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"Report and Accounts 2001"

Financial Markets

The economic slowdown and diminishing inflationary pressure, as well as the consequences of the terrorist attacks on the USA on 11 September, caused central banks in primarily the USA, but also in Europe and Japan, to take a number of measures to ease monetary policy. The Bank of Japan in practice returned to its "zero-interest-rate policy". At the end of the year long-term yields in the USA and Europe were at virtually the same level as at the beginning of the year. In the autumn the long-term yields briefly reached a very low level.

The dollar strengthened by 5 per cent against the euro and by almost 15 per cent against the yen in 2001. This strengthening e.g. reflects investors' continued preference to invest in US rather than European or Japanese enterprises.

Stock prices in the industrialised countries generally declined up to the autumn, against the background of the slowdown in the economy. Stock prices fell strongly after the terrorist attacks on 11 September. A recovery followed, however, and by the end of 2001 the leading stock indices in the USA, Japan and several European countries were higher than immediately prior to 11 September.

Interest rates

Interest rates in the USA
The terrorist attacks on the USA on 11 September affected New York's financial centre. The US bond market was closed and was not re-opened until 13 September, while the New York Stock Exchange remained closed for almost a week. When the bond market re-opened the settlement period was increased temporarily from the normal two days to five days. There were no major interruptions to payment systems. Immediately after the terrorist attacks the Federal Reserve made considerable amounts of liquidity available, cf. p. 35 and lowered the fed funds target rate by 0.5 per cent when the stock market re-opened. Prior to the terrorist attacks the Federal Reserve had cut the fed funds target rate on seven occasions in 2001 by a total of 3 per cent, in order to prevent a hard landing of the economy. After interest rates were reduced on 17 September the rates were lowered on a further three occasions by a total of 1.25 per cent. The fed funds target rate hereby reached 1.75 per cent, which is the lowest level for 40 years.

At the end of 2001 the yield on 10-year US government bonds was 5.1 per cent, which is generally unchanged from the beginning of the year. The easing of monetary policy thus implied a steepening of the yield curve, cf. Chart 12. This was also the case in the euro area.

At the beginning of November the 10-year yield briefly reached the same low level as during the unrest on the financial markets in autumn 1998. The preceding decline in interest rates was sustained by the recession and the highly expansionary monetary policy, but also by a number of special factors. These include the greater uncertainty in the aftermath of the terrorist attacks on 11 September, causing investors to move from stocks into bonds. Furthermore, long-term yields fell strongly on the last day of October and first days of November after the US Treasury announced the suspension of issues in 30-year government bonds. Finally, the low and declining level of interest rates in the autumn pushed up the prepayment risk on mortgage bonds, whereby the expected remaining time to maturity was reduced. This gave rise to extraordinarily strong demand for long-term government bonds, causing yields on government bonds to decline further.^[7] Long-term yields rose strongly in the course of a few weeks from the low level at the beginning of November. Investors increasingly preferred stocks to bonds, in view of the positive data releases for the US economy. Interest rates increased more as the extraordinary demand for government securities declined in step with the diminishing prepayment risk for mortgage bonds.

In recent years there has been a relatively close positive co-variation between the development in the 10-year yield and in stock prices, cf. Chart 13. This reflects that investors to a certain degree have sold bonds to finance purchases of stocks, and vice versa.

The sustained upswing in the US economy up to mid-2000 led to an improvement in the government budget balance, and thereby a reduced financing requirement, contributing to a lower level of interest rates. The recession and the easing of fiscal policy reversed this pattern in 2001, and the US budget balance is expected to deteriorate further in 2002. In the short term, issues of government securities are thus expected to increase. This is also the case in a number of European countries and in Japan.

Interest rates in Europe
The development in interest rates in the USA had a significant impact on the European bond markets in 2001. In the autumn long-term yields fell to a very low level, but were by and large unchanged for the year overall, cf. Chart 14.

