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Economics Weekly: When will the rapid growth in derivatives slow? Commentary on economic data in the week: Busy week for economic data could renew focus on fundamentals

Economics Weekly:
When will the rapid growth in derivatives slow?

Measuring derivatives is not an easy thing to do, but the latest figures from the Bank for International Settlements (BIS) suggest that it needs to be done because the market shows no sign of slowing down. Indeed, the market in these instruments has exploded in the last few years. From almost nothing twenty years ago, it now stands at $370 trillion, and has been growing by an average of about 20% a year. What are the reasons for this rapid growth and how long can it continue?

What are derivatives?
Derivatives are financial instruments whose values stem from that of something else, such as bonds, interest rates, equities, foreign currency, commodities etc. They are traded as a way of taking bets on the direction of markets without having to own the underlying asset and to protect against swings in the value of those assets, i.e. insurance. Most derivatives are traded in the over the counter (OTC) market and the deals are concluded privately, explaining why there are not conclusive data collected by some third party independent to the transaction. But the BIS surveys financial institutions about their derivatives exposure twice each year, and it is this data that we use in this analysis.

How fast has the growth of derivatives been?
Adding up the nominal value of all the reported outstanding contracts shows a gross outturn of $370 trillion. Netting out the derivative contacts against each other still gives a big figure but one of ‘only’ around $10 trillion. However, to fully understand the size of the exposure that banks and others have in the derivatives market, we need to look at the gross figure, as shown in charts a and b. As the charts show, by far the biggest sector is interest rate swaps, followed by exchange rate derivatives and credit derivatives, most commonly credit default swaps, one of the fastest growing elements. Equity-based derivatives are still popular but less so. Commodity derivatives are rising most rapidly, but are still a small share of the total though, in our opinion, likely to rise as quickly in the next few years as in the last five.

What has been driving this rapid growth in derivatives?
The short answer is that low interest rates and abundant liquidity have been driving down rates of return for assets around the world, forcing investors to look for yield in ever inventive new financial products. The following charts, c, d, e and f, illustrate this point more clearly. Using growth in UK money supply as a proxy for global liquidity trends, it is clear that there is a link between money supply growth and derivatives activity. Of course, there needs to be sophisticated financial instruments and technology to measure and keep track of these instruments and deep and liquid global financial markets in the actual assets themselves in order to make them likely to be traded by large financial institutions. Technology and greater liquidity also lowers the transaction cost of doing business in the derivative markets, allowing traders to move in and out of the markets with minimal impact on costs or the price of the derivative.

Low interest rates stemming from low and stable inflation in the last decade or so also seems to have helped lead to the sharp rise in derivatives issuance and usage we are currently seeing, as returns have been lowered from betting on changes in short term official interest rates or protecting against the risk of shifts in market interest rates. A further sign of lower returns in traditional investments, and corresponding rise in derivative activity is shown by the fall in long term bond yields and by the drop in the yield spread between government and company bonds. A long period of low and stable interest rates has also probably lulled investors into a sense that markets are predictable, low risk and low return so it is worth taking bigger and bigger bets and in devising ever new higher yielding assets to invest in.

Are there economic and market risks from this rapid growth in derivatives?
This is, of course, a big risk and something that central banks have warned against. A big default they believe could endanger the entire financial system; especially since the ultimate ownership of the liabilities in derivatives markets is not clear. However, the fact is that official short term interest rates are low and returns from other traditional investments are also low, so it seems that the rapid growth and use of derivatives will remain a feature of the global financial landscape until there is a sharp rise in short term interest rates and the risk profile changes. Any sharp reversal of recent benign trading conditions, however, could have severe consequences for any overexposed participants, potentially having negative economic effects. This could occur either through a big default, widening credit spreads and potentially reducing business investment.
Trevor Williams, Chief Economist

Commentary on economic data in the week

Busy week for economic data could renew focus on fundamentals

• Focus in financial markets this week is likely to be on whether the recent sharp depreciation of the dollar will be sustained or if it rallies back, with trading volumes returning to normal after Thanksgiving. It is a busy economic calendar, with some key US data released and a series of Fed speakers, including Chairman Bernanke, Moskow, Lacker and Plosser.

• In the UK, given the renewed uncertainty in financial markets of whether base rates could rise again in February, the testimony to a Treasury select committee by BoE governor King and other members of the MPC, on Thursday, will be closely monitored. Housing market data, on Wednesday, should remain robust. We expect a further increase in consumer confidence (Gfk), possibly underpinning stronger retail sales (CBI), both out on Thursday.

• Economic data in the EU-12 this week are likely to consolidate expectations of further interest rate hikes in 2007, possibly underpinning the €. The flash CPI estimate may show inflation at 1.8% in November, up from 1.6% in October. Survey data should signal solid growth ahead.

• On Monday, BoJ governor Fukui could offer a strong signal on the chances of an interest rate rise in December. Unless convinced otherwise, we look for the next hike to be in Q1 2007.

Foreign exchange provided the main story in financial markets last week, as the dollar came under strong selling pressure, tumbling to an almost two-year low against the pound and a 19-month low versus the euro. The extent of the fall, particularly in the absence of any real change in underlying US economic data, suggests that the thin trading conditions associated with the Thanksgiving holiday in the US may have played a significant role. It will be intriguing to see whether the dollar will be able to recoup some or all of its falls this week. Along with the return of more normal trading volumes, a raft of economic data and speeches from prominent Fed members could support the dollar this week. The key factor will be what they imply for US interest rates and economic growth in 2007. The second estimate of Q3 gdp, on Wednesday, may show growth was revised up from 1.6% previously, but is unlikely to be a significant upgrade and forward-looking indicators could possibly elicit most market reaction. Consumer confidence, on Tuesday, is expected to have rebounded in November, aided by lower oil prices, the recent strength of equities and an easing in fears over a potential collapse of the US housing market. However, figures for existing and new homes sales in October will attract attention, as year-on- year falls are likely to be very sharp. The Fed's preferred inflation measure, the core PCE deflator, is published on Thursday and could provide a surprise, but the consensus is that the annual rate remained at 2.4% in October. This is still well above the Fed's stated comfort level of 1%-2%. Personal income and spending data for October are released at the same time, but are likely to be overshadowed by other news. However, initial jobless claims could elict some reaction after the surprise sharp rise last week. The November Chicago PMI, is out later on Thursday, and may show a small rise, as may the manufacturing ISM for November on Friday.

The housing market is likely to provide the main talking point in the UK this week. Mortgage lending activity has been buoyant and net lending in October, according to the BoE, may have neared £10bn, the highest since 2003. Mortgage approvals may have eased, but are likely to have remained high, underpinning a strong outlook for house prices in the months ahead. Gfk consumer confidence, on Thursday, could have improved for a third straight month in November, as unemployment fears ease. The November manufacturing PMI, should show expansion, although we see a small fall in the index.

It is a busy week for economic data in the euro zone. The highlight is likely to be the flash estimate of November euro zone CPI, on Thursday, which should show that the annual rate rebounded to 1.8%, from 1.6% in October. Money supply data, on Tuesday, will also attract attention and may show the annual growth rate accelerated for a third consecutive month, to 8.6% in October. The ECB's reference target is 4.5%. Euro zone survey data on Thursday and Friday may signal that economic growth could be stronger in Q4 than in Q3. Comments from ECB officials will also draw some attention this week. Wednesday is particularly busy for ECB speakers, with president Trichet, Noyer and Liebscher all taking the stage at different events.

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