Monetary and capital markets

Economic and monetary divergence
As we reach the end of 2010, the different points at which advanced and emerging economies find themselves in the cycle is becoming moremarked.Moreover, the outlook for 2011 is that developed countries will continue to see sluggish growth while emerging countries will only slightly slow up the good pace they’ve enjoyed throughout 2010. Notable differences can also be seen in inflation.

Within this context, industrialized countries are very likely tomaintain a lax monetary policy while less developed countries will continue restricting theirs. The economy of the United States, which has accumulated a high negative output gap (the difference between effective and potential GDP) and low inflation, is one of the key players within this scenario of contrasts. The latest actions to be taken by the Federal Reserve (Fed) are framed within this complex situation. At its meeting on 3 November, the Fed took a far-reaching decision: to extend its quantitative easing (QE2), announcing a lower amount than for 2009 with a flexible monthly calendar and dependent on how economic activity develops. In fact, the reserve bank stated that the QE2 has a dual priority: to support the revival in growth and sustain price stability, preventing the economy fromfalling
into deflation.

The strategy that the institution presided over by Ben Bernanke has decided to follow has both supporters and critics. The latter argue that themeagre economic benefit does not offset the high risk of inflation incurred. In this respect, importantmembers of the Fed have countered these criticisms by reminding detractors that the institution has the necessary instruments (such as the capacity to remunerate surplus reserves, reverse repos and termdeposits) to toughen upmonetary conditions without the need to reduce the size of its balance.

The greater liquidity provided by the QE2, together with additional regulatory and supervisorymeasures (for example, the Fed’s guidelines to banks regarding the payment of dividends and share buybacks) help to contain and consolidate counterparty risk premia in the interbankmarket. This supports the stable behaviour seen in the Libor dollar interest rate, expected to continue in the short andmediumterm.

The case of the euro area is different to that of the United States, as although the region is growing below its potential, it does not face any serious deflationary risk. For this reason, statements by the members of the European Central Bank (ECB) have kept on the same lines and arguments of the last fewmonths. The

monetary authority has hinted that it will continue to gradually remove exceptional stimuli to provide liquidity and support for credit during the first quarter of 2011.

Given that, apparently, the financial problems facing Ireland will be resolved through the European Financial Stability Fund (governmental bailout fund), the ECB will havemoremargin to remain on its course. In any case, several spokespeople for the reserve bank have repeated that the reference rate could be raised before the financial schemes have been completely withdrawn, although themarket does not think this option very likely.

Within a scenario where the ECB is not hinting at any substantial changes and in whichmost of the surplus liquidity has already been drained off (October’s LTRO), the Euribor interbank interest rates are unlikely to vary significantly over the coming months. In themedium term, European interbank rates will probably rise gently as the central bank carries out additional adjustments to liquidity or clearly indicates that it will start to raise the official rates.

Lastly, this panorama of global divergence is completed with several emerging economies. Countries such as China, Brazil, South Korea, India and Chile have recorded strong economic growth and a significant upswing in inflationary risks. The response of their national central banks has been to raise official interest rates to keep these pressures under control.

China particularly stands out due to how much effect itsmonetary policymight have globally. Once China’s annual inflation rate was found to be 4.4%, the central bank increased the ratio for mandatory reserves by 100 basis points in the first half of November. One latent risk would be the reserve bank toughening up its monetary policy toomuch, thereby increasing the risk of a bumpy economic landing.

The Irish sovereign debt crisis is resolved
During themonths of September and October, the financial sovereign debt crisis in the euro area seemed to have slackened, only to reappear with twice the virulence in November. The epicentre of this earthquake was in Ireland. Two factors led to this stormin the financial markets. Firstly, the London Clearing House (LCH), with Clearnet asking for greater guarantees in repo operations involving Irish public debt. A clearing house acts as the counterparty for the parties to a contract and determines, on a daily basis, the guarantee deposits

for open positions, finally settling contracts at maturity.When it increased the guarantee requirements, several Irish banks found it difficult to meet these conditions. Given this situation, they were forced to sell part of the Irish sovereign bonds in their portfolios and therefore pushed up yields.

The second element that led to sales of Irish bonds was the uncertainty regarding possible reductions for public debt holders fromthe euro area in the case of a bailout. The result was a fall in the price of bonds and a rise in yields, with Irish 10-year bonds having a yield of 8.9%.

To calmdown investors, Finance Ministers from the euro area issued a memo denying that, in the case of the bailout mechanism being activated for amember of the European Union, the private sector would lose on any
sovereign debt already issued. This managed to pacify the markets for a few days but it didn’t stop fears from ultimately spreading to the sovereign debt of other countries in the euro area, such as Portugal and, to a lesser extent, Spain.

Although Ireland has enough liquidity to meet its public debt payments up to mid-2011, its financial systemis in a difficult situation. In fact, the extensive bad debt suffered by Irish banks and the government’s financial effort to inject capital convinced the European Union that it was necessary to draw up a bailout plan for the country. Inmid-November, experts from the International Monetary Fund, in combination with those from the European Union and the European Central Bank, went to Ireland in person to design the bailout plan. Finally Ireland, after Greece, is the second country in the euro area to officially ask for aid from the European Union. The Irish Finance Minister, Brian Lenihan, confirmed that part of themoney will be channelled towards the financial systemthrough a contingent capital fund.

Yields also rose slightly on United States debt. For example, the interest rate for 10-year Treasury bonds rose from2.6% at the end of October to amaximumof 2.96%on 16 November. This increase is not due to greater sovereign credit risk or to a rapid deterioration in the inflation expectations of economic players, which
are still reasonably anchored. There are two elements that explain thismovement.

The first relates to mere profit-taking after the announcement that the Fed would extend itsmonetary policy. The second relates to the encouraging improvement in the situation of US consumers, confirmed by retail sale
figures for October. Both factors helped to raise debt interest rates to levelsmore in line with the economic situation.

These reasonsmean that we can rule out any change in trend in sovereign debt interest rates for the United States.What is most likely is that, over the next few months, the current rates will fluctuate although they’re unlikely to return to the low levels reached this year. In the medium term, and depending on the economic expansion, there should be a slight upward trend. Lastly, it should be noted that, in the long term, insufficient fiscal adjustment in the United States might push its sovereign debt interest rates upmore quickly.

In the case of the euro area’s public debt, and after the strong signal from the European Union that it will do everything required to bail out those member countries that need it, over the coming months the tensions in the
region’s debt should decrease, although theremay be some specific disturbances.

In the long term, the outlook is a gentle upward trend in sovereign debt yields for the region as a whole. Much ado about nothing in the currency markets Since the start of the year, there have been many official statements bymanagers of economic policy around the world on the level of exchange rates.

During the last fewmonths, the press has even called this situation a «currency war», although volatility has hardly increased in the currencymarket, in spite of thismedia scenario. Certainly, the «war» has been perceived in the press’s headlines but the impact on themarkets and the economy has been small, as shown by the latest growth figures for international trade published by the World Trade Organization.

Even the absence of any specific agreement at the G-20 summit, held in South Korea on 11 and 12 November, regarding exchange rate coordination has not led to any sharpmovements in themain exchange rates, beyond the ranges considered normal by economic players.

This does notmean that exchange rates have been stationary. Although, after the Fed announced its QE2 policy, the dollar lost value against the euro, the Irish crisis then had the opposite effect. The graph below shows this to-ing and fro-ing. Whereas, at the end of October, one euro was worth 1.39 dollars, it started to rise in value until reaching 1.42 dollars (4 November), later returning to the level of 1.35 dollars bymid-November.

Over the next 12months, the approach taken by Asian countries and particularly China will be decisive.We expect their currencies to appreciate steadily, which will allow the euro-dollar exchange rate to be determined essentially by the relative economic andmonetary fundamentals of both regions. Taking these factors into account, the euro is likely to stay around its current value over the next fewmonths.

Corporate bonds with and without bubbles
Within a context of global economic recovery and expansionarymonetary policies in developed countries, corporate bonds continue to performwell, i.e. recording price increases and reductions in yields. This cycle is singular because the rapid drop recorded in yields in the emerging countries has been similar to or greater than the one in developed economies, as the latter are affected by large fiscal deficits or foreign debt.

Recently, the Fed’s QE2 announcement has boosted the appetite for higher risk assets and,more specifically, corporate bonds. Thesemeasures are pushing flows frommonetary assets towards corporate bond assets and have led to an additional reduction in credit spreads and a drop in yields to record lows in various sectors,
as a consequence of strong buyer pressure among investors.

Within this scenario of high liquidity and fund availability in the world’s capital markets, together with low interest rates in money markets, managers are diversifying their strategy and making room in their portfolios
for securities from new issuers with lower credit quality but higher yields.

Surprisingly, the sovereign debt crisis in the euro area is hardly altering the continual flow of funds towards corporate bonds. Rather it seems as if the opposite is happening, as investors believe that corporate bonds are safer, given the uncertain developments in public debt.

Due to the scarcity of public debt from emerging countries, their corporate bond markets also offer an attractive riskreturn ratio. Consequently, institutional investors have gradually improved their perception of these economies’ capital markets, considering themto bemore stable and safer, as opposed to unstable
sovereign debt of some developed countries.

Given the consolidating pattern of economic recovery, the outlook for corporate bonds is favourable. On the one hand, future expectations of profit are positive; on the other, the result of the restructuring and financial
deleveraging of firms is also helping to reduce credit risk. For these reasons, large firms with access to corporate bond markets havemanaged to refinance their debt at very low interest rates, while this fall in financial cost should also boost company accounts.

Although risk premia will probably continue to fall, which would strongly support this family of financial assets, two reservations should be made. Firstly, there are signs of overheating in some corporate bond segments and we can’t rule out possible declines at times of uncertainty, be it global or local.

Secondly, the conditions suggest that the good performance of corporate bonds compared with the stockmarkets will not be repeated in 2011.

Stock markets: good prospects in spite of the risks
In November, themajor stockmarkets were characterized by divergences and erraticmovements, as seems to have been the predominant tone since the start of the year. Strong upward trends have been the name of the game in the indices of the United States and emerging economies, as a result of expectations of economic growth and monetary policy measures. However, European markets have been caught up in another rise in uncertainty given the delicate financial situation of Ireland and Portugal, although the euro area’s economic
forecasts have not worsened.

In themediumterm, the outlook for international equity is still positive, although analysts don’t rule out further reductions in the short termdue to factors such as amore restrictive monetary policy in China or the sovereign debt crisis in the euro area.

The expected improvement in economic activity, rising profits and acceleration in announcements ofmergers and acquisitions, as well as less defensive strategies on the part of large listed firms, point towards equity performing well in the future.

The greater fall in European stock markets, and especially the Spanish stockmarket, has pushed indicators to more attractive levels. Consequently, and in themediumtermas the sovereign debt crisis abates in the euro area, the gap should narrow between European equity prices and those in the United States and emerging countries.
Full report: Monetary and capital markets