Financial Markets
The US dollar weakened vis-à-vis the euro and the yen in 2003. The weakening reflected imbalances in the US economy, among other factors.
At the beginning of 2003 the financial markets were characterised by uncertainty, inter alia as a result of the weak global economic development and the prospects of war in Iraq. In the USA long-term interest rates fell throughout the 1st half of the year to a very low level, but from June they increased considerably within few months. Long-term interest rates in Europe more or less mirrored the development in the USA, but the fluctuations were smaller.
Stock prices fell at the beginning of 2003, but generally rose up to the onset of the war in Iraq.
Foreign-exchange markets
The US dollar weakened by 20 per cent vis-à-vis the euro in 2003, cf. Chart 14, and the exchange rate at end-2003 was 1.26 dollars per euro. The dollar fluctuated at the beginning of 2004, and at the end of February it was on a par with the level seen at the turn of the year. The weakening of the dollar reflected e.g. concerns as to the financing of the large, growing balance-of-payments deficit, as well as the sustainability of the government finances in the long term, cf. Box 2. The expansionary US monetary policy relative to that of the euro area may also have contributed to the weakening of the dollar.
| Euro vis-à-vis dollar and yen |
Chart 14
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| Note: Weekly observations. | |
| Source: Ecowin. | |
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Box 2
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After the introduction of the euro on 1 January 1999, the dollar strengthened until the beginning of 2002 and then it weakened again. At the beginning of 2004 the real effective dollar rate was in line with the historical average since 1980, cf. the Chart. The real dollar rate takes account of differences in price developments in different countries. The real effective dollar rate, consisting of weighted exchange rates for a large number of trading partners, is more stable than the real dollar rate vis-à-vis the euro alone. The reason is that some countries, particularly in Asia, more or less follow the dollar. The weakening of the dollar over the last two years is often attributed to the increasing US balance-of-payments deficit and the simultaneous build-up of a large government deficit. However, this explanation cannot be viewed in isolation, and general experience shows that theoretical determination of exchange rates does not match the actual developments, i.e. very large fluctuations of considerable duration. The weakening of the dollar affects economic development in the euro area, and due to the fixed-exchange-rate policy also economic development in Denmark. Exporters become less competitive in the US market and in the markets where the currencies follow the dollar. On the other hand, the strengthening of the euro means that imports from e.g. the USA become cheaper. This contributes to reducing inflation in the euro area, thus increasing purchasing power. |
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| Real dollar rate | |
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| Note: Before 1999 the D-mark and German consumer prices have been used for calculating the real euro/dollar rate. Source: Ecowin (Federal Reserve) and own calculations. |
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At the meetings of the G7 countries in September 2003 and February 2004 the participants called for a more flexible, market-based development of exchange rates between the major economies. This contributed to weakening the dollar in the autumn since many market participants interpreted this declaration as a wish for a weaker dollar with a view to reducing the US balance-of-payments deficit. In recent years Asian central banks have intervened in the foreign-exchange market to prevent their currencies from strengthening vis-à-vis the dollar. China and Hong Kong maintain fixed-exchange-rate policies against the dollar.
In 2003 the Japanese yen weakened by 9 per cent vis-à-vis the euro and strengthened by 10 per cent vis-à-vis the dollar. During 2003 and in early 2004 the Bank of Japan intervened in the foreign-exchange market on numerous occasions to weaken the yen vis-à-vis the dollar. After a sustained weak period, the Japanese economy saw GDP growth of 2.7 per cent in 2003.
The pound sterling weakened by 8 per cent vis-à-vis the euro to 0.7, cf. Chart 15. The Swedish krona remained more or less unchanged in 2003 at 9.1 kronor per euro in 2003. The Swedish referendum on the euro had no major impact on the exchange rate. The Norwegian krone weakened by 15 percent vis-à-vis the euro to 8.4 kroner per euro. By end-February 2004 the Norwegian krone had further weakened by 4 per cent. The weakening was a result of the narrowing of the Norwegian yield spread to the euro area.
| Pound sterling, swedish krona and norwegian krone vis-à-vis the euro |
Chart 15
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| Note: Weekly observations. | |
| Source: Ecowin. | |
Interest rates
In the USA the long-term yields fluctuated in 2003, cf. Chart 16. The yield on the benchmark 10-year US government bond fell from 3.8 per cent at the beginning of 2003 to 3.1 per cent in June, the lowest level for more than 40 years. This should be seen against the background of e.g. deflation concerns.
| 10-year yields in the USA, the UK, the euro area1 and Japan |
Chart 16
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| Note: Weekly observations. | |
| Source: Ecowin. | |
| 1 10-year German government bond. | |
From mid-June expectations of an economic upswing grew among investors, and by the beginning of September the 10-year US yield had increased by around 1.5 per cent. The subsequent development was more subdued. In addition to growing optimism among investors, the increase was supported by e.g. large issues of government bonds owing to the large government deficit in the USA, and reduced deflation concerns as growth picked up and growth prospects improved. Finally, risk-management mechanisms also played a role. Hedging the interest-rate sensitivity of holdings of callable US mortgage-credit bonds thus had a further upward impact on long-term yields, cf. Box 3. At end-2003 the 10-year US yield was 4.3 per cent.
