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....BIS

BIS Quarterly Review, March 2016       

Turbulence extends as markets focus on banks

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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 (Graph 6, left-hand panel) 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 (see Box 1).

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, 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 (Graph 1, right-hand panel). 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 (Graph 6, right-hand panel).

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 previous week, the ECB left its monetary stance unchanged but announced a review in March, with markets regarding further accommodation as more likely. 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. The BoJ thus joined the ECB and the Swiss National Bank in imposing negative rates on bank reserves (Graph 7, left-hand panel).4

The BoJ decision had an outsize effect on financial markets. 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 (Graph 7, right-hand panel). 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. 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.

These developments resulted in large swings in the extent of the divergence that market expected between G3 monetary policies going forward. A simple measure compares the expected average overnight rates over one year in the United States with the corresponding averages for the euro area and Japan (Graph 8, left-hand panel). This measure of policy divergence rose in late 2015 on the way to US lift-off, and declined in January as markets reduced their expected pace of US tightening. With the BoJ's foray into negative rates, however, the expected divergence widened again relative to the United States. Roughly in line with the divergence in monetary policies across the major currency areas, cross-currency basis swap spreads widened against the dollar, by about 15 basis points in the case of the yen, and by 8 basis points for the euro (right-hand panel).5

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 (Graph 9, left-hand panel). US banks also underperformed the S&P 500 index by 10% since early January, but Japanese banks plunged 15% vis-à-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 (Graph 9, centre panel). 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 (Box 2).

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 (Graph 9, right-hand panel). Price-to-book ratios slid further during the turmoil, but the persistent gap between European and Japanese banks vis-à-vis their US peers remained. Banks' reluctance to pass negative rates on to depositors contributed to the gradual erosion in net interest income (Box 2).6 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.

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