Financial Markets

Even though monetary policy was tightened in the USA the US 10-year yield remained by and large unchanged over the year. The equivalent euro area yield fell as a consequence of uncertainty concerning the future development of the European economy.

The US dollar strengthened vis-à-vis the euro, pound sterling and yen in 2005. Among other things, this reflected the higher level of interest rates in the USA.

US stocks increased moderately, while euro area stocks rose substantially, and Japanese stocks rose even more in 2005. As in the preceding two years, the Scandinavian stock markets performed better than the euro area.

INTEREST RATES

The yield on the benchmark 10-year US government bond increased from approximately 4.3 per cent at the beginning of 2005 to approximately 4.4 per cent at end-2005, cf. Chart 16 . In the 2nd quarter, the 10-year yield fell, inter alia due to unrest in the market for credit bonds in the wake of the downgradings of General Motors and Ford, see below. The unrest led to increasing demand for secure government bonds. At the beginning of the 3rd quarter, the tide turned and the yield began to rise, partly in reaction to stronger key indicators and increasing fears of higher inflation as oil prices continued to rise.

The Federal Reserve tightened monetary policy on eight occasions in 2005. This raised the fed funds target rate by 2 percentage points in the course of the year, to 4.25 per cent at end-2005. However, this did not have any significant impact on long-term US yields and consequently the yield curve for US government bonds flattened during the year. The spread between the 10- and 2-year yields narrowed by approximately 120 basis points in 2005. The spread continued to narrow and by the end of February 2006 the 10-year yield had fallen below the 2-year yield. In January 2006, the fed funds target rate was raised by a further 0.25 percentage points to 4.50 per cent.

In the euro area, the yield on the benchmark 10-year German government bond fell from approximately 3.6 per cent at the beginning of 2005 to approximately 3.3 per cent at end-2005, cf. Chart 16. This led to a widening of the 10-year yield spread to the USA by approximately 50 basis points, to around 110 basis points. The falling yield in the euro area is attributable to uncertainty regarding future economic growth, among other factors. Towards the end of the year there were clearer indications of an upswing. This strengthened the expectations of future inflationary pressure, which contributed to the decision by the European Central Bank, ECB, to raise its key interest rate by 0.25 percentage points in December 2005 and by a further 0.25 percentage points in March 2006.

Even though US monetary policy was tightened repeatedly, long-term yields in the USA and in the euro area are still considered to be low. The background includes globalisation effects, low and stable inflation expectations and purchases of government bonds by pension funds and Asian central banks.^[1]

The yield on the benchmark 10-year Japanese government bond remained relatively stable in 2005. At the end of the year, the 10-year yield was approximately 1.5 per cent, cf. Chart 16. The discount rate remained unchanged at 0.1 per cent in 2005, and was last adjusted in 2001.

In the UK, the yield on the benchmark 10-year government bond fell from approximately 4.5 per cent at the beginning of 2005 to approximately 4.1 per cent at the end of the year, cf. Chart 16 . In the 4th quarter, the 10-year yield was lower than the 10-year US yield, among other things because the Bank of England lowered its base rate in August. The 10-year yield spread to the euro area, which has been widening in recent years, narrowed substantially in the 4th quarter of 2005, cf. Chart 17. The yield spread stabilised in December, to approximately 80 basis points at the end of 2005.

In Denmark, the yield on the benchmark 10-year government bond fell from approximately 3.8 per cent to approximately 3.2 per cent in the 1st half-year. The Danish yield fell more strongly than the euro area yield, so that the 10-year yield spread to the euro area became negative in the early summer, cf. Chart 17 . In the 2nd half-year, the 10-year yield spread stabilised, and was close to zero at the end of 2005. The low yield in Denmark compared to the euro area reflects the strong Danish economy, among other factors.

