## FINANCIAL MARKET UPDATE December 2006

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### Overview: global outlook and market sentiment
- Data as of December 14, 2006.
- The September 2006 Global Financial Stability Report (GFSR) baseline: solid global growth, contained inflation, continued financial stability, but risk tilted to the downside.
- Since September developments broadly followed the baseline: market sentiment gravitated toward a central scenario of a benign slowdown with contained inflationary pressures, but downside risks remain and underlying financial conditions warrant continued vigilance.
- Key observations:
  - Markets expect a benign slowdown rather than a sharp global downturn.
  - Private forecasts have become less optimistic and slightly more uncertain since September.
  - As the U.S. economy slows, other major economic areas have shown limited decoupling, with a rebalancing of global growth.

### United States: growth, inflation expectations, and monetary policy outlook
- Third quarter U.S. GDP growth slowed to a 2.2 percent annualized pace, with weaker residential investment a principal factor.
- Labor market indicators (payrolls and wages) continue to expand at a moderate pace, supporting consumption so far.
- Markets anticipate the U.S. Federal Reserve will begin to cut rates next year to support a soft landing; bond markets show declining real yields and an inverted yield curve consistent with further softening expectations.
- Inflation signals and risks:
  - Market expectations of inflation in the United States have fallen considerably in recent months, driven by falling oil prices and favorable inflation surprises.
  - The average level of expected inflation over the next 10 years, though declining somewhat, remains relatively elevated.
  - Tension persists between market consensus of abating inflation (supporting Fed easing) and Fed-expressed concerns over inflation risks.
- Downside scenarios identified:
  - An inflation shock would force a reassessment of price stability and the Fed easing path, likely raising volatility and risk premia.
  - A sharper U.S. slowdown tied to a deeper housing downturn could have more pronounced spillovers to consumption and global growth.
  - In a harder U.S. landing, there is concern whether growth elsewhere can remain self-sustaining.

### U.S. housing market and mortgage-sector vulnerabilities
- Housing slowdown and subprime stress:
  - The U.S. housing market slowdown has been more severe than some had expected, increasing concern about subprime mortgage segments; early signs of distress have emerged.
- Mortgage product characteristics and risks:
  - Innovations expanded access to housing finance, including mortgages for subprime borrowers, high-leverage mortgages, and mortgages that produce “payment shock.”
  - More than half of mortgages originated in 2005 and 2006 are estimated to contain provisions that will eventually lead to a sharp rise in payments, even if market interest rates do not change.
  - Shorter-term interest rate increases have raised payments on conventional adjustable-rate mortgages, adding to payment shock.
  - Although aggregate home equity remains high, pockets of purchasers may have low or negative equity due to regional price declines, debt-building mortgage features, and speculative overpayment facilitated by loose underwriting.
- Current indicators and near-term risks:
  - Delinquency rates have picked up only slightly and primarily in the subprime segment to date.
  - Mortgage spreads have remained low, reflecting a broader search for yield and suggesting potential complacency in risk pricing.
  - A sharp economic downturn would likely raise homeowner defaults more significantly and broaden credit risk in mortgage and household credit sectors.
- Securitization and risk distribution:
  - The riskiest mortgage-related securities have been concentrated into structured products such as collateralized debt obligations (CDOs), which can transform mid-quality underlying securities into high-quality tranches while concentrating risk in small, very risky securities.
  - Higher-risk tranches are reportedly bought largely by hedge funds.
  - The complex packaging and repackaging of risk makes it difficult to identify ultimate holders of mortgage credit risk.
  - Recent closures of two small subprime originators indicate stress in subprime origination, securitization, and distribution channels.