In the euro area the ECB lowered the interest rate for the main refinancing operations by a total of 1.5 per cent to 3.25 per cent by the close of 2001,cf.p. 33.Theyieldonthebenchmark10-yearGermangovernment bond was 5.0 per cent at the end of the year, against 4.9 per cent at the beginning.

In Denmark Danmarks Nationalbank lowered the discount rate in step with the ECB's reductions of interest rates, while the lending rate was reduced by a further 0.30 per cent, cf. pp. 33-34. With effect from 1 Feb-ruary 2002 Danmarks Nationalbank again lowered the lending rate by 0.05 per cent. At the end of 2001 the yield on the benchmark 10-year government bond was 5.2 per cent, compared to 5.1 per cent at the beginning of the year. The decline in long-term yields in the autumn was stronger in Denmark than in Germany, and the 10-year yield spread between Denmark and Germany narrowed from 0.3 to 0.2 percentage points, while the yield on 30-year government bonds even fell below the German level. The narrowing of the long-term yield differentials reflects a particularly strong interest in these Danish securities from especially domestic pension funds and life assurance companies. In view of their interest guarantees and substantial holdings of mortgage- credit bonds, pension funds and life assurance companies generally require assets with a longer remaining term to maturity when interest rates are low and still falling.^[8] Subsequently the 10-year yield differential between Denmark and Germany widened slightly, and at the end of February the yield on the 30-year government bond exceeded the equivalent German yield. In the autumn, when interest rates were low, a number of pension funds and life assurance companies moreover purchased euro-denominated interest derivatives to gain a degree of protection against further decreases in interest rates. This demand pressure contributed to a considerable increase in prices for these instruments.

In the UK the Bank of England lowered the base rate on seven occasions by a total of 2 per cent. The background was diminishing inflationary pressure and increasing risk of a slowdown in the economy. The yield on the benchmark 10-year government bond was 5.1 per cent at the end of 2001, against 4.9 per cent at the beginning of the year. The 30-year government-bond yield was lower than the 10-year yield in view of significant demand pressure from pension funds and life assurance companies in the UK.

In Sweden,Sveriges Riksbank raised the repo rate by 0.25 per cent in July in order to keep inflation within the target band of 2 per cent +/- 1 per cent in the medium term. After the terrorist attacks on the USA, Sweden's repo rate was reduced by 0.5 per cent. The yield on 10-year Swedish government bonds rose by 0.6 per cent to 5.4 per cent during 2001. The 10-year yield differential to Germany widened by 0.3 per cent in view of the Swedish AP funds’ preference to invest in other assets, including foreign stocks. Rising inflation also contributed to a higher level of interest rates in 2001. Moreover, the yield differential was extraordinarily narrow at the beginning of the year.

In March 2001, Norway abandoned its formal fixed-exchange-rate policy in favour of an inflation target. The aim of monetary policy is now to keep growth in consumer prices within a band of +/-1 per cent around 2.5 per cent. In view of the development in prices Norges Bank lowered the official interest rates by 0.5 per cent in December. At the close of 2001 the 10-year yield on Norwegian government bonds was 6.3 per cent, against 6.0 per cent at the beginning of the year.

Iceland also abandoned its fixed-exchange-rate policy in March 2001, in favour of an inflation target. The aim over time is to keep consumer- price inflation within a band of +/-1.5 per cent around 2.5 per cent. Seðlabanki Íslandslowered the repo rate on two occasions in 2001 by a total of 1.3 per cent to 10.1 per cent. The yield on 10-year Icelandic government bonds was 6.1 per cent at the end of 2001, compared to 7.0 per cent at the beginning of the year. This is a real yield as the cash flows are linked to the consumer-price index. The annual rate of increase in Iceland's consumer-price index was 8.6 per cent at the end of 2001.