In response to the ECB's interest-rate adjustments, in both December 2005 and March 2006 Danmarks Nationalbank raised the lending rate, the discount rate and the interest rate on the current accounts of the monetary- policy counterparties by 0.25 percentage points. After Danmarks Nation albank unilaterally raised the lending rate by 0.10 percentage points to 2.50 per cent in February 2006, cf. p. 32, the 10-year yield spread to the euro area widened slightly. After interest rates were raised on 2 March, the lending rate was 2.75 per cent, while the discount and current-account rates were 2.50 per cent.

The yield on the benchmark 10-year Swedish government bond fell from approximately 3.9 per cent at the beginning of 2005 to approximately 3.0 per cent in September. The explanatory factors included Sveriges Riksbank's lowering of its repo rate by 0.5 percentage points in June 2005, as well as uncertainty concerning new rules for risk compilation by the pension and life insurance sector.^[2] The spread to the euro area became negative in May and remained negative until the beginning of December, cf. Chart 17 . In the wake of the announcement of the rules, which were less restrictive than first expected, the downward trend reversed, and the Swedish 10-year yield rose to approximately 3.3 per cent at the end of 2005. Sveriges Riksbank raised its repo rate from 1.50 per cent to 1.75 per cent in January 2006, and to 2.00 per cent in February 2006.

In Norway, the yield on the benchmark 10-year government bond fell from approximately 4.0 per cent at the beginning of 2005 to approximately 3.7 per cent at the end of the year. The sight deposit rate was raised by 0.25 percentage points in July and in November, to 2.25 per cent at end-2005.

Credit spreads, i.e. the spread between the yields on, respectively, corporate and mortgage-credit bonds and a secure government bond, have narrowed considerably in recent years, cf. Chart 18. This is attributable among other factors to the falling level of interest rates and thus lower potential earnings from investment in highly rated government bonds. This has attracted investors to less safe investments with higher expected returns.

In April and May 2005, the US credit spread with the rating A, and especially BBB, widened substantially. This also affected the credit spread in the euro area. The background was the downgrading of General Motors and Ford.^[3] However, the spread soon narrowed again, and by mid-June it was at around the same level as prior to the downgradings. The credit spreads widened slightly in the 2nd half of 2005 and in the beginning of 2006.

FOREIGN-EXCHANGE MARKETS

The US dollar strengthened in 2005 in spite of sustained large balance-of-payments and government budget deficits. Altogether, the dollar strengthened by approximately 11 per cent vis-à-vis the euro and the yen, and by approximately 8 per cent against the pound sterling. At the end of 2005, the exchange rate was 1.19 dollars per euro, and it remained at around this level at the beginning of 2006, cf. Chart 19.

The strengthening of the dollar in 2005 should, inter alia, be viewed against the background of the continued tightening of monetary policy in the USA, which has led to a generally higher level of interest rates in the USA than in the euro area and Japan. The uncertainty concerning the economic development in the euro area, and the rejection of the EU's Constitutional Treaty in France and the Netherlands in the early summer, may also have contributed to the dollar's strengthening vis-à-vis the euro.

At the end of July, the People's Bank of China announced that it would adjust its fixed-exchange-rate policy vis-à-vis the dollar. This entailed revaluation of the renminbi by 2 per cent against the dollar, cf. Box 4. Subsequently, the dollar weakened marginally against the major currencies for a brief period. This weakening was, among other things, a result of uncertainty concerning China's future strategy in relation to its dollar stock in the foreign-exchange reserve.

