The deteriorating global backdrop and central bank actions nurtured market expectations of further reductions in interest rates and fuelled concerns over bank profitability...BIS

6 March 2016                                     Press Release

BIS Quarterly Review, March 2016

International banking and financial market developments  (USA)

The Federal Reserve's interest rate lift-off in December did little to disturb the uneasy calm that had reigned in financial markets in late 2015. But the new year had a turbulent start, featuring one of the worst stock market sell-offs since the financial crisis of 2008.

At first, markets focused on slowing growth in China and vulnerabilities in emerging market economies (EMEs) more broadly. Increased anxiety about global growth drove the price of oil and EME exchange rates sharply lower and fed a flight to safety into core bond markets. 

The turbulence spilled over to advanced economies (AEs), as flattening yield curves and widening credit spreads made investors ponder recessionary scenarios.

In a second phase, the deteriorating global backdrop and central bank actions nurtured market expectations of further reductions in interest rates and fuelled concerns over bank profitability. In late January, the Bank of Japan (BoJ) surprised markets with the introduction of negative interest rates, after the ECB had announced a possible review of its monetary policy stance and the Federal Reserve issued stress test guidance allowing for negative interest rates. On the back of poor bank earnings results, banks' equity prices fell well below the broader market, especially in Japan and the euro area. Credit spreads widened to a point where markets fretted about a first-time cancellation of coupon payments on contingent convertible bonds (CoCos) at major global banks.

Underlying some of the turbulence was market participants' growing concern over the dwindling options for policy support in the face of the weakening growth outlook. With fiscal space tight and structural policies largely dormant, central bank measures were seen to be approaching their limits.

US monetary policy lift-off

On 16 December, the Federal Reserve raised the target range for the federal funds rate, after eight years of monetary policy easing across the major currency areas. Even after the increase, the US monetary policy stance remained highly accommodative: the increase in the federal funds target range was minimal - 25 basis points - and the stock of assets acquired over years of large-scale asset purchases was left unchanged. In real terms, the US policy rate had been negative since 2008 (Graph 1, left-hand panel). The Federal Open Market Committee (FOMC) signalled that the shortfall of inflation below its 2% objective, and uncertainty surrounding economic conditions more broadly, were expected to warrant only gradual increases in the federal funds rate. Nonetheless, the decision marked a turning point in an era of extraordinary monetary accommodation.

Tensions in high-yield bond markets

Ben Cohen and Gianpaolo Parise

The high-yield debt market was subject to significant tensions in 2015. The BofA Merrill Lynch US High Yield Index fell 4.6% and high-yield credit spreads exceeded 5% in Europe and 7% in the US (Graph A). At the end of 2015, market turbulence affected a number of specialised investment funds and severe investor redemptions forced them to try to unload illiquid assets as prices plunged. In the second week of December, the Third Avenue Focused Credit Fund stopped fulfilling investor sell orders and announced plans to liquidate its whole portfolio in an orderly fashion within one year. In the days following the events at Third Avenue, other high-yield oriented funds, including funds managed by Sunlion Capital Partners, Lucidus Capital Partners and Whitebox Advisors, either suspended redemptions or set plans to liquidate their holdings.

As the difficulties on the demand side of the market emerged, the issuance of new high-yield securities slowed. While corporate bond issuance remained strong, issuance in the high-yield segment contracted, particularly in the second half of the year. From a low of $98 billion in 2008, high-yield debt issuance had exceeded $400 billion annually in 2013-14, before falling to $334 billion in 2015 (Graph B).

The ongoing turmoil in the energy sector is central to explaining the tensions experienced by high-yield debt securities. The Merrill Lynch HY Energy Index plummeted in 2015, underperforming both US Corporate High Yield and Emerging Markets High Yield indices. Even though previous crises have also inflicted substantial losses on high- yield securities, the tensions in the energy sector are specific to the most recent period (Graph C). An increasing number of defaults toward the end of 2015, however, hints at the possibility of broader fragilities (Graph C, right-hand panel).

One interpretation of recent events is that the high-yield rout is an isolated development, driven by US oil industry weakness; another is that this is a "canary in the coal mine" moment signalling broader fragilities. Recent experience, supported by academic research, suggests that sharp increases in credit spreads are a leading indicator of recessions. This is the case even when wider spreads initially reflect sector-specific strains: high-yield credit spreads started to rise in the technology sector at the beginning of 2000, just before the burst of the tech bubble (Graph C, left-hand panel), while financial sector high-yield spreads rose in 2007, before the Great Financial Crisis (centre panel). Spreads of other risky securities in these episodes only started to widen when the broader economy turned down. 

More recently, while spreads have widened dramatically since the second quarter of 2015 in the energy sector, other credit spreads, including those on emerging market corporate debt, have crept up much more gradually (right-hand panel).

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Press officers are Margaret Critchlow and Bettina Eberhard. Lisa Weekes heads the press office.

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