Financial Markets

The financial markets were characterised by great uncertainty in 2002. The background to this uncertainty included the global course of the economy, the risks of terrorist actions and war in Iraq, and investors' greater risk aversion.

During 2002 the stock markets played a significant role in financial‑ market developments in general. Stock prices in the industrialised countries were falling up to the autumn. Besides the pronounced uncertainty, another factor was a number of accounting scandals in the USA and generally lower corporate earnings expectations.

The falling stock prices contributed to pushing long‑term interest rates in the USA and Europe down to a very low level.

In the foreign‑exchange market the dollar weakened by 18 per cent against the euro and by 10 per cent against the yen in 2002. The weakening was attributable to such factors as investors' declining propensity to invest in US business enterprises and bonds.

The negative trends in the stock markets continued in 2002, and stock prices in the industrialised countries fell up to the autumn, cf. Chart 13. The benchmark stock markets subsequently recovered, but overall for the year the leading stock indexes for the USA, Europe and Japan declined. These stock indexes dropped further at the beginning of 2003.

In the USA the S&P 500 index, comprising a broad range of US stocks, reached a 5‑year low on 9 October 2002. The Nasdaq index, which has a large share of technology stocks, fell by more than the S&P 500 index up to the low in October.

The falling stock prices can be explained by several factors. Accounting scandalsinvolvingseveralUScorporations gave rise to general concern as to whether the accounts reflect corporations' actual earnings, risks and commitments. This led to the introduction of a new law in the USA^[1] in 2002 aimed at restoring investor confidence in the information given by stock-exchange-listed companies. The new Act tightens the standards and norms for corporate governance and introduces stricter provisions on accountability and higher penalties for fraudulent accounts. The Act also enhances the surveillance of accounting firms by establishing an independent accounting oversight board. The Act furthermore includes elements to ensure the independence of accounting firms. These are e.g. prohibited from providing a number of consulting services to the corporations whose accounts they audit. The Act also includes measures to ensure that stock analysts remain independent of the companies they analyse.

Lower corporate earnings expectations also contributed to the falling stock prices. At the same time, US economic data releases generated uncertainty concerning the rate of growth in the US economy. Further uncertainty was due to the risks of war in Iraq and terrorist actions. The many uncertainties may have caused investors to perceive investments in stocks as being subject to an excessively high risk, causing them to prefer more secure investments. Finally, the declining stock prices can also be perceived as an adjustment from a high level.

The stock‑price increases after 9 October were e.g. related to better than expected 3rd‑quarter accounts for US companies overall. At the beginning of 2003, increased nervousness at the prospect of a war in Iraq contributed to pushing stock prices back down again.

In Japan, the Nikkei 225 index rose in the 1st half of 2002, but then fell again. On 14 November the index was at its lowest level for 19 years due to e.g. falling prices for Japanese banking stocks.

Stock markets in Europe generally followed the pattern of the US stock markets. However, the degree to which stock prices fell varied across Europe, cf. Chart 14. The Danish KFX index thus dropped by less than the European stock indexes in general, since the KFX index comprises relatively few stocks that are very sensitive to cyclical fluctuations. The major decreases in the Swedish and German indexes can be attributed to e.g. significant price drops for technology and telecommunication stocks, which are a major element of these indexes. Moreover, the strong decline in the German stock index is also related to the drop in prices of banking and insurance stocks.

In the USA, the yield on the benchmark 10‑year US government bond was 3.9 per cent at the end of 2002, against 5.2 per cent at the start of 2002, cf. Chart 15. It fell further to 3.7 per cent at the end of February 2003. In November 2002, the Federal Reserve lowered the key short‑ term rate – the federal funds target rate – by 0.5 per cent, bringing this interest rate down to 1.25 per cent, the lowest level for more than 40 years.

10-year yield and stock index in the USA	Chart 15
Note: Weekly observations.
Source: Bloomberg.

At the beginning of 2002, US interest rates were expected to increase across the entire yield curve during the year. In the 1st quarter, long‑term yields rose by around 0.25 per cent, but fell strongly in the two subsequent quarters. In October, the 10‑year US yield had thus fallen to 3.6 per cent, which is around 0.5 per cent lower than the level during the unrest on financial markets in 1998, and in the period immediately after 11 September 2001.

The drop in interest rates was supported by the weak economy and by special circumstances. A number of accounting scandals involving some of the largest corporations in the USA augmented investors' perception of the risk of holding stocks, and heightened financial‑market uncertainty. Stock prices and bond yields typically move in the same direction in periods of marked uncertainty on the financial markets. This was strongly evident in 2002, cf. Chart 15. One factor is that investors prefer the expected lower, but safer, return on bonds.

The business scandals and weak economic growth also affected the corporate bond market where spreads to government bonds widened, cf. Chart 16. Towards the end of the year, the situation normalised to a degree in step with predominantly better than expected economic data releases and accounts for the 3rd quarter.

In the USA there was a growing requirement for government bond issues in 2002 in view of a deterioration in the government budget, cf. Table 4. However, the uncertainty and the weak economic cycle overshadowed the impact of the large government issues on the long‑term interest rates. The same was the case in most of Europe and in Japan.