Interest rates in Japan

The Bank of Japan lowered the discount rate on 3 occasions in 2001 by a total of 0.4 per cent to 0.1 per cent. As a ceiling for the very short-term money-market interest rates, in early February 2001 the Bank of Japan introduced a standing credit facility at a rate of interest equivalent to the discount rate. The discount rate thus became of real significance to the money-market interest rates. In mid-March the Bank of Japan adjusted its monetary-policy instruments from a target for the overnight interest rate to a target for the banks' deposits at the central bank. At the same time the overnight interest rate fell to a level close to zero. In practice, Japan had returned to the "zero-interest-rate policy" pursued from February 1999 to August 2000. Long-term interest rates remained at a very low level in 2001. For most of the year the 10-year government bond was traded at a yield in the range of 1.25-1.50 per cent. The background to the low level of interest rates is the highly expansionary monetary policy, the economic downturn and falling prices, as well as Japanese investors' relatively strong interest in domestic bonds. Moreover, as part of monetary policy the Bank of Japan increased its purchases of government bonds. These factors overshadowed the upward pressure on interest rates from the rapidly increasing government debt and from the leading rating agencies' downgrading of the credit ratings of Japan's domestic government debt. In 2001 Japan's debt was downgraded to Aa3 by Moody's and to AA by both Fitch and Standard & Poor's. Up to the autumn of 1998 Japan's government debt held the best rating from all three rating agencies (Aaa by Moody's and AAA by both Fitch and Standard & Poor's).

Interest rates in the emerging markets
The worsening economic and political crisis in Argentina caused bond yields to increase significantly during the autumn of 2001, cf. Chart 15. The situation in Argentina had only a short-lived and limited impact on the other emerging markets, including Brazil. The widening of the yield differential between Turkey and the USA from mid-2000 to mid-2001, cf. Chart 15, should be viewed against the background of Turkey's financial crisis. The financial conditions in Argentina and Turkey are described in further detail on p. 83-84.

Foreign-exchange markets

During 2001 the dollar strengthened by approximately 5 per cent vis-à- vis the euro, and by a further 2 per cent at the beginning of 2002 to the level of 0.87 dollar per euro at the end of February, cf. Chart 16. The substantial easing of monetary policy in the USA in 2001 meant that yields on short-term interest-bearing US securities, e.g. short-term US Treasury notes, fell in both absolute and relative terms compared to equivalent instruments denominated in euro. The initial limited impact of monetary policy on the development in exchange rates can be explained by the fact that a large share of the USA's capital imports in 2001 were related to non-interest-bearing instruments such as share purchases, mergers and acquisitions. This adheres to the pattern of recent years, cf. Chart 17, whereas a larger proportion of the capital imports up to 1999 comprised investments in bonds and other interest- bearing instruments. The interest-rate differential between the USA and abroad thus has a less immediate impact on the exchange rate.

The Japanese yen weakened by almost 15 per cent against the dollar and by almost 10 per cent against the euro in 2001. The currency weakened mainly in the 4th quarter, after coordinated intervention between the Bank of Japan and the Federal Reserve.

The pound sterling strengthened slightly against the euro and weakened a little against the dollar in 2001. The Norwegian krone strengthened by almost 4 per cent against the euro.

The Swedish krona weakened by almost 13 per cent against the euro up to the end of September 2001 to a level very close to 10 kronor per euro, cf. Chart 18. This weakening reflects an outflow of capital due to diminished interest in Swedish stocks on the part of foreign investors, in view of the falling Swedish stock market, which has an overweight of technology stocks, and increased investments in foreign stocks by the AP funds. Subsequently the krona has strengthened by almost 9 per cent. This strengthening was supported by a wider spread between official interest rates in Sweden and the euro area, an increase in stock prices, and expectations of a stronger krona on its possible participation in EMU.

The Icelandic krone weakened considerably by almost 21 per cent against the dollar in 2001. It fell most during the spring after the announcement by the government and the central bank that Iceland would abandon its fixed-exchange-rate policy in favour of an inflation target.