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Box 3
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Callable mortgage-credit bonds differ from e.g. most government bonds in that the borrower may prematurely redeem the loan at par. Consequently, the interest-rate risk – defined as the sensitivity of the bond price to changes in interest rates – changes considerably as the level of interest rates changes. Typically the interest-rate risk rises when interest rates go up, and vice versa. An investor holding mortgage-credit bonds will often prefer that the sensitivity of the portfolio to changes in interest rates neither increases when interest rates go up nor falls when interest rates go down. The investor may compensate for the increasing or decreasing interest-rate risk on mortgage-credit bonds by selling or purchasing government bonds or other interest-rate instruments, e.g. swaps. In June 2003 long-term US yields began to rise, thus increasing the interest-rate risk in the considerable market for callable US mortgage-credit bonds. In order to maintain the interest-rate risk, investors sold US government bonds. This resulted in a steeper yield curve. For a short while the US swap spread widened considerably as the demand for swap agreements increased, cf. the Chart below. In 2003 the European swap spreads were more stable than the US spread. One explanation is that the need to hedge the interest-rate risk on callable mortgage-credit bonds is much smaller in Europe. The Danish mortgage-credit market is the largest market for callable bonds in Europe. Hedging of Danish mortgage-credit bonds typically takes place in the much larger European government-bond market, where the impact is limited. |
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| Slope of the yield curve and 10-year us swap spread | |
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| Note: Weekly observations. The slope of the yield curve is determined as the 10-year US government-bond yield less the federal funds target rate. The swap spread is determined as the 10-year US swap rate less the 10-year US government-bond yield. Source: Bloomberg, Ecowin. |
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| 1 For a more detailed description of these dynamics, see Louise Mogensen, Market Dynamics at Low Interest Rates, Danmarks Nationalbank, Monetary Review, 1st Quarter 2002, and BIS, Quarterly Review, September 2003. | |
In June the Federal Reserve System reduced the federal funds target rate by 0.25 per cent to 1.0 per cent.
Long-term government-bond yields in Europe almost mirrored the development in the USA, cf. Chart 16. The fluctuations in European government-bond yields were less pronounced, although recent years have generally seen a high degree of covariation between the various national financial markets.
In the euro area the yield on the benchmark 10-year German government bond was 4.3 per cent at end-2003 against 4.2 per cent at the beginning of 2003. The 10-year government-bond yields in the other euro area member states were also almost unchanged over the year. The mutual 10-year yield spreads for the euro area member states lay within a narrow interval at year-end. The European Central Bank, ECB, lowered the minimum bid rate for its main refinancing operations by 0.25 per cent in March and by a further 0.5 per cent in June to 2.0 per cent, cf. p. 30ff.
In Denmark the 10-year Danish government-bond yield was 4.5 per cent at end-2003, as it was at the start of the year. The 10-year Danish yield spread to the euro area[1] for the benchmark government bonds was 0.26 per cent at the beginning of 2003, against 0.18 per cent at year-end, cf. Chart 17. The 30-year Danish mortgage rate remained more or less unchanged during the year, whereas the short-term mortgage rate, calculated on the basis of 1- and 2-year bonds, decreased by approximately 0.5 per cent to 2.5 per cent. Danmarks Nationalbank followed suit when the ECB lowered its interest rates, and also unilaterally lowered its lending rate by 0.05 per cent in May, cf. p. 33.
In the UK the yield on the benchmark 10-year government bond went up from 4.4 per cent at the beginning of 2003 to 4.8 per cent at year-end. The 10-year yield spread to the euro area widened by around 0.3 per cent during the year, to 0.5 per cent at year-end, cf. Chart 17. The widening of the yield spread is attributable e.g. to large public issues in the UK relative to the euro area, the widening of the spread between monetary-policy interest rates, and an increase in inflation in the UK relative to the euro area. The Bank of England changed its repo rate on three occasions during 2003. In February and July the repo rate was lowered by 0.25 per cent, while it was raised by 0.25 per cent in November to 3.75 per cent at year-end. In February 2004 the Bank of England raised its interest rate by a further 0.25 per cent.
| 10-year yield spreads to the euro area1 |
Chart 17
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| Note: Weekly observations. | |
| Source: Ecowin. | |
| 1 10-year German government bond. | |
In Sweden the yield on the benchmark 10-year government bond was 4.8 per cent at year-end against 4.7 per cent at the beginning of 2003, implying that the 10-year yield spread to the euro area remained unchanged at 0.5 per cent. Sveriges Riksbank lowered its repo rate on three occasions by a total of 1 per cent to 2.75 per cent, and by a further 0.25 per cent in February 2004.
The development in Norway differed from that of the euro area. The yield on the benchmark 10-year government bond thus declined by 1.2 per cent to 4.6 per cent at year-end, whereby the yield spread to Germany narrowed to 0.3 per cent, cf. Chart 17. During the year Norges Bank reduced its monetary-policy interest rate, the sight deposit rate, on seven occasions by a total of 4.25 per cent. At year-end the sight deposit rate was 2.25 per cent, and in January 2004 it was reduced by a further 0.25 per cent. This caused a further decrease in the 10-year yield.
In Japan the level of interest rates is still very low. In the light of improved growth prospects the yield on the benchmark 10-year government bond increased from 0.9 per cent at the beginning of 2003 to 1.4 per cent at year-end. The Bank of Japan maintains a "zero-interest-rate policy", and the official discount rate was 0.1 per cent throughout the year.
In the acceding countries Poland, the Czech Republic and Hungary the 10-year yield spread to the euro area widened by 0.9 per cent, 0.5 per cent and 1.4 per cent, respectively, in 2003. The widening of Hungary's yield spread to the euro area can, inter alia, be attributed to fact that the Hungarian central bank, Magyar Nemzeti Bank, raised its monetary-policy interest rate by 3 per cent in November following currency unrest.
Due to historically low yields on highly rated government bonds, a number of investors invested in lower-rated bonds in order to achieve a higher yield. The increased demand narrowed the yield spread for lower-rated government bonds and corporate bonds (known as "high-yield" bonds) vis-à-vis highly rated government bonds, cf. Chart 18. During 2003 the credit ratings of several lower-rated countries, particularly in Asia, were upgraded by the three major international rating agencies – Fitch, Moody's and Standard & Poor's. These upgrades were typically based on improved fiscal-policy conditions as well as larger foreign-exchange reserves.
Stock markets
In 2003 global stock markets were characterised by positive trends, cf. Chart 19, and the negative trend since 2000 was thus reversed. The positive development has continued in 2004, particularly in Europe.
| Stock indices for the USA, Europe and Japan |
Chart 19
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| Note: Weekly observations. | |
| Source: Bloomberg. | |
At the beginning of 2003, the US stock markets were characterised by uncertainty due to the prospects of war in Iraq. Stock prices rose relatively strongly in the week up to the outbreak of the war. Subsequently, investors focused on corporate accounts. The corporate prospects were generally found to be good, and combined with positive data releases concerning economic growth this contributed to the positive trend. The value of the technology-based Nasdaq index showed a particularly strong increase. Expectations regarding corporate accounts were more than met in the rest of the year. However, some investors question whether the high growth in corporate earnings can be sustained.
The US stock markets generally increased more strongly than the European ones in 2003. Growth prospects were found to be more subdued in Europe than in the USA, but the expectations of higher US growth pulled European stock indices upwards. At the same time, the weaker dollar drew attention to the declining competitiveness and export revenues of European enterprises. In euro terms the increase in S&P 500 index was, however, lower than the increase in the European index.
Like the German DAX index and the Swedish OMX index, the Danish KFX index rose more than the European stock indices in general, cf. Chart 20. An important factor contributing to the development in the KFX index is the significant rise in the A.P. Moller – Maersk shares after the merger of D/S 1912 and D/S Svendborg. A number of foreign investors have acquired shares in the merged company.
| European stock indices |
Chart 20
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| Note: Weekly observations. | |
| Source: Bloomberg. | |
The Japanese Nikkei index rose more strongly than the broad European and US stock indices until October. The level in April was the lowest level for more than 20 years but indications that the Japanese economy was picking up made foreign investors invest in Japanese shares. Towards the end of 2003 stock prices fell, however, partly as a result of the strengthening of the yen, which led to concerns about the competitiveness of Japanese exporting enterprises.
[1] Measured by the 10-year German government bond.