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Monetary and capital markets
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Federal Reserve to continue raising interest rates
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Upward movements in interest rates by the main central banks were again predominant factors in September. Both the Federal Reserve and the Bank of Canada raised their reference rates continuing to bring them to normal levels although rates continue at all-time lows. The progress of the US and Canadian economies is coming close to potential level, that is to say, sustainable economic growth without generating inflation, along with the substantial increase in oil prices, were behind these moves. On the other hand, the moderate drive in the euro area economy and the deflationary situation in Japan brought maintenance of easier monetary policies in those areas.
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Hurricane Katrina cools off prospects of interest rate rise but Greenspan makes no change of plan.
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In the United States, following the disastrous effects of hurricane Katrina in various southern states at the beginning of September, the market speculated that the Federal Reserve would make a pause in its round of reference rate increases once it was known that the chairman of the Federal Reserve, Alan Greenspan, had met with president George W. Bush following the impact of Katrina. Nevertheless, once the initial shock had passed the predominant opinion was that the macroeconomic effects of the hurricane would not be great and, while it could have a negative effect on growth in the fourth quarter, subsequent reconstruction would bring about increased economic growth.
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In this framework, the Federal Open Market Committee of the Federal Reserve at its meeting on September 20 decided to again raise official interest rates by 25 basis points. As a result, the reference rate for overnight interbank deposits rose to 3.75%. This was the eleventh consecutive increase in this rate.
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Market discounting only one or two more increases of 25 basis points by Fed in coming months...
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In its press release, the Federal Reserve held largely to the wording used in recent months. It stated that it would still continue to raise interest rates gradually although at this meeting one of the committee members, Mark W. Olson, voted against an interest rate rise. In these circumstances, the market is discounting that the USA reference rate will rise once more to 4% before the end of the year.
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...nevertheless, Fed reference rate could rise to 4.50% in coming year.
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Nevertheless, the US official interest rate could go to 4.50% in 2006 if pressures in the labour market are confirmed, given that the Federal Reserve would be obliged to react in order to avoid a price-wage spiral which, while up to now this has been avoided, among other reasons because of the anti-inflationary credibility won in the fight against inflation in the Eighties and Nineties of last century. Given that at the end of January Alan Greenspan will step down as president of the Federal Reserve, it is likely that the new head of monetary policy will want to establish his own reputation so that the Federal Reserve interest rate could possibly continue upward in the coming year.
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ECB revises downward economic growth projections for euro area but raises those for inflation because of oil...
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In the euro area, the European Central Bank (ECB) revised downward its economic growth projections for 2005 and 2006 to the range of 1.0%-1.6% and 1.3%-2.3% respectively. At the same time, it raised figures for inflation to 2.1%-2.3% in 2005 and 1.4%-2.4% in 2006, largely because of higher than expected oil prices. The European Central Bank has maintained the opinion that the Eurosystem interest rate stands at the proper level to ensure price stability over the medium-term below 2%. In fact, harmonized inflation in August held at 2.2% at year-to-year rate while core inflation (excluding the more volatile elements) stood at 1.3%.
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...and could begin an upward round in the first half of 2006 if economic situation improves.
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The ECB indicated that risks for growth rather suggest a downward trend while inflation risks pointed upward. Nevertheless, ECB president, Jean-Claude Trichet, maintains that price stability is not in danger at least while wage increases remain contained. As a result, the monetary policy of the euro area continues to be very easy, with interest rates, both nominal and real, at historically very low levels.
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The 1-year Euribor rose by 5 hundredths on monthly average in August going to 2.22% although it stood 8 hundredths below 12 months earlier. In the early weeks of September, the 1-year Euribor tended to stand at around this level. The interest rate curve is not indicating an upward swing by the European Central Bank until the second half of 2006. Nevertheless, the ECB could be obliged to bring forward a tightening of monetary policy to the first half-year if oil prices go up even higher, as is likely, and these begin to shift to the core of consumer prices.
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Rise in Fed interest rates aids dollar over short term
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The dollar appreciated by 2.7% in the first eight months of the year measured against a broad group of currencies. This rise was based on a favourable interest rate differential against the euro and the yen and relatively high economic growth. As a result, the US currency was able to overcome downward pressures arising from the massive foreign imbalance in the US economy.
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Dollar should depreciate against Asian currencies over the mid-term to correct foreign imbalance.
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In the early days of September, however, speculation that the Federal Reserve would make a pause in the process of raising interest rates because of the effects of hurricane Katrina weakened the greenback. Nevertheless, later on, once those expectations wore out, the dollar recovered strength. At the same time, the July figure for the trade deficit, lower than expected, helped the dollar in mid-September. However, over the medium term the dollar should make a downward correction, especially against Asian currencies, in order to decrease the foreign imbalance.
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Election results in Germany making progress in structural reforms difficult hurt euro.
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Euro depreciated by 5.7% in the January-August period against the currencies of its main trading partners after having appreciated strongly in the fourth quarter of 2004. The moderate economic growth in the euro area, the unfavourable widening of the interest rate differential against other currencies and rejection of the European Constitution in referