Forex: BIS: Rising Concerns Over Fiscal Outlook To Add Pressure On Real Forward Rates

(RTTNews) - Monday, the Bank for International Settlements said rising concerns about the fiscal outlook is expected to add upward pressure on real forward rates. Also, the institution said central banks around the world should frame different exit strategies from the monetary stimulus measures.
The BIS assessed that the introduction of central counterparty clearing houses or CCPs and improvements in trading and settlement infrastructure are required to ensure efficiency in the over-the-counter derivatives markets.
According to BIS, the U.S. government is expected to borrow a total of US$1.8 trillion in FY 2009, reflecting a 137% surge from an already elevated level in FY 2008. Such large new government debt would make it difficult for markets to absorb. Along with this concern, worries about the sustainability of rapidly rising fiscal deficits were seen as reasons behind the rise in US long-term yields that was seen in the first half of the year.
Basel, Switzerland-based BIS said in its latest quarterly review, "Fiscal sustainability concerns are likely to affect forward yields that span distant horizons, which are less influenced by near-term expectations about inflation, economic growth and monetary policy."
Despite surging fiscal deficits and record low monetary policy rates, long term inflationary pressures appear to be contained for now, the BIS added. This might mirror the belief that the current high level of economic slack would persist for some time.
According to BIS, financial markets are showing signs of normalizing, as risk tolerance edged further upwards and risk premia receded.
"In interbank money markets, key spreads narrowed to levels not seen since the beginning of 2008, and in some cases even further. Improvements were also visible in credit markets, although important segments continued to rely on central bank support," the quarterly review stated.
The LIBOR/OIS spread, an indicator for the level of stress in the money market, widened sharply after the collapse of Lehman Brothers in September 2008.
In the case of U.S. rates, the spread dropped to the lowest level since the outbreak of the financial crisis in mid-2007, the bank for central banks said.
Despite uncertainty about the pace of economic recovery, investors remained cautiously optimistic in the period between end-May and early September 2009, the report added.
Further, the Bank for International Settlements said the Federal Reserve, the Bank of England and the Swiss National Bank may need to frame different exit strategies from the monetary stimulus measures, as they have different views on how bond purchases would support economic growth.
"The Bank of England and the Federal Reserve, purchasing bonds in order to lower long-term rates, and the Swiss National Bank, purchasing foreign exchange to hold down the Swiss franc, find themselves in different positions from the BoJ," BIS official Robert McCauley wrote in a report, which is part of the latest BIS quarterly review.
Basel, Switzerland-based BIS said various considerations will bear on the choice of the exit path for these central banks, including market functioning, prices and reaction, as well as the run-off of any short-term assets. Different concepts of balance sheet policy - stock versus flow - may also condition the path chosen.
According to the BIS report, the Fed is of the view that hiking interest rate would given enough stimulus without bond sales, while the BoE may want to raise the bank rate and may sell assets at the same time.
The BoE believes that raising the short-term interest rate, while never selling the bond holdings would be "to tap the brake while the other foot remained firmly on the accelerator", the report said. But, the Fed thinks, "without a foot on the accelerator, one could consistently tap the brake."
While deciding to leave its base rate unchanged at a record low of 0.5% on September 10, the BoE also chose to continue the GBP 175 billion asset purchase scheme. The central bank expects the asset purchase scheme to take another two months to complete and will review the scale of the scheme from time to time.
The Swiss National Bank has offered little guidance on its exit from its policy of purchases of foreign assets to resist currency appreciation, the official noted.
The BIS said the contribution of an institution to system-wide risk generally increases more than proportionately with its size.
Any "systemic capital charge" applied to individual institutions should increase more than proportionately with relative size, BIS, also known as the central bank of central banks said in a study, which is part of its quarterly review. Tighter prudential standards should be applied to larger institutions, the Basel, Switzerland-based BIS added.
The charge should rise with the exposure of the institution to sources of systematic risk. That is firms with higher capital charges would be applicable to institutions that are more similar to the typical institution.
With respect to derivatives markets, the BIS assessed that the introduction of central counterparty clearing houses or CCPs is not likely to be sufficient to ensure efficiency in the over-the-counter derivatives markets.
A CCP is an entity that interposes itself between counterparties to contracts traded in one or more financial markets, becoming the buyer to every seller and seller to every buyer.
The introduction of CCPs should be complemented with improvements in trading and settlement infrastructure, the report said. This covers the greater use of automated trading, registration of all trades in central data depositories, and enhanced risk management and disclosure requirements for market participants themselves.
The Basel, Switzerland-based BIS added that experience during the recent crisis highlighted the need for fundamental improvements in the management of counterparty risk and transparency in OTC derivatives markets.
During the financial crisis, existing CCPs arrangements performed well, the report said. However, the crisis exposed the need for international coordination of the oversight of systemically important CCPs by central banks and other relevant authorities. "One important and as yet unresolved question is whether CCPs should have access to central bank credit facilities and, if so, when."