REVALUATION OF THE CHINESE CURRENCY	Box 4
On 21 July 2005, the People's Bank of China announced that it would adjust the fixed-exchange-rate policy vis-à-vis the US dollar in favour of a managed float based on a basket of currencies. The four principal currencies in the reference basket are the dollar, the euro, the yen and the South Korean won. The weights of the individual currencies are determined on the basis of bilateral trade shares, the currency structure of the external debt (interest payments), direct foreign investments (dividends) and the currency structure for current transfers (includes e.g. development aid). Under the new system, the People's Bank of China fixes a bilateral exchange rate on a daily basis. The exchange rate is calculated on the basis of the closing rates for the currencies in the reference basket on the preceding trading day. The day-to-day fluctuation band for the Chinese renminbi vis-à-vis the dollar has been set at +/- 0.3 per cent. The day-to-day fluctuation band in relation to the other currencies in the reference basket is +/- 1.5 per cent. On the transition to the new exchange-rate regime, the central rate was fixed at 8.11 renminbi per dollar, equivalent to revaluation by 2 per cent, cf. the Chart (left). The day-to-day fluctuations after the change of currency regime have been small, typically below +/- 0.05 per cent. The total appreciation vis-à-vis the dollar since 22 July 2005 has been just below 1 per cent. In the period from 1994 – when China replaced a double exchange-rate system with a system based on a single exchange rate – until 1997, the renminbi appreciated by approximately 5 per cent vis-à-vis the dollar. From 1994 China by and large maintained a fixed-exchange-rate policy against the dollar, keeping the exchange rate constant at 8.28 renminbi per dollar since 1998, cf. the Chart (left). The People's Bank of China uses intervention as a means of managing the exchange rate of the renminbi, which has contributed to a rapidly expanding foreign-exchange reserve in recent years, cf. the Chart (right). However, the liberalisation of China's foreign-exchange policy in July has not led the People's Bank of China to stabilise the reserve. On the contrary, it has continued to rise and amounted to approximately 819 billion dollars at end-2005.
RENMINBI VIS-À-VIS DOLLAR AND THE DEVELOPMENT IN CHINAS FOREIGN-EXCHANGE RESERVE
Note: Reverse axis for left-hand Chart. Source: EcoWin.

Viewed over the full year, the Japanese yen remained unchanged against the euro. At the close of 2005, the exchange rate was 139 yen per euro, cf. Chart 19. The relative parities of the two currencies were, however, volatile during the year.

In the 1st half of 2005, the pound sterling strengthened by approximately 6 per cent against the euro, cf. Chart 20. The situation reversed in the 2nd half-year, and sterling weakened briefly, while the development in the rest of the year was relatively stable. Over the full year sterling appreciated by approximately 3 per cent, to 0.69 pounds sterling per euro at the end of 2005.

The Swedish krona weakened by approximately 4 per cent vis-à-vis the euro in 2005, cf. Chart 20. The falling currency in the 1st half-year was e.g. attributable to less positive growth prospects. During May 2005 there were also mounting expectations that Sveriges Riksbank would lower its repo rate. These expectations were fulfilled in June, when the repo rate was lowered by 0.5 percentage points. Towards the end of the year, the krona strengthened against the euro, which in part reflected growing expectations that Sveriges Riksbank would raise the repo rate. In January 2006 the rate was increased to 1.75 per cent, and in February 2006 to 2.00 per cent. At the end of 2005, the exchange rate was 9.43 Swedish kronor per euro.

As the price of oil continued to rise throughout 2005, the Norwegian krone strengthened vis-à-vis the euro, and by the end of the year it had appreciated by approximately 3 per cent to 8.01 Norwegian kroner per euro. Strong economic growth and Norges Bank's raising of the sight deposit rate on two occasions contributed to the strengthening of the Norwegian krone. At the end of the year, the krone weakened slightly against the euro, e.g. reflecting lower oil prices and the ECB's raising of its key interest rate.

STOCK MARKETS

The global stock markets rose overall in 2005, but with considerable individual variations, cf. Chart 21. US stocks increased moderately, while euro area stocks rose substantially, and Japanese stocks rose even more – at a rate unsurpassed since 1986.

High demand for energy, and global oil production close to its capacity limit led to rising oil prices in 2005, which was clearly reflected in the global stock markets, cf. Box 5.

