## FINANCIAL MARKET UPDATE June 2004 ## Source details **Canonical URL:** [FINANCIAL MARKET UPDATE June 2004](https://www.imf.org/-/media/files/publications/fmu/0604.pdf) ## Other formats - [Markdown version](/-/media/files/publications/fmu/0604.pdf.md) - [Structured JSON version](/-/media/files/publications/fmu/0604.pdf.json) --- ### Overview - Data as of June 15, 2004. - Changing expectations for the pace and timing of the U.S. tightening cycle have had a profound effect on global investor sentiment, positioning, asset prices, and credit spreads. - Since early 2004, the prospect of higher short-term interest rates has made investors more cautious and triggered deleveraging across a wide range of markets; the process has been orderly without posing a threat to financial stability or financial intermediaries. - Transition to a higher interest rate environment is viewed as welcome and healthy amid a strengthening global recovery; earlier unwinding of leveraged positions should help remove risk of a sharper market correction later. - If inflation is higher than expected, the extent and duration of the tightening cycle would be much less certain and could lead to an overshooting of bond yields and credit spreads and a further deterioration in the external financing environment for emerging market countries. Major factors explaining relative calm in markets adjusting to higher U.S. short-term rates: - The U.S. Federal Reserve’s clear communication of its intentions has resulted in anticipatory, orderly adjustments to speculative positions. - Strong growth and rising corporate earnings, and strengthened corporate balance sheets (particularly in the United States, and to a lesser extent in Europe) have supported equity and corporate bond prices. - The persistent output gap in major economies has limited inflationary pressure to date and moderated expectations for the pace and degree of tightening in the United States and Europe; however, higher oil prices and reemerging corporate pricing power are raising concerns. Speculative positioning and carry trades in 2003–early 2004: - Carry trades exploited the steep yield curve using the repo and swaps markets to fund positions in longer term U.S. treasury securities and mortgage-backed securities. - Leveraged positions established in the U.S. high-yield corporate bond market and in emerging market bonds aimed to profit from higher yields and steeply declining credit spreads. - Rapid growth in China and U.S. rebound fueled commodity demand and speculative interest in commodities. - In foreign exchange markets, higher yielding currencies in mature and emerging markets tended to appreciate as investors reached for yield; the U.S. dollar was the preferred funding currency. - Asian equity markets experienced speculative inflows, with many small and relatively young hedge funds contributing to leveraged positions in local stock markets. Market developments since mid-March 2004: - Partial unwinding of speculative positions has hit riskier assets hardest, particularly high-yielding emerging market bonds. - Financing conditions for emerging market borrowers are likely to remain less accommodating than in 2003 and early 2004. ### Key Risks to the Outlook - An unanticipated increase in inflationary pressure could call into question the pace of short-term interest rate hikes currently discounted in the market and potentially result in market turbulence; a faster than anticipated closure of the output gap could trigger concerns that the Fed had “fallen behind the curve”, causing yields and credit spreads to overshoot. - Geopolitical concerns are an imponderable risk factor; security concerns have put pressure on oil prices, and a spike in oil prices would dampen economic activity and pressure the external accounts of oil importers; geopolitical events unrelated to oil supply continuity could heighten risk aversion, widening credit spreads and lowering asset prices. - In emerging markets, rising short-term interest rates are likely to be associated with a less hospitable external financing environment and increased investor discrimination among borrowers; in an environment of higher funding costs and more restricted access to external financing, emerging market borrowers need to address factors underlying high debt levels and potentially unstable debt structures; countries facing political challenges to strong policies would be particularly vulnerable if higher-than-expected inflation pushed up mature market bond yields. - The orderly adjustment of global imbalances remains a medium-term challenge; large capital inflows needed to finance the U.S. external current account deficit and their heavy tilt toward U.S. bonds could, if reduced, result in higher bond yields and a weaker dollar, generating potential instability in currency markets with spillovers to other assets. ### Orderly Unwinding of Carry Trades Predicated on Measured Increases in Rates - The Fed has prepared the market for U.S. interest rates to be raised from exceptionally low levels at a measured pace; the stance of U.S. monetary policy