts about the impact of fiscal consolidation on growth; and finally,doubts about political stability inside the euro area. All of this, combined withearly signs of more fragile US and Chinese growth, made investors morecautious and drove up global financial market volatility.
Short-lived optimism about the recovery
The ECB’s special longer-term refinancing operations (LTROs) successfullyreduced the perceived risk of a severe banking crisis in Europe. By earlyMarch, the scale of the combined liquidity injection in the two operations hadproduced a noticeable impact across financial markets. Concerns about severedownside risks of market participants faded and investors’ risk appetitegenerally picked up.The temporary improvement in risk sentiment was also clearly reflected inthe implied volatility of equity options. After having been elevated during the
1
Questions related to this article should be addressed to Jacob Gyntelberg(jacob.gyntelberg@bis.org) and Andreas Schrimpf (andreas.schrimpf@bis.org). Questionsabout data and graphs should be addressed to Magdalena Erdem(magdalena.erdem@bis.org) and Garry Tang (garry.tang@bis.org).
 
 
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BIS Quarterly Review, June 2012
 
latter part of 2011, the VIX reached its lowest level since June 2007 (Graph 1,left-hand panel) on 19 March.Funding conditions for euro area banks improved significantly as theybenefited from the second instalment of the ECB’s longer-term operations on29 February. With a take-up of €530 billion for three years at the average policyrate over the duration of the loans (currently 1%), the LTRO funds helpedfinancial institutions with funding difficulties cover maturing debt. As riskperceptions eased, European and US bank credit spreads fell, at leasttemporarily. The decline in spreads was most pronounced for lower-ratedbanks (Graph 1, centre panel). The successful easing of funding stress washighly visible in money markets, where Libor-OIS spreads tightened by around60 basis points in the euro market and by around 20 basis points in the USdollar market (Graph 1, right-hand panel).The improvement was also visible in the primary market for long-termunsecured bank bonds, which reopened temporarily at the beginning of theyear. This funding channel had been closed for a large number of euro areabanks in the second half of 2011. Many banks from the euro area periphery,however, continued to rely heavily on covered bonds and government-guaranteed bonds for funding (see the box on page 20). The overall benignmarket conditions in March also helped ensure a smooth completion of the€200 billion Greek debt swap. This took place in the second week of Marchwith very limited impact on other European sovereign bond and credit defaultswap (CDS) markets. The debt swap triggered payouts on a moderate amountof outstanding CDS written on Greek government bonds. These were settledwithout difficulty, thus removing earlier investor concerns about theineffectiveness of hedging sovereign risk via CDS contracts.The spurt of euro area optimism driven by policy actions and growthexpectations provided temporary relief for policymakers and investorsconcerned about the outlook for euro area sovereigns. Yields on both Spanishand Italian government bonds declined significantly (Graph 2, left-hand panel).
Asset prices in global markets
Equity implied volatilities
1
Credit spreads for financialinstitutions
2, 3
Three-month Libor-OIS spreads
2
01530452010 2011 2012VIX (S&P 500)VSTOXX (DJ EURO STOXX)
 
02004006002010 2011 2012AA-ratedA-ratedBBB-rated
 
02550752010 2011 2012US dollarEuroPound sterling
1
Volatility implied by the price of at-the-money call option contracts on stock market indices, in per cent.
2
In basispoints.
3
Option-adjusted spread on Merrill Lynch Global Broad Market Financials index.Sources: Bank of America Merrill Lynch; Bloomberg; Datastream. Graph 1
Italian and Spanishspreads fall… and ease bankfunding conditionsPolicy actions spuroptimism …
 
 
BIS Quarterly Review, June 2012
3
 
This may in part reflect large bond purchases by Italian and Spanish banks inboth primary and secondary markets following the ECB’s LTRO. Spanish andItalian sovereign credit spreads also fell as investor fears subsided (Graph 2,centre panel). The more positive view was similarly reflected in the slope of thecredit risk curve, which became less flat (Graph 2, right-hand panel). Theimprovement was particularly strong for Italy, with the Italian credit curveregaining its positive slope after having been inverted during the last two tothree months of 2011.
Improved global economic outlook 
As euro area strains eased, market participants focused on the global growthoutlook. Positive news about the US economic recovery led market participants
Global growth outlook and patterns
2012 growth forecasts
1
Emerging market economies
3
Purchasing managers’ indices
7
 –1.50.01.53.04.5
United Euro Asia- Latin EmergingStates area Pacific
2
America Europe
Nov 2011Feb 2012May 2012
 
 –10 –505102009 2010 2011 2012 2013Latin America
4
Other emerging Asia
5
Central and easternEurope
6
China
 
20304050602009 2010 2011 2012United StatesEuro areaEmerging markets ex China
8
China
1
Consensus forecasts, in per cent.
2
Excluding Japan.
3
Annual changes in real GDP, in per cent. Actual (quarterly) data up to2011. Forecasts for full-year 2012 and 2013 growth are shown as dots.
 
For regions, weighted averages based on 2005 GDP and PPPexchange rates.
4
Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela.
5
Hong Kong SAR, India, Indonesia, Korea,Malaysia, the Philippines, Singapore and Thailand.
6
The Czech Republic, Hungary, Poland, Russia and Turkey.
7
Levels above(below) 50 indicate an expansion (contraction).
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Hong Kong SAR, Hungary, India, Mexico, Russia, Singapore, South Africa andTurkey.Sources: Bloomberg; © Consensus Economics; national data; BIS calculations. Graph 3
Euro area sovereign bonds and CDS
Bond yields
1
Credit spreads
2
Credit curve steepness
3
024682011 2012FranceItalyNetherlandsSpain
 
01252503755002011 2012
 
 –100 –500501002011 2012
1
Five-year government bond yields, in per cent.
2
Five-year CDS, in basis points.
3
Difference between 10-year CDS and two-year CDS spread, in basis points.Sources: Bloomberg; Markit; BIS calculations. Graph 2
 
Recovery optimismtakes hold

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