OIL AND PETROL PRICES AND ENERGY-RELATED STOCKS 2005	Box 5
The rising oil price influenced the global stock markets in 2005. The impact on energy-related stocks was positive, while other stocks were mainly negatively affected, although to a lesser extent than expected in the market. The oil price rose from a level of just under 45 dollars per barrel at the beginning of the year to 70 dollars per barrel at end-August, i.e. an increase by more than 50 per cent in eight months. This was the highest nominal level ever and the highest real level since 1981. In the autumn the oil price dropped back to below 60 dollars, but has subsequently risen moderately, cf. the Chart.
OIL AND PETROL PRICES AND US ENERGY-RELATED STOCKS
Note: Weekly observations. Oil and petrol are the shortest generic futures contracts, i.e. the price of oil and petrol for delivery in one month. Source: Bloomberg.
The primary reason for the increase is sustained high demand for oil, e.g. from China, which imports much of its consumption. The low investments in the oil sector in recent years also began to influence price formation, since production capacity was close to its upper limit. Moreover, the number of speculative investors increased as more investment banks and hedge funds sought arbitrage opportunities in the market. Several temporary factors, e.g. resumption of Iran's nuclear programme and Hurricanes Katrina and Rita in the Mexican Gulf, also exerted upward price pressure in some intervals. Particularly the hurricanes had significant impacts on petrol prices, which increased considerably on some days by, respectively, 20 per cent during Katrina and 14 per cent during Rita. Even though petrol prices fell during the autumn the overall increase in 2005 was 60 per cent. Energy-related stocks in both the USA and the euro area benefited from the higher energy prices in 2005, which in both cases rose by approximately 30 per cent. These were the sectors in S&P 500 and S&P Euro that saw the highest increases. Energy-related stocks are included with a weight of only 9 per cent in the S&P 500, but are the primary reason for the overall increase in the US stock markets 2005.

Up to the end of the 3rd quarter, US stock markets were influenced by the tightening of monetary policy, the strengthening of the dollar and higher energy prices, which flattened the price trend for US stocks. The downgrading of the large US conglomerates General Motors and Ford, cf. above, also contributed to keeping US stock prices down. However, sustained high economic activity and rising employment helped to prevent stock prices from falling, and towards the end of the year the broad US stock index, S&P 500, edged upwards. Over the full year the index increased by a total of 3 per cent.

From the beginning of 2005, euro area stock prices were under pressure from the weak economy. From May stock prices rose considerably, however, e.g. as a result of the low interest rates. In addition, the weakening of the euro vis-à-vis the dollar improved competitiveness. The stock index for the euro area, S&P Euro, rose by 23 per cent in 2005.

The Japanese stock index, Nikkei 225, remained virtually unchanged in the 1st half of 2005, but then rose very strongly, primarily reflecting more positive economic prospects. More than 90 per cent of the Nikkei stocks rose, and 10 per cent of the companies more than doubled their value during the year. Overall, Nikkei 225 rose by 40 per cent over the year.

British stocks have generally been affected by the same factors as in the euro area, but with the major difference that UK companies again in 2005 faced higher investment costs as a result of higher interest rates. Economic growth in the UK generally diminished in 2005, but nonetheless the FTSE 100 rose by 17 per cent over the year.

The Scandinavian stock markets matched the positive development in euro area stock prices in 2005, cf. Chart 22. As in the preceding two years, the Scandinavian stock markets performed better than the euro area.

The increase in the Danish OMXC20 index – previously the KFX index – was primarily attributable to the key A.P. Moller – Maersk stocks, which accounted for just below one third of the increase. Danske Bank and TDC also contributed to the positive development, and virtually all companies appreciated during the year. The overall index rose by approximately 37 per cent over the year, making 2005 the Danish stock market's best year since 1997.

All stocks rose in the Swedish OMX index, and for the third consecutive year the electronics enterprise LM Ericsson made the most positive contribution to the index. Norwegian shares benefited mainly from the higher oil prices, and particularly Statoil and Norsk Hydro contributed to the increase in the OBX index over the year.