is widely perceived to be at a turning point. - Markets are discounting with near certainty that the Fed Funds rate will be increased by 25 basis points at end-June. - Futures contracts suggest that the Fed Funds rate will reach at least 2 percent by year end. - Tightening is expected to be initiated or continue in other major financial centers: - Bank of England has raised rates four times since October 2003 to 4.5 percent; U.K. base rates are expected to continue to rise to 5-5½ percent by end-2005. - In the euro area, the market anticipates tightening to begin sometime in the first quarter of 2005; the pace of euro rate increases now discounted is relatively slow. - U.S. short-term interest rates are expected to exceed euro rates before the end of this year. - Markets expect Japan’s zero interest rate policy to be maintained, although yields on Japanese government bonds have increased in response to promising signs of stronger economic growth. - Longer-term government bond yields in major financial centers have increased significantly since the trough in mid-March; U.S. yields led the increase. - Futures markets and low implied volatility of options on longer-term U.S. interest rates suggest further increases in longer-term bond yields are expected to be modest. - Anticipated increase in short-term rates is expected to cause the U.S. yield curve to flatten; the U.K. yield curve is considerably flatter than those of the euro area and the United States. - The increase in nominal government bond yields since mid-March 2004 appears largely to reflect rising real yields; real yields on inflation-indexed bonds remain well below historical averages. - Inflation expectations continue to be subdued, although they have increased and remain above the actual rate of inflation; long-term yield increases will remain moderate so long as inflation expectations and the related inflation risk premium remain well anchored. Oil and commodity developments: - Oil prices were pushed to a record high in May (West Texas Intermediate Crude, U.S. dollars per barrel); fears eased with OPEC’s early June announcement of higher production quotas. - Non-oil commodity prices rose strongly in 2003 and early 2004 but fell precipitously on expectations that measures by China to restrain credit growth would dampen demand for commodity imports; the unwinding of speculative positions in commodity markets contributed to the decline in non-oil commodity prices. ### Currency Markets Respond to Stronger Growth and Unwinding of Carry Trades - Contrary to end-2003 expectations and notwithstanding large U.S. external financing needs, the dollar appreciated against other major currencies since early 2004; strong U.S. growth and anticipation of higher U.S. interest rates are main factors. - Large capital inflows needed to finance the U.S. current account deficit remain a continuing concern; the composition of flows—heavily skewed toward fixed-income securities—and the large share of U.S. government and corporate bonds held by foreigners raise the possibility that a sustained reduction in inflows could result in higher bond yields and a weaker dollar. - Speculative positions against the dollar have been reduced since end-2003, and expectations for currency market volatility have remained subdued. - Japanese intervention to stem yen appreciation was extraordinarily high in 2003 and early 2004; with the dollar appreciating, Japanese intervention ceased in mid-March. Commodity-driven currencies and emerging market FX: - The Australian, Canadian, and New Zealand dollars had experienced long rallies reflecting strong global growth and speculative pressures; as markets brought forward expectations for U.S. interest rate increases and questioned sustainability of strong commodity imports by China, speculative carry trades were reduced and these currencies gave back about a third of earlier gains. - Deleveraging affected emerging market currencies; speculative positions in non-deliverable forwards anticipating a de-pegging of the Chinese yuan appear to have been unwound. --- ### Mature Corporate Bonds: fundamentals and tightening prospects - Strengthening balance sheets, rising cash flows, and increased corporate profitability have underpinned improvements in credit quality in 2004. - Improvement in credit quality evidenced by ratings actions and declining corporate defaults. - Credit spreads on high-grade and high-yield corporate bonds in Europe and the United States remain narrow following marked compression in 2003 and early 2004. - Corporate bond spreads in mature markets typically narrow in the early stages of tightening cycles as improved earnings outweigh the prospect of higher funding costs. ### Equity markets and earnings - Mature equity prices have been supported by rising earnings and strengthening balance sheets. - Low implied equity option volatility in mature markets suggests investors see limited downside risk to equity prices. - Since last year, valuations have risen roughly in line with higher earnings; earnings in mature markets have tended to exceed analyst