### Market liquidity, leverage, low volatility, and carry trades
- Volatility and risk spreads:
  - Volatility across a wide range of assets has fallen to generational lows; realized volatility on U.S. equities is well below levels seen at comparable points in the last three business cycles.
  - Risk spreads are historically tight.
- Drivers of low volatility:
  - Structural factors: reduced inflation risk (partly from emerging-economy supply), improved macroeconomic policies and central bank credibility, and wider dispersion of risks via financial innovation and credit derivatives.
  - Cyclical contributors: abundant global liquidity, relatively low corporate leverage, and elevated risk appetite.
- Liquidity and interest-rate dynamics:
  - Evidence suggests that moving from very low to higher interest rates, financial volatility responds with a lag; the long period of ample liquidity has encouraged the search for yield and high risk appetite.
  - Even as U.S. monetary policy has tightened, liquidity has remained ample elsewhere.
- Carry trades and currency exposures:
  - Low currency volatility plus high cross-border interest rate spreads supported growth in carry trades—borrowing in low-rate currencies to invest in higher-yielding currencies.
  - Favored funding currencies for carry trades have been the Japanese yen and, to a lesser extent, the Swiss franc.
  - Indirect indicators (Japanese balance of payments) show substantial foreign-asset purchases by domestic Japanese investors and rising “other” investment outflows starting in 2005 and increasing in 2006, consistent with cross-border yen lending and carry trade activity.
- Market implication:
  - Growth of carry trades and their potential unwinding could cause market perturbations and contribute to a rapid rise in volatility.

### Emerging markets and cross-border flows
- Asset prices and issuance:
  - Emerging market asset prices recovered strongly from the May–June turbulence, reflecting continued fundamental improvements and policy actions in some countries to stabilize markets and shore up policy credibility.
  - As sovereign issuance in international capital markets declined, private corporate issuance filled the void.
- Geographic patterns and capital movements:
  - Household and corporate credit growth has been strong in emerging Europe and Central Asia.
  - Foreign inflows into sub-Saharan Africa have increased as the region becomes a new frontier for emerging-market investment.
  - Market intelligence suggests Nigeria received inflows of around $1 billion in the first half of 2006, with significant flows also to Ghana, Kenya, Tanzania, Uganda, and Zambia.
  - The number of sub-Saharan assets that can be settled on Euroclear grew significantly over the last year, reducing settlement costs for foreign investors.
- Policy note:
  - Authorities in recipient countries need to ensure policies are in place to best benefit from foreign investor flows into local markets and to avoid associated instability.

### Currency futures, carry trades, and low-yield currency positioning
- Positioning and indicators:
  - “Noncommercial” investors held large short yen positions in 2005 and early 2006, and again after the market turbulence of May-June 2006 subsided.
  - Positioning in the Swiss franc has closely followed that in the yen.
  - Currency futures positions on the Chicago Mercantile Exchange cover only a small segment of professional market activity but may provide a useful barometer of broader market positioning.
- Risk from unwind:
  - Growth of carry trades and their potential unwinding could cause market perturbations and contribute to a rapid rise in volatility.

### Corporate leverage, private equity, and leveraged buyouts
- Public vs. private leverage:
  - Corporate leverage in listed firms across major markets has continued to decline, supported by strong profitability and cashflows and still-modest corporate investment.
  - In private markets, corporate leverage has been rising, driven by massive increases in private equity buyouts using leveraged loans.
- Scale and valuations:
  - In the 12 months ending September 2006, total leveraged loan issuance reached almost $900 billion.
  - Valuation metrics for leveraged buyouts have become increasingly stretched: firms are being bought at higher multiples of earnings and average leverage in buyouts has reached record highs.
- Funding and risks:
  - Private equity groups have attracted huge inflows from real money investors; buyout groups often recoup part of investments quickly via dividend and fee payments, which further raises leverage in target firms.
  - Ratings agencies remain relatively sanguine given low default levels and abundant liquidity, but business plans for leveraged buyouts would look less attractive if global growth slowed rapidly or interest rates rose.
  - The U.K. Financial Services Authority found U.K. banks’ exposures to private equity were significant and rising, though somewhat mitigated by risk distribution to institutional investors.

### Rising risk appetite, asset valuations, and emerging market flows
- Market performance and investor behavior:
  - Risk appetite has risen across a wide range of assets, evidenced by tight spreads and rising valuation ratios in mature markets and by strong performance in emerging markets.
  - Emerging market equities were the best-performing major asset class year-to-date in 2006 despite the sharp sell-off in May/June.
  - Emerging market debt—both external and local—produced higher returns than all other fixed-income classes except high-yield corporate debt.
  - Foreign investor allocations have been moving into more “exotic” emerging market assets as sovereign issuance declined and corporate issuance filled the void.
  - Sovereign spreads narrowed to historic lows, fueling search-for-yield flows into riskier emerging market assets.

