USA
In recent weeks, financial markets have moved dramatically in the direction of pricing in a cyclical recovery. The broadest measure of the U.S. stock market has moved up about 35 percent from its recent low, while oil prices are up more than 50 percent and copper is up more than 70 percent. Issuance in the corporate bond market has been robust, and spreads on corporate bonds have dropped notably. Break even inflation rates in the Treasury Inflation Indexed Securities (TIPS) market have moved up sharply and are now much closer to historical norms. These movements are likely comforting to the Fed [Federal Reserve System] because they suggest market participants believe the Fed will be successful in preventing depression and an extended period of deflation. In this sense, the Fed welcomes a more "normal" financial market environment.
However, the Fed does not hope for all markets to normalize yet. Because it views a housing market recovery as essential to a sustainable recovery, it has been buying massive amounts of mortgages and Treasuries in an attempt to keep these rates lower than market forces would otherwise push them. However, the 10-year Treasury yield has been rising rapidly of late and is now about 110 basis points above its level when the Fed announced in March that it would purchase $U.S. 300 billion in Treasury securities. While measures of retail mortgage rates are still low, wholesale mortgage rates have moved up significantly, and it appears inevitable that retail mortgage rates will increase notably if the recent rise in Treasury yields is not soon reversed.
This is likely to be a significant concern to the Fed. However, there are some hopeful signs in the data that the plunge in housing construction may be nearing an end. Builders have cut back so severely on construction that new home inventories have plunged an annualized 38.9 percent during the past six months, the fastest decline in the 45-year history of this series. Meanwhile, new home sales have stabilized over the past three months, and the combination of stable sales and plunging inventories will likely help the economy to speed up about a percentage point.
Euro zone
The euro area housing market has many diverse property markets, yet in aggregate the index of euro area house prices has shown a very similar lagging profile to that of the U.S. since the late 1970s. This shows the common trends at work across financial sectors and economies. The euro area continues to lag behind the U.S. in terms of the Gross Domestic Product (GDP) cycle, though in a somewhat less clear-cut way.
This year and in 2010 euro area house prices are likely to show a substantial decline of about 6 percent in each year. Despite mortgage rates which look to be heading down to about 4.0 percent (i.e., close to record lows in recent decades), the euro area housing market has negative momentum induced by the record collapse in GDP (which in turn is fuelling a record uptrend in unemployment), and by a loss of faith in housing assets as an investment vehicle. In some markets, particularly Ireland and Spain, excess capacity is also a factor.
For example, during 2004 - 2006 2.2 million new homes were under construction in Spain, compared with an average annual increase in households of about 400,000. Last year Spanish housing starts were still significant at 360,000, though the trend in permits suggests that this year's pace will be more like 200,000. European citizens vote for a new parliament on June 7. Although the date is looming, the European political debate has been virtually non-existent, due to several reasons. For the markets, the focus of debate surrounding these elections is not the result exactly.
However, there is one reason at least for which financial markets should keep a watchful eye on the European Parliamentary elections this June. Soon after, a new internal market Commission will be nominated, a body whose legislative power has an important influence on financial market regulation. With feelings running high in the wake of the financial crises, the nomination of this Commission could potentially produce a shift in the balance of power from a pro free market to a more regulated one with increased state intervention.
Central and Eastern Europe
While the Baltic States have very small economies (their combined 2008 GDP was $U.S.100 billion, or two-thirds the size of Hungary's), the continued challenges they face do pose questions for their neighboring countries 's not just in the EM, but also in Scandinavia, particularly Sweden. There have been some interesting new developments recently.
Riksbank's market participant survey highlighted the main concern as Baltic exposures to Swedish banks. In addition, Riksbank decided to take a 9.48 billion euro loan from the Swedish National Debt Office to reestablish its own FX reserve position, having lent a similar amount to Swedish banks and, in swaps, to the central banks of Iceland, Estonia and Latvia.
This news has led to increased speculation about the crisis in the Baltic States, which is further being fueled by reports in Lithuania of a -13.6 percent drop in GDP compared to the first quarter of 2008. The economies have shut down, and reserves continue to decline. Meanwhile, the authorities in the region continue to argue that currency pegs will not falter, citing, in particular in Latvia, that balance sheet effects from open FX positions are too vulnerable to move off the pegs. T
he Riksbank plans to release its annual Financial Stability Report, which will provide some insight into its decision to raise funds, and what risk profile they see from the Baltics. Perhaps more notable will be the conclusion of the IMF visit, which is expected to wrap up on June 8.
Written using materials from Bloomberg and Reuters Research