expectations. - U.S. Q1 corporate earnings were robust and broad-based, with particularly strong gains in the materials producing, technology, and finance sectors. - An unusually high share of S&P 500 earnings was attributable to the finance sector, which benefited from the proliferation of carry trades. - Japan equity markets have risen with signs of a deepening economic recovery. - Equity valuations, as measured by price/earnings ratios, are at or below averages since 1990, though that period includes bubble-era valuations. - Comparisons of U.S. equity earnings yield with 10-year government bond yields suggest favorable valuation levels. - Higher interest rates and input costs could put downward pressure on mature equity market valuations. ### Emerging market debt: repricing and investor flows - Expectations for abundant global liquidity were a key factor in the compression of emerging market bond spreads in 2003 and early 2004; revision of those expectations in 2004 led to significant spread widening. - Since the January 2004 Federal Open Market Committee, market expectations for the timing and speed of Fed tightening moved forward, and emerging market spreads widened some 100 basis points. - The sell-off gathered pace in April after U.S. employment data accelerated expectations of higher U.S. yields. - The sell-off led to a change in the investor base: speculative investors sharply reduced exposure. - Initial phase appears led by speculative trading accounts (such as hedge funds) unwinding highly leveraged positions. - Dedicated emerging market mutual funds experienced net outflows beginning in April and allocated larger portfolio proportions to cash; anecdotal signs of reinvestment of cash holdings emerged in early June. - Institutional investors generally remain committed to the asset class, with significant new funds in the pipeline. - The deleveraging process hit high-yielding, liquid credits hardest; the Brazilian component of the EMBI+ had the largest negative return year to date, reflecting high liquidity of Brazilian bonds favored for deleveraging. - The rise in credit spreads since early 2004 was broad-based, increasing cross-correlations of returns among emerging market debt. - The sell-off occurred despite generally improving credit fundamentals: rating upgrades exceeded downgrades for the third consecutive quarter in Q1 2004, and the share of credits with positive outlooks increased, notably in Eastern Europe influenced by EU accession in May. ### Emerging market issuance and market access - After an initial surge in issuance in Q1 2004, financing conditions for emerging market issuers deteriorated; the widening of spreads limited funding options, especially for higher-yielding issuers. - Bond market issuance slowed sharply from 2003 and from Q1 2004, when many issuers frontloaded funding programs due to low global rates and investor appetite. - Analysts estimate that by end-May 2004, emerging market sovereigns had completed some 60 percent of their bond issuance programs for 2004. - Since April, market access largely restricted to high-grade issuers; no new bonds issued by Latin American sovereign borrowers in the period described. - Several Asian borrowers delayed bond issues; signs of a moderate increase in issuance emerged since early June. - Equity issuance by emerging market borrowers slowed in Q2 2004; issuance remains heavily concentrated in Asia, with China accounting for half of all new emerging market equity issuance so far in 2004. - Syndicated lending surged in 2003 and early 2004 but primary market activity slowed sharply thereafter, with particularly tight access for Latin American borrowers. - Foreign direct investment (FDI) flows in Q1 2004 were higher than in Q1 2003; flows remained heavily concentrated on China. ### Quantified issuance and funding figures - Emerging market sovereign international new issuance for 2004, net (In billions of U.S. dollars): - Asia: Net requirement 5.1; Funded 2.5; Remaining 2.6 - Emerging Europe: Net requirement 20.1; Funded 11.2; Remaining 9.0 - Latin America: Net requirement 15.6; Funded 11.6; Remaining 4.0 - Middle East and Africa: Net requirement 4.4; Funded 3.6; Remaining 0.8 - Total: Net requirement 45.2; Funded 28.8; Remaining 16.4 - Percent of emerging market issuance needs covered for 2004: 64% ### Outlook, vulnerabilities, and investor positioning - Investors appear broadly balanced between those prepared to re-enter emerging market debt due to relatively attractive valuations and improved market technicals and those preferring to wait for firmer evidence that deleveraging has run its course. - Emerging market spreads versus comparably rated corporate spreads have returned closer to long-term averages after compressing to near historical lows in late-2003 and early 2004. - Surveys suggest investors are approaching historically low exposures relative to benchmark allocations. - A positive factor is heavy issuance success in Q1 2004, but the market remains vulnerable to: - Faster-than-expected U.S. rate hikes. - Unanticipated credit events in key emerging markets. *International Monetary Fund, Financial Market Update, data as of June 15, 2004.