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Prospects Weekly: The up-tick in market tensions have caused CDS rates to rise sharply

Global Macroeconomics Team's picture
The up-tick in market  tensions following recent bank downgrades, partial nationalizations and elections have caused CDS rates to rise sharply, although in most countries they remain below their fall 2011 highs. Stock markets have also tumbled, exchange rates depreciated and the turmoil has contributed to falling commodity prices. The real side effects of the recent bout of market nervousness remains uncertain, however based on the relative size of the financial turmoil, its impact could be half as severe as the GDP growth deceleration (relative to earlier forecasts) observed in the fall of 2011.
Contagion from renewed tensions in the Euro Area appears less extensive than in the fall of 2011. Recent bank downgrades, partial nationalizations and elections have caused developing and high-income country stock markets to lose about 12 percent of their value since May 1st, giving up almost all of the gains generated over the preceding 4½ months. Yields on high-spread economies have risen, while those of safe-haven assets have declined. Virtually all developing economy currencies have lost between 3 and 7 percent against the U.S. dollar. Credit default swaps (CDS) rates have also increased significantly. Nevertheless, CDS rates in non-European high-income and developing economies remain well below their July 2011 levels. Emerging market bond spreads, although up are still 149 basis points lower than in October. 
Real side effects of the recent increase in market nervousness remain uncertain. It is too soon to observe the impact of the renewed financial-market turmoil on the real-side of the economy, but it is likely to be negative — particularly in high-income Europe. How negative is of course unknown. To-date, Euro Area financial market indicators have deteriorated about half as much as they did in the fall of 2011 (relative to July 2011), which suggests that the hit on activity could be about half as severe as in the fall of 2011 — when Euro Area quarterly growth rates declined by about 0.5 percentage points relative to expectations in June 2011 and whole year growth was off about 0.2 percent. 

The recent increase in market nervousness has driven commodity prices downward. Since the beginning of May, crude oil prices have fallen 15.8%, influenced primarily by concern that financial turmoil will cut into global growth and oil demand (improving supply conditions and easing tensions with Iran helped as well). Recent events also contributed to falls in copper and aluminum prices of 11.2% and 5.4% respectively. Many agricultural commodity prices have declined as well (corn, cotton and rubber), which should help relieve inflationary trends in developing countries. Developing countries are not expected to suffer large impacts if financial tensions do not worsen, and lower commodity prices will buffer those impacts for importers. However, for commodity exporters, lower commodity prices will reduce government revenues, weaken current account positions, and if long-lasting, will cut into growth.


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