### Correlations, diversification, and the potential for a volatility shock
- Correlation and diversification concerns:
  - Correlations between asset classes appear to be rising along with risk appetite and the search for yield; if correlations persist or rise, traditional diversification benefits may be reduced.
  - Persistently higher correlations could lead investors to demand higher risk premiums.
- Option market positioning and volatility risk:
  - Many hedge funds reportedly sold options to generate premium income, contributing to very low implied volatilities in option markets; such funds are thus exposed to sudden shifts in market sentiment and may scale back provision of volatility insurance when sentiment turns, which would tend to raise implied volatility further.
  - A “volatility shock” could be triggered by a downward shift in growth expectations or renewed inflationary pressures, precipitating portfolio adjustments and raising underlying volatility.
  - Rapid unwinding of carry trades, similar to the May-June 2006 episode, could lead investors to retrench from some emerging markets.

### Vulnerabilities in regions reliant on portfolio inflows and crowded local market trades
- EMEA sensitivities:
  - Several countries in the Europe, the Middle East, and Africa (EMEA) region have high current account deficits coupled with heavy reliance on portfolio inflows, making them more sensitive to global risk conditions.
  - Sensitivity to global risk aversion in some EMEA countries is roughly three times that in other regions.
- Crowded trades and liquidity risk:
  - Recent trades that attracted significant foreign inflows are liable to unwind rapidly if risk aversion increases; indicators of crowded local trades show it could take many days for foreign investors to fully unwind local equity and bond positions in some markets.

### Rapid growth of private cross-border debt into Eastern Europe and Central Asia
- Scale and composition of flows:
  - Cross-border private debt flows into emerging markets, particularly Eastern Europe, have grown rapidly.
  - Foreign-currency-denominated bond issuance by Russian entities is running at a $20 billion annual rate.
  - Issuance in Russia has increasingly been dominated by banks, including some less well-known banking sector names.
- Banking sector pressures and funding risks:
  - Domestic loan growth in some Russian banks averaged about 75 percent over the past four years, putting pressure on capital adequacy.
  - Banks are now relying on capital markets for around a third of their funding, exposing them to substantial rollover risk.
  - Lending to Kazakh banks has also grown rapidly and, as a proportion of GDP, is higher than lending to Russian banks.

*Monetary and Capital Markets Department (Global Markets Monitoring and Analysis Division), International Monetary Fund*

### Section 1

### FINANCIAL MARKET UPDATE December 2006 (Section 1)

### Overview: global outlook and market sentiment
- Data as of December 14, 2006.
- The September 2006 Global Financial Stability Report (GFSR) presented a baseline of solid global growth, contained inflation, and continued financial stability, but risked tilted to the downside.
- Since September, developments have broadly followed the baseline: market sentiment has gravitated toward a central scenario of a benign slowdown with contained inflationary pressures, but downside risks remain and underlying financial conditions warrant continued vigilance.
- Key observations:
  - Markets expect a benign slowdown rather than a sharp global downturn.
  - Private forecasts have become less optimistic and slightly more uncertain since September.
  - As the U.S. economy slows, other major economic areas have shown limited decoupling, with a rebalancing of global growth.

### United States: growth, inflation expectations, and monetary policy outlook
- Third quarter U.S. GDP growth slowed to a 2.2 percent annualized pace, with weaker residential investment a principal factor.
- Labor market indicators (payrolls and wages) continue to expand at a moderate pace, supporting consumption so far.
- Markets anticipate that the U.S. Federal Reserve will begin to cut rates next year to support a soft landing; bond markets show declining real yields and an inverted yield curve consistent with further softening expectations.
- Inflation signals and risks:
  - Market expectations of inflation in the United States have fallen considerably in recent months, driven by falling oil prices and favorable inflation surprises.
  - The average level of expected inflation over the next 10 years, though declining somewhat, remains relatively elevated.
  - Tension persists between market consensus of abating inflation (supporting Fed easing) and Fed-expressed concerns over inflation risks.
- Downside scenarios identified:
  - An inflation shock would force a reassessment of price stability and the Fed easing path, likely raising volatility and risk premia.
  - A sharper U.S. slowdown tied to a deeper housing downturn could have more pronounced spillovers to consumption and global growth.
  - In a harder U.S. landing, there is concern whether growth elsewhere can remain self-sustaining.