* ### Section 1 ### FINANCIAL MARKET UPDATE June 2004 — Section 1 ### Overview - Data as of June 15, 2004. - Changing expectations for the pace and timing of the U.S. tightening cycle have had a profound effect on global investor sentiment, positioning, asset prices, and credit spreads. - Since early 2004, the prospect of higher short-term interest rates has made investors more cautious and triggered deleveraging across a wide range of markets; the process has been orderly without posing a threat to financial stability or financial intermediaries. - Transition to a higher interest rate environment is viewed as welcome and healthy amid a strengthening global recovery; earlier unwinding of leveraged positions should help remove risk of a sharper market correction later. - If inflation is higher than expected, the extent and duration of the tightening cycle would be much less certain and could lead to an overshooting of bond yields and credit spreads and a further deterioration in the external financing environment for emerging market countries. Major factors explaining relative calm in markets adjusting to higher U.S. short-term rates: - The U.S. Federal Reserve’s clear communication of its intentions has resulted in anticipatory, orderly adjustments to speculative positions. - Strong growth and rising corporate earnings, and strengthened corporate balance sheets (particularly in the United States, and to a lesser extent in Europe) have supported equity and corporate bond prices. - The persistent output gap in major economies has limited inflationary pressure to date and moderated expectations for the pace and degree of tightening in the United States and Europe; however, higher oil prices and reemerging corporate pricing power are raising concerns. Speculative positioning and carry trades in 2003–early 2004: - Carry trades exploited the steep yield curve using the repo and swaps markets to fund positions in longer term U.S. treasury securities and mortgage-backed securities. - Leveraged positions established in the U.S. high-yield corporate bond market and in emerging market bonds aimed to profit from higher yields and steeply declining credit spreads. - Rapid growth in China and U.S. rebound fueled commodity demand and speculative interest in commodities. - In foreign exchange markets, higher yielding currencies in mature and emerging markets tended to appreciate as investors reached for yield; the U.S. dollar was the preferred funding currency. - Asian equity markets experienced speculative inflows, with many small and relatively young hedge funds contributing to leveraged positions in local stock markets. Market developments since mid-March 2004: - Partial unwinding of speculative positions has hit riskier assets hardest, particularly high-yielding emerging market bonds. - Financing conditions for emerging market borrowers are likely to remain less accommodating than in 2003 and early 2004. ### Key Risks to the Outlook - An unanticipated increase in inflationary pressure could call into question the pace of short-term interest rate hikes currently discounted in the market and potentially result in market turbulence; a faster than anticipated closure of the output gap could trigger concerns that the Fed had “fallen behind the curve”, causing yields and credit spreads to overshoot. - Geopolitical concerns are an imponderable risk factor; security concerns have put pressure on oil prices, and a spike in oil prices would dampen economic activity and pressure the external accounts of oil importers; geopolitical events unrelated to oil supply continuity could heighten risk aversion, widening credit spreads and lowering asset prices. - In emerging markets, rising short-term interest rates are likely to be associated with a less hospitable external financing environment and increased investor discrimination among borrowers; in an environment of higher funding costs and more restricted access to external financing, emerging market borrowers need to address factors underlying high debt levels and potentially unstable debt structures; countries facing political challenges to strong policies would be particularly vulnerable if higher-than-expected inflation pushed up mature market bond yields. - The orderly adjustment of global imbalances remains a medium-term challenge; large capital inflows needed to finance the U.S. external current account deficit and their heavy tilt toward U.S. bonds could, if reduced, result in higher bond yields and a weaker dollar, generating potential instability in currency markets with spillovers to other assets. ### Orderly Unwinding of Carry Trades Predicated on Measured Increases in Rates - The Fed has prepared the market for U.S. interest rates to be raised from exceptionally low levels at a measured pace; the stance of U.S. monetary policy is widely perceived to be at a turning point. - Markets are discounting with near certainty that the Fed Funds rate will be increased by 25 basis points at end-June. - Futures contracts