BIS Quarterly Review, March 2000

The first few months of 2000 were a period of heightened market volatility. Equity markets were the most volatile, particularly those trading technology stocks. However, the volatility also extended to the fixed income markets and major currencies. One source of volatility seemed to be the uncertainty, engendered by data released during the period, about how much US and euro area monetary policy would tighten. Not only did the stock markets seem unusually susceptible to such uncertainty but order flows also appeared to exert an inordinate impact on prices. These conditions set the stage for sharp market declines in May. In the fixed income markets, participants in the United States and Europe also seemed to react more forcefully than usual to macroeconomic news. At the same time, liquidity factors served to exaggerate the movements of US long yields and caused an inversion in the yield curve. A degree of ambiguity about the credit status of US gove rnment-sponsored agencies contributed further to the gyration of yields.

The most recent BIS banking data show that international banks continued to invest heavily in international debt securities in the fourth quarter of 1999. Such investment throughout 1999 helped to ease credit spreads in traded debt markets, thus encouraging a shift by international borrowers from loan financing to securities issuance. Indeed, banks appear to have had few opportunities for traditional lending. In the fourth quarter, some banks did resume lending to non-bank borrowers in developed countries, particularly in the form of syndicated facilities to finance mergers and acquisitions. While such lending to non-bank borrowers was modest, it seems to have allowed a slowing of interbank flows between developed countries. These interbank flows had surged in the previous quarter partly to accommodate unusually large repayments. The fourth quarter also saw an end to a retrenchment from offshore centres, with a build-up of interbank positions in the Caribbean. Emerging market bor rowers in Latin America continued to show a preference for securities financing over bank credit and those in Asia continued to repay their loans. End-year data from the BIS consolidated statistics indicate that most emerging market borrowers continued to lengthen the average maturity of their bank debt.

Data collected by the BIS on international debt securities in the first quarter of 2000 show a recovery of activity compared to the previous quarter, when business had been dampened by concerns about possible market disruptions related to the millennium date change. Although the widening and volatility of credit spreads in early 2000 derailed many issuance plans, total net issuance still rose to $266 billion from $212 billion in the final quarter of 1999 and was on track to approach the record levels reached during 1999 as a whole. Activity continued to be dominated by financial institutions and state agencies rather than non-financial corporations. With their triple-A ratings, US housing credit agencies brought record amounts of large-sized issues in an ongoing effort to establish benchmark securities. At the same time, some emerging market borrowers, including private sector entities from Brazil and Mexico, returned to the capital markets to take advantage of the dramatic narro wing of credit spreads since 1999.

Data collected by the BIS on exchange-traded financial derivatives show a sharp rebound in aggregate turnover in the first quarter of 2000 indicating a return of financial market participants to more active trading. The dollar value of turnover rose by 34%, to $102 trillion, the highest figure since the record $107 trillion observed in the third quarter of 1998. Much of the upsurge took place in contracts based on fixed income instruments. Somewhat surprisingly, the high level of activity seen on global equity markets, particularly in the high-technology sector, did not spill over to the equity-related derivatives sector.

With respect to the over-the-counter (OTC) market, the most recent semiannual data published by the BIS show an acceleration of activity in the second half of 1999. After adjustment for double-counting resulting from positions between reporting institutions, the total estimated notional amount of outstanding OTC contracts stood at $88.2 trillion at end-December 1999, an 8% increase over the amount reported for end-June 1999. This compared with an increase of 1% in the first half of 1999 and stood in contrast to activity on exchange-traded markets, which experienced a decline over the same period. Much of the growth in business occurred in the interest rate swaps market, particularly in the euro and yen segments. The near stagnation of US dollar interest rate swaps would seem to contradict anecdotal evidence of an increased use of such swaps for position-taking on US interest rate movements and for hedging against these movements. However, it is also possible that such increase d use of swaps was offset by a decline in arbitrage activity between those contracts and US Treasury securities. In the euro area and Japan, where such arbitrage activity in the relevant currencies had in any case not been very strong, the growth of swaps may have reflected wider use for hedging and positioning.

A special article explores the link between heightened market volatility and increases in correlations between asset returns. The article suggests that periods of high volatility should also be periods of high correlations purely as a result of the statistical properties of a process that is observed within limited time intervals. A fundamental change in the underlying process is not required for a rise in correlations. The article draws implications of this result for risk management and explanations of contagion.