Financial Markets

Equity prices rose considerably in 2006 despite falling prices in mid-year. The tightening of monetary policy in both the USA and the euro area had only little impact on the long-term yields, so that the yield curves became flatter. At the same time, credit spreads remained historically low.

The volatility in mid-2006 shows how exposed the financial markets are to even small changes in market expectations. Large geared positions in different currencies, including carry trades, contribute to increased volatility in the market.

INTERNATIONAL FINANCIAL MARKETS AND FINANCIAL STABILITY

The financial markets are of great importance to the banking institutions' earnings and balance sheets. There is a direct impact through various channels as value adjustments of the banking institutions' bond and equity portfolios, and via fee and commission income from financial-market-related customer services. The financial markets also have an impact on the financial situation of the banking institutions' clients and financial counterparties.

In addition, the general development in the financial markets affects the banks' costs of raising capital via bond or equity issues.

EQUITY AND BOND MARKETS

Equity markets continued to rise in 2006
Global equity prices rose considerably in 2006 despite falling prices in mid-year. The European Stoxx index rose by 20 per cent, while the US S& P 500 index increased by 14 per cent, cf. Chart 27. The Danish OMXC20 index mirrored the development in the international markets closely, rising by 12 per cent in 2006. The relatively large price drops in mid-year were attributable to increasing uncertainty among investors, who moved towards assets entailing lower risk. Despite significant increases in recent years, the price-earnings ratios seem to indicate that the equity markets are not yet at the same high price levels seen before the dotcom bubble burst in 2001.

Expectations of the banks' earnings remained strong in 2006, so that the bank equity indices rose more than the general equity indices. The bank equity indices increased by almost 23 per cent in both the euro area and Denmark, cf. Chart 28. The increase was less pronounced in the USA, where the bank index rose by just over 12 per cent.

Yield curves in the USA and Europe flatten out
10-year yields rose slightly in 2006, in spite of a decrease in the 2nd half of the year, cf. Chart 29. The increase in the 1st half-year was driven by high economic activity and rising core inflation. In step with expectations of lower growth in the economy, however, the US 10-year yield fell in the 2nd half-year. The European 10-year yield followed the development in the US market.

In general, long-term yields rose less than short-term yields, so that the yield curves flattened out in 2006. Especially in the euro area the short-term yield rose strongly as a result of sound economic growth. The European Central Bank, ECB, raised its official interest rate from 2.25 per cent to 3.75 per cent in six increments during 2006 and the start of 2007. The substantial increases in short-term interest rates in Europe and the USA, and in other countries with sound economic growth, led to increasing carry-trade speculation, cf. Box 2. The market utilised the low interest rates in countries such as Japan and Switzerland to invest in countries with relatively higher interest rates.

CARRY TRADES	Box 2
The carry-trade strategy is a well-known phenomenon and essentially reflects that investors seek out assets yielding a relatively high return. In this case, an investor borrows an amount in a currency with a low interest rate (the funding currency) and invests in a currency that pays a higher interest rate (the target currency). Assuming that exchange rates are constant, the investor's profit is the interest-rate spread between the two currencies. Exchange rates are not constant, however. The Chart below shows the interest-rate spread and the exchange-rate volatility for a number of currency pairs. The interest gain at the various crosses is clearly positive, but is subject to uncertainty in the form of exchange-rate volatility. It is difficult to assess the actual size of carry trades since, for many investors, carry trades are effected as off-balance-sheet transactions. Some assessments of the total volume of carry trades are as high as 1,000 billion dollars.[1] Once the volume of carry trades becomes sufficiently large, the strategy becomes self-enhancing. The reason is that when large volumes of capital flow from a low-interest currency to a high-interest currency, the latter will appreciate vis-à-vis the former. This means that the gain on carry trades is equivalent to the interest-rate spread and the appreciation of the high-interest currency. For example, the total yield on sterling-yen carry trades was 19.3 per cent in 2006, but only 8.5 per cent in 2005. A major risk factor in connection with carry trades is the threat of an exchange-rate bubble. The formation of a bubble leads to further uncertainty in addition to the historical exchange-rate volatility. When a bubble bursts, it does so very quickly, and it tends to spread. The consequences may be pronounced depreciation of various target currencies vis-à-vis funding currencies.
INTEREST-RATE SPREADS AND HISTORICAL EXCHANGE-RATE VOLATILITY
Note: 3-month LIBOR rates from 26 February 2007 have been applied. The historical exchange-rate volatility has been calculated as the annualised standard deviation for the period since 2003. Source: Reuters and Ecowin.

In the USA, the 2-year yield exceeded the 10-year yield throughout most of 2006. Normally, this has indicated an imminent recession in the US economy. This time, however, the low long-term yields are attributed to low and stable inflation expectations, investments by OPEC countries and Asian central banks in long-term US government bonds, and high demand for duration on the part of pension funds.

The market expects further interest-rate increases in Europe
Prices of financial assets contain information on market participants' expectations of future market developments. Future interest rates, called forward rates, can be calculated on the basis of yields on bonds with different maturities. A forward rate can be perceived as a break-even interest rate that indicates how much the spot yield curve must change if bonds with different maturities are to provide the same yield. The forward interest rate between e.g. year 1 and year 2 shows the 1-year interest rate one year ahead if an investor is to receive the same yield from purchasing either a 2-year bond – of which the yield is known today – or a 1-year bond – of which the yield is known today – followed by another 1-year bond at the forward interest rate.

The full break-even probability distribution for the future short-term European interest rate can be derived on the basis of the prices of interest-rate options. In Chart 30 it is seen that the interest rate is still expected to increase as the short-term interest rate is around 4 per cent at the end of April 2007. This reflects market confidence in the economic development and thereby expectations of a further tightening of monetary policy. The uncertainty of interest-rate expectations has also diminished from the spring of 2006, as the distribution has narrowed.

Credit spreads in Europe and the USA remain narrow
Ample international liquidity has significantly narrowed the credit spreads between corporate bonds in recent years, cf. Chart 31. The falling trend in the USA continued in 2006, while the spread widened slightly in the European market.

Most recently the spreads have widened a little in the USA, among other things due to increasing uncertainty concerning the economic development in the USA. Investors have sold higher-risk assets in favour of more secure government bonds. Another factor of uncertainty is related to increasing payment difficulties among less creditworthy US homeowners in the " subprime" mortgage-credit market. The bond index, which reflects the price development for the high-risk mortgage-credit bonds, thus fell by more than 30 per cent towards the end of February.