suggest that the Fed Funds rate will reach at least 2 percent by year end. - Tightening is expected to be initiated or continue in other major financial centers: - Bank of England has raised rates four times since October 2003 to 4.5 percent; U.K. base rates are expected to continue to rise to 5-5½ percent by end-2005. - In the euro area, the market anticipates tightening to begin sometime in the first quarter of 2005; the pace of euro rate increases now discounted is relatively slow. - U.S. short-term interest rates are expected to exceed euro rates before the end of this year. - Markets expect Japan’s zero interest rate policy to be maintained, although yields on Japanese government bonds have increased in response to promising signs of stronger economic growth. - Longer-term government bond yields in major financial centers have increased significantly since the trough in mid-March; U.S. yields led the increase. - Futures markets and low implied volatility of options on longer-term U.S. interest rates suggest further increases in longer-term bond yields are expected to be modest. - Anticipated increase in short-term rates is expected to cause the U.S. yield curve to flatten; the U.K. yield curve is considerably flatter than those of the euro area and the United States. - The increase in nominal government bond yields since mid-March 2004 appears largely to reflect rising real yields; real yields on inflation-indexed bonds remain well below historical averages. - Inflation expectations continue to be subdued, although they have increased and remain above the actual rate of inflation; long-term yield increases will remain moderate so long as inflation expectations and the related inflation risk premium remain well anchored. - Oil market developments: - Oil prices were pushed to a record high in May (West Texas Intermediate Crude, U.S. dollars per barrel); fears eased with OPEC’s early June announcement of higher production quotas. - Non-oil commodity prices rose strongly in 2003 and early 2004 but fell precipitously on expectations that measures by China to restrain credit growth would dampen demand for commodity imports; the unwinding of speculative positions in commodity markets contributed to the decline in non-oil commodity prices. ### Currency Markets Respond to Stronger Growth and Unwinding of Carry Trades - Contrary to end-2003 expectations and notwithstanding large U.S. external financing needs, the dollar appreciated against other major currencies since early 2004; strong U.S. growth and anticipation of higher U.S. interest rates are main factors. - Large capital inflows needed to finance the U.S. current account deficit remain a continuing concern; the composition of flows—heavily skewed toward fixed-income securities—and the large share of U.S. government and corporate bonds held by foreigners raise the possibility that a sustained reduction in inflows could result in higher bond yields and a weaker dollar. - Speculative positions against the dollar have been reduced since end-2003, and expectations for currency market volatility have remained subdued. - Japanese intervention to stem yen appreciation was extraordinarily high in 2003 and early 2004; with the dollar appreciating, Japanese intervention ceased in mid-March. - Commodity-driven currencies: - The Australian, Canadian, and New Zealand dollars had experienced long rallies reflecting strong global growth and speculative pressures; as markets brought forward expectations for U.S. interest rate increases and questioned sustainability of strong commodity imports by China, speculative carry trades were reduced and these currencies gave back about a third of earlier gains. - Deleveraging affected emerging market currencies; speculative positions in non-deliverable forwards anticipating a de-pegging of the Chinese yuan appear to have been unwound. *International Monetary Fund, Financial Market Update, data as of June 15, 2004.* ### Section 2 ### Section 2 ### Mature Corporate Bonds: fundamentals and tightening prospects - Strengthening balance sheets, rising cash flows, and increased corporate profitability have underpinned improvements in credit quality in 2004. - Improvement in credit quality evidenced by ratings actions and declining corporate defaults. - Credit spreads on high-grade and high-yield corporate bonds in Europe and the United States remain narrow following marked compression in 2003 and early 2004. - Corporate bond spreads in mature markets typically narrow in the early stages of tightening cycles as improved earnings outweigh the prospect of higher funding costs. ### Equity markets and earnings - Mature equity prices have been supported by rising earnings and strengthening balance sheets. - Low implied equity option volatility in mature markets suggests investors see limited downside risk to equity prices. - Since last year, valuations have risen roughly in line with higher earnings; earnings in mature markets have tended to exceed analyst expectations. - U.S. Q1 corporate earnings were robust and broad-based, with particularly strong gains in