Stock markets

Two separate courses of the global stock markets can be distinguished for 2001. The negative tendencies from 2000 continued, and the industrialised countries saw a general decline in stock prices up to the autumn, as a consequence of the economic slowdown in the USA, cf. Chart 19. The relaxations of monetary policy buoyed up stock prices at the beginning of the year, but the moderate optimism was replaced by widespread pessimism as business earnings declined. The negative trend was amplified by the terrorist attacks on the USA on 11 September 2001, which triggered substantial price drops on the European stock exchanges on the ensuing days. Stock exchanges in the USA were closed after the terrorist attacks. When they re-opened on 17 September there was record-high turnover at plummeting prices up to 21 September, when the stock markets in the USA and Europe closed at the lowest level for the year.^[9] The leading stock markets then recovered, and by the end of the year the benchmark stock indices in the USA, Europe and Japan were at a higher level than just before 11 September.

Again in 2001, the development in technology stocks was a strong factor driving stock-market prices. IT stocks in Europe generally fell more than IT stocks in the USA. The background includes the relatively larger number of newly established enterprises in the European IT indices. As yet, these new enterprises cannot present positive financial results to support their continued existence.^[10] In addition, the European indices were affected negatively by the debt-burdened European telecommunications companies, while certain computer stocks had a positive impact on the US stock market.^[11] From the end of September and up to the turn of the year especially IT stocks rose in expectation of a reversal of the US economy in 2002, leading to an upswing in tech-nology investments. Stock prices fell again, however, at the beginning of 2002.

 The Nordic stock markets matched the global markets, with a general decline up to 21 September, after which prices recovered, cf. Chart 20. Whereas stock markets in Denmark and Norway rose in 2000 contrary to global markets, the leading indices in all the Nordic countries ended 2001 at a lower level. The price decreases were least pronounced in Denmark since the KFX index has a relatively small proportion of very cyclical stocks. Sweden and Finland were still most severely affected by the development, due to the relatively high proportion of telecommunications enterprises in their stock indices. This applies to the drop in stock prices up to the autumn, as well as to the subsequent price fluctuations.

The stock prices of emerging markets took highly varied courses in 2001, cf. Chart 21. The price fluctuations in the Chinese Shenzhen B-share index attributable to e.g. domestic adjustments to Chinese share legislation are particularly noteworthy. The more stable political climate in Russia supported Russian stock prices in 2001. The buoyant Russian stock market in early 2002 is related especially to the most recent increase in oil prices. The deterioration of Argentina's economic situation was reflected in falling stock prices. The benchmark stocks rose at the end of the year, however, in anticipation of a devaluation and its beneficial impact on competitiveness, and also as a consequence of the flight from cash holdings due to fears of restrictions and sequestrations.

Footnotes

^[7] This is described in further detail in Louise Mogensen, Market Dynamics at Low Interest Rates, Danmarks Nationalbank, Monetary Review, 1st Quarter 2002.

^[8] This is described in further detail in Louise Mogensen, Market Dynamics at Low Interest Rates, Danmarks Nationalbank, Monetary Review, 1st Quarter 2002.

^[9]The Japanese stock market reached its lowest level on 17 September.

^[10] Neuer Markt (Germany), techMARK 100 (UK) and Nouveau Marché (France) are examples of European IT-related stock indices. In terms of market value and turnover, these indices are far smaller than the Nasdaq 100 (USA). IT stocks also fell on the Copenhagen Stock Exchange, and the KVX index for growth stocks had fallen by 40 per cent at the end of the year.

^[11] Microsoft and Intel rose by 53 per cent and 1.3 per cent respectively in 2001. Since these companies are strongly weighted in Nasdaq 100, this in itself contributed to the development of the index (on 16 January, 2002 Microsoft accounted for approximately 11 per cent of the Nasdaq 100 market value, while on the same date Intel accounted for 7 per cent).

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Version 1.0 March 2002 Nationalbanken.
Published by Danmarks Nationalbank March 2002, http://www.nationalbanken.dk/