### U.S. housing market and mortgage-sector vulnerabilities
- The U.S. housing market slowdown has been more severe than some had expected, increasing concern about subprime mortgage segments; early signs of distress have emerged.
- Mortgage product characteristics and risks:
  - Innovations expanded access to housing finance, including mortgages for subprime borrowers, high-leverage mortgages, and mortgages that produce “payment shock.”
  - More than half of mortgages originated in 2005 and 2006 are estimated to contain provisions that will eventually lead to a sharp rise in payments, even if market interest rates do not change.
  - Shorter-term interest rate increases have raised payments on conventional adjustable-rate mortgages, adding to payment shock.
  - Although aggregate home equity remains high, pockets of purchasers may have low or negative equity due to regional price declines, debt-building mortgage features, and speculative overpayment facilitated by loose underwriting.
- Current indicators and near-term risks:
  - Delinquency rates have picked up only slightly and primarily in the subprime segment to date.
  - Mortgage spreads have remained low, reflecting a broader search for yield and suggesting potential complacency in risk pricing.
  - A sharp economic downturn would likely raise homeowner defaults more significantly and broaden credit risk in mortgage and household credit sectors.
- Securitization and risk distribution:
  - The riskiest mortgage-related securities have been concentrated into structured products such as collateralized debt obligations (CDOs), which can transform mid-quality underlying securities into high-quality tranches while concentrating risk in small, very risky securities.
  - Higher-risk tranches are reportedly bought largely by hedge funds.
  - The complex packaging and repackaging of risk makes it difficult to identify ultimate holders of mortgage credit risk.
  - Recent closures of two small subprime originators indicate stress in subprime origination, securitization, and distribution channels.

### Market liquidity, leverage, low volatility, and carry trades
- Volatility and risk spreads:
  - Volatility across a wide range of assets has fallen to generational lows; realized volatility on U.S. equities is well below levels seen at comparable points in the last three business cycles.
  - Risk spreads are historically tight.
- Drivers of low volatility:
  - Structural factors cited include reduced inflation risk (partly from emerging-economy supply), improved macroeconomic policies and central bank credibility, and wider dispersion of risks via financial innovation and credit derivatives.
  - Cyclical contributors include abundant global liquidity, relatively low corporate leverage, and elevated risk appetite.
- Liquidity and interest-rate dynamics:
  - Evidence suggests that moving from very low to higher interest rates, financial volatility responds with a lag; the long period of ample liquidity has encouraged the search for yield and high risk appetite.
  - Even as U.S. monetary policy has tightened, liquidity has remained ample elsewhere.
- Carry trades and currency exposures:
  - The conjunction of low currency volatility and, in some cases, high cross-border interest rate spreads has supported growth in carry trades—borrowing in low-rate currencies to invest in higher-yielding currencies.
  - Favored funding currencies for carry trades have been the Japanese yen and, to a lesser extent, the Swiss franc.
  - Indirect indicators (Japanese balance of payments) show substantial foreign-asset purchases by domestic Japanese investors and rising “other” investment outflows (including banking and derivatives flows) starting in 2005 and increasing in 2006, consistent with cross-border yen lending and carry trade activity.

### Emerging markets and cross-border flows
- Emerging market asset prices have recovered strongly from the May–June turbulence, reflecting continued fundamental improvements and policy actions in some countries to stabilize markets and shore up policy credibility.
- As sovereign issuance in international capital markets has declined, private corporate issuance has filled the void.
- Household and corporate credit growth has been strong in emerging Europe and Central Asia.
- Foreign inflows into sub-Saharan Africa have increased as the region becomes a new frontier for emerging-market investment.
- Policy note: Authorities in recipient countries need to ensure policies are in place to best benefit from foreign investor flows into local markets and to avoid associated instability.

*Monetary and Capital Markets Department (Global Markets Monitoring and Analysis Division), International Monetary Fund*

### Section 2

### Section 2

### Currency futures, carry trades, and low-yield currency positioning
- “Noncommercial” investors held large short yen positions in 2005 and early 2006, and again after the market turbulence of May-June 2006 subsided.
- Positioning in the Swiss franc has closely followed that in the yen.
- Currency futures positions on the Chicago Mercantile Exchange cover only a small segment of professional market activity but may provide a useful barometer of broader market positioning.
- Growth of carry trades and their potential unwinding could cause market perturbations and contribute to a rapid rise in volatility.