the materials producing, technology, and finance sectors. - An unusually high share of S&P 500 earnings was attributable to the finance sector, which benefited from the proliferation of carry trades. - Japan equity markets have risen with signs of a deepening economic recovery. - Equity valuations, as measured by price/earnings ratios, are at or below averages since 1990, though that period includes bubble-era valuations. - Comparisons of U.S. equity earnings yield with 10-year government bond yields suggest favorable valuation levels. - Higher interest rates and input costs could put downward pressure on mature equity market valuations. ### Emerging market debt: repricing and investor flows - Expectations for abundant global liquidity were a key factor in the compression of emerging market bond spreads in 2003 and early 2004; revision of those expectations in 2004 led to significant spread widening. - Since the January 2004 Federal Open Market Committee, market expectations for the timing and speed of Fed tightening moved forward, and emerging market spreads widened some 100 basis points. - The sell-off gathered pace in April after U.S. employment data accelerated expectations of higher U.S. yields. - The sell-off led to a change in the investor base: speculative investors sharply reduced exposure. - Initial phase appears led by speculative trading accounts (such as hedge funds) unwinding highly leveraged positions. - Dedicated emerging market mutual funds experienced net outflows beginning in April and allocated larger portfolio proportions to cash; anecdotal signs of reinvestment of cash holdings emerged in early June. - Institutional investors generally remain committed to the asset class, with significant new funds in the pipeline. - The deleveraging process hit high-yielding, liquid credits hardest; the Brazilian component of the EMBI+ had the largest negative return year to date, reflecting high liquidity of Brazilian bonds favored for deleveraging. - The rise in credit spreads since early 2004 was broad-based, increasing cross-correlations of returns among emerging market debt. - The sell-off occurred despite generally improving credit fundamentals: rating upgrades exceeded downgrades for the third consecutive quarter in Q1 2004, and the share of credits with positive outlooks increased, notably in Eastern Europe influenced by EU accession in May. ### Emerging market issuance and market access - After an initial surge in issuance in Q1 2004, financing conditions for emerging market issuers deteriorated; the widening of spreads limited funding options, especially for higher-yielding issuers. - Bond market issuance slowed sharply from 2003 and from Q1 2004, when many issuers frontloaded funding programs due to low global rates and investor appetite. - Analysts estimate that by end-May 2004, emerging market sovereigns had completed some 60 percent of their bond issuance programs for 2004. - Since April, market access largely restricted to high-grade issuers; no new bonds issued by Latin American sovereign borrowers in the period described. - Several Asian borrowers delayed bond issues; signs of a moderate increase in issuance emerged since early June. - Equity issuance by emerging market borrowers slowed in Q2 2004; issuance remains heavily concentrated in Asia, with China accounting for half of all new emerging market equity issuance so far in 2004. - Syndicated lending surged in 2003 and early 2004 but primary market activity slowed sharply thereafter, with particularly tight access for Latin American borrowers. - Foreign direct investment (FDI) flows in Q1 2004 were higher than in Q1 2003; flows remained heavily concentrated on China. ### Quantified issuance and funding figures - Table 2 estimates for emerging market sovereign international new issuance for 2004, net: - Asia: Net requirement 5.1; Funded 2.5; Remaining 2.6 (In billions of U.S. dollars) - Emerging Europe: Net requirement 20.1; Funded 11.2; Remaining 9.0 - Latin America: Net requirement 15.6; Funded 11.6; Remaining 4.0 - Middle East and Africa: Net requirement 4.4; Funded 3.6; Remaining 0.8 - Total: Net requirement 45.2; Funded 28.8; Remaining 16.4 - Percent of emerging market issuance needs covered for 2004: 64% ### Outlook, vulnerabilities, and investor positioning - Investors appear broadly balanced between those prepared to re-enter emerging market debt due to relatively attractive valuations and improved market technicals and those preferring to wait for firmer evidence that deleveraging has run its course. - Emerging market spreads versus comparably rated corporate spreads have returned closer to long-term averages after compressing to near historical lows in late-2003 and early 2004. - Surveys suggest investors are approaching historically low exposures relative to benchmark allocations. - A positive factor is heavy issuance success in Q1 2004, but the market remains vulnerable to: - Faster-than-expected U.S. rate hikes. - Unanticipated credit events in key emerging markets. --- _Source: https://www.imf.org/-/media/files/publications/fmu/0604.pdf_