Financial Markets Overview - February 2014
Financial markets are undergoing a significant transition as strengthening growth in high-income economies is prompting an end to the extraordinary stimulus measures taken in the wake of the global financial crisis.
During the spring and summer of 2013, long-term interest rates on U.S. sovereign debt nearly doubled as financial markets reacted to the prospect of a tapering-off of the Federal Reserve’s quantitative easing policies. The sharp increase in U.S. yields sparked a sudden portfolio adjustment by international investors away from developing country assets, leading to a significant decline in capital flows. Most of this adjustment had played itself out by end-August 2013, with equity, bond and foreign exchange markets recovering or stabilizing in the final months of the year. Gross capital inflows also recovered during the fourth quarter of 2013, with the volume of foreign capital raised through new bond, equity and syndicated bank lending up 13.6 percent from a year earlier.
In contrast to the summer, financial markets did not react when the U.S. Federal Reserve actually announced on December 18 and began reducing the extent of its quantitative easing policies (early January 2014). Long-term U.S. Treasury yields remained stable and volatility on currency markets was low, suggesting that a large part of the tapering impact had already been priced in.
However, this period of relative market calm was broken towards the end of January, when the Argentine peso devalued by 16 percent, which, amid concerns about slowing growth in China, led to a sudden shift in market sentiment. While not entirely unexpected, global equity markets weakened sharply. The sell-off was initially concentrated among developing countries, including several that were already hard hit in the summer of 2013. However, stock-market losses in high-income countries were nearly as heavy, pointing toward a broadly-based equity market correction rather than a targeted pullback from developing-country assets. As of February 14 (the cut-off date of this publication), markets appeared to have stabilized and recouped some of their earlier losses, with stock-market indices in both developing and high-income countries down around 3 percent since January 22.
Although the turmoil coincided with the further unwinding of the Federal Reserve’s quantitative easing program, it does not appear to have been caused by it. The actual decision to continue tapering asset purchases was made on January 29, after the sell-off began and in line with market expectations. Unlike the mid-2013 episode, when U.S. long term interest rates increased by 130 basis points, they have actually declined by 20 basis points since the start of 2014. These developments suggest a modest flight to quality and general rotation from equity markets into highly rated sovereign bonds.
Although, developing country spreads have increased by about 35 basis points, the decline in U.S. rates means that yields and borrowing costs have risen only marginally. A somewhat larger number of developing-country currencies depreciated this January when compared with last summer, with new pockets of vulnerabilities observed, in particular in Eastern Europe and Central Asia.
Responding to currency and domestic inflationary pressures, monetary policy was tightened in several developing countries since January 22. In particular, an aggressive increase in policy rates in Turkey helped stabilize its currency, and was soon followed by a period of relative calm in foreign exchange markets. Policy rates do not appear to be too tight given domestic conditions.
Looking forward, prospects are mixed. Financing conditions are likely to tighten further in the coming months as monetary policies continue to normalize. This, combined with a shrinking growth differential between developing and high-income countries, should translate into weaker capital inflows to developing countries this year. Overall, net private capital inflows are projected to slow from $1.078 trillion (4.6 percent of developing-country GDP) in 2013 to $1.065 trillion (4.2 percent of GDP) in 2014 (see table below).
Should global interest rates increase more abruptly than currently expected or market volatility becomes the new norm, more disorderly adjustments could not be ruled out. Simulations suggest that a sudden and sustained 100 basis points increase in U.S. bond yields could dent capital inflows to developing countries by around 50 percent for several months while a persistent 10 point rise in the VIX index, a common measure of market risk aversion, could reduce them by around 30 percent over a similar horizon (see figure below).