### Corporate leverage, private equity, and leveraged buyouts
- Corporate leverage in listed firms across major markets has continued to decline, supported by strong profitability and cashflows and still-modest corporate investment.
- In private markets, corporate leverage has been rising, driven by massive increases in private equity buyouts using leveraged loans.
- In the 12 months ending September 2006, total leveraged loan issuance reached almost $900 billion.
- Valuation metrics for leveraged buyouts have become increasingly stretched: firms are being bought at higher multiples of earnings and average leverage in buyouts has reached record highs.
- Private equity groups have attracted huge inflows from real money investors; buyout groups often recoup part of investments quickly via dividend and fee payments, which further raises leverage in target firms.
- Ratings agencies remain relatively sanguine given low default levels and abundant liquidity, but business plans for leveraged buyouts would look less attractive if global growth slowed rapidly or interest rates rose.
- The U.K. Financial Services Authority found U.K. banks’ exposures to private equity were significant and rising, though somewhat mitigated by risk distribution to institutional investors.

### Rising risk appetite, asset valuations, and emerging market flows
- Risk appetite has risen across a wide range of assets, evidenced by tight spreads and rising valuation ratios in mature markets and by strong performance in emerging markets.
- Emerging market equities were the best-performing major asset class year-to-date in 2006 despite the sharp sell-off in May/June.
- Emerging market debt—both external and local—produced higher returns than all other fixed-income classes except high-yield corporate debt.
- Foreign investor allocations have been moving into more “exotic” emerging market assets as sovereign issuance declined and corporate issuance filled the void.
- Sovereign spreads narrowed to historic lows, fueling search-for-yield flows into riskier emerging market assets.
- Foreign investor interest in sub-Saharan Africa increased in 2006 (from a low base); market intelligence suggests Nigeria received inflows of around $1 billion in the first half of 2006, with significant flows also to Ghana, Kenya, Tanzania, Uganda, and Zambia.
- The number of sub-Saharan assets that can be settled on Euroclear grew significantly over the last year, reducing settlement costs for foreign investors.

### Correlations, diversification, and the potential for a volatility shock
- Correlations between asset classes appear to be rising along with risk appetite and the search for yield; if correlations persist or rise, traditional diversification benefits may be reduced.
- Persistently higher correlations could lead investors to demand higher risk premiums.
- Many hedge funds reportedly sold options to generate premium income, contributing to very low implied volatilities in option markets; such funds are thus exposed to sudden shifts in market sentiment and may scale back provision of volatility insurance when sentiment turns, which would tend to raise implied volatility further.
- A “volatility shock” could be triggered by a downward shift in growth expectations or renewed inflationary pressures, precipitating portfolio adjustments and raising underlying volatility.
- Rapid unwinding of carry trades, similar to the May-June 2006 episode, could lead investors to retrench from some emerging markets.

### Vulnerabilities in regions reliant on portfolio inflows and crowded local market trades
- Several countries in the Europe, the Middle East, and Africa (EMEA) region have high current account deficits coupled with heavy reliance on portfolio inflows, making them more sensitive to global risk conditions.
- Sensitivity to global risk aversion in some EMEA countries is roughly three times that in other regions.
- Recent trades that attracted significant foreign inflows are liable to unwind rapidly if risk aversion increases; indicators of crowded local trades show it could take many days for foreign investors to fully unwind local equity and bond positions in some markets.

### Rapid growth of private cross-border debt into Eastern Europe and Central Asia
- Cross-border private debt flows into emerging markets, particularly Eastern Europe, have grown rapidly.
- Foreign-currency-denominated bond issuance by Russian entities is running at a $20 billion annual rate.
- Issuance in Russia has increasingly been dominated by banks, including some less well-known banking sector names.
- Domestic loan growth in some Russian banks averaged about 75 percent over the past four years, putting pressure on capital adequacy.
- Banks are now relying on capital markets for around a third of their funding, exposing them to substantial rollover risk.
- Lending to Kazakh banks has also grown rapidly and, as a proportion of GDP, is higher than lending to Russian banks.

---


_Source: https://www.imf.org/-/media/files/publications/fmu/1206.pdf_