In the euro area the yield on the benchmark 10‑year German government bond fell from 5.0 per cent at the start of 2002 to 4.2 per cent at year‑end, and moreover to 3.9 per cent at the end of February 2003. The 10‑year government‑bond yield also fell in France and Italy, to 4.0 per cent and 4.1 per cent respectively at the end of February 2003. The 10‑year yield spreads among the euro area member states were within a relatively narrow range at year‑end. Only Greece and Italy have relatively high 10‑year government‑bond yields. In December 2002 the European Central Bank, ECB, lowered the minimum bid rate for the main refinancing operations from 3.25 per cent to 2.75 per cent, cf. p. 32.

In Denmark Danmarks Nationalbank in December followed the ECB by lowering the discount and lending rates by 0.5 per cent. Earlier in the year, the lending rate was lowered by a total of 0.15 per cent, cf. p. 33. At year‑end the yield on the benchmark 10‑year Danish government bond was 4.5 per cent, against 5.1 per cent at the beginning of the year. The interest rate dropped further to 4.2 per cent at the end of February 2003.

The 10‑year Danish‑German yield spread for the benchmark government bonds was around 0.2 per cent at the beginning of the year, cf. Chart 18. At the start of September, the spread widened to just under 0.4 per cent as a consequence of a new 10‑year Danish benchmark bond with a longer maturity than the previous benchmark. The widening of the yield spread was thus due to technical factors. The spread subsequently narrowed to its previous level. At year-end it was 0.26 per cent, and virtually unchanged at the end of February 2003.

In the UK, the yield on the benchmark 10‑year government bond was 4.4 per cent at year‑end, against 5.0 per cent at the beginning of 2002. The 10‑year yield spread to Germany widened by almost 0.15 per cent, ending the year at 0.22 per cent, cf. Chart 18. The Bank of England kept the official interest rate – the base rate – unchanged at 4.0 per cent throughout the year. At the beginning of 2003 the Bank of England lowered the interest rate by 0.25 per cent.

In Sweden, the yield on the benchmark 10‑year government bond fell from 5.3 per cent at the beginning of the year to 4.7 per cent at year‑end. The 10‑year yield spread to Germany closed the year at 0.5 per cent, cf. Chart 18. Sveriges Riksbank adjusted the repo rate on four occasions during the year. In March and May the repo rate was raised by 0.25 per cent, while it was lowered by 0.25 per cent in both November and December. The repo rate was 3.75 per cent at the end of 2002.

Interest rates in Norway are generally higher than in most other European countries. At the close of 2002, the 10‑year Norwegian government‑bond yield was 5.8 per cent, against 6.3 per cent at the beginning of the year. The 10‑year Norwegian‑German yield spread for benchmark government bonds widened by around 0.3 per cent during the year, and closed at 1.6 per cent, cf. Chart 18. In July, Norges Bank raised its official interest rate by 0.5 per cent. In December, the interest rate was lowered by 0.5 per cent, bringing the current‑account rate to 6.5 per cent. At the beginning of 2003 Norges Bank lowered the interest rate by 0.5 per cent.

In the UK and Sweden yields on benchmark 10‑year government bonds fell by a further 0.2‑0.3 per cent in the first two months of 2003, while in Norway the yield fell by 0.6 per cent.

In Japan, the benchmark 10‑year government-bond yield was 1.4 per cent at the beginning of the year, and 0.9 per cent at its close, cf. Chart 17. Japan continues to pursue a "zero‑interest‑rate" policy and the very short‑term interest rate was 0.002 per cent at the close of the year. The Bank of Japan maintained an unchanged discount rate of 0.1 per cent throughout the year, and adopted a number of monetary‑policy measures in 2002 such as raising the target for the monthly purchases of government bonds from 800 billion yen to 1,000 billion yen in February 2002. In October, the target was raised further to 1,200 billion yen.

During 2002, the dollar weakened by 18 per cent against the euro, cf. Chart 20. The dollar strengthened against the euro at the beginning of the year, when an economic upswing in the USA was still expected. Towards April, this trend reversed with increasing uncertainty concerning the cyclical development in the USA. The strongest weakening took place in respectively the 2nd and 4th quarters. The dollar weakened further at the beginning of 2003.

Euro vis-à-vis dollar and yen	Chart 20
Note: Weekly observations.

The Japanese yen weakened by 7 per cent vis‑à‑vis the euro, and strengthened by 10 per cent against the dollar. The Japanese economy has suffered a prolonged weakening and a stronger yen against the dollar can dampen export opportunities. Furthermore, a strengthening of the yen may augment the deflationary trends. In the summer of 2002, these considerations led the ECB and the Federal Reserve to intervene on behalf of the Bank of Japan so as to weaken the yen.

The pound sterling was also affected to a degree by the dollar's weakening, falling by 5 per cent against the euro, cf. Chart 22. The Swedish krona fluctuated between 9.0 and 9.5 vis‑à‑vis the euro in 2002, ending the year at 9.2.

The Norwegian krone strengthened against both the euro and the dollar to its strongest level since 1986. The strengthening was primarily related to a high level of interest rates in Norway, and to rising oil prices, since a large proportion of Norway's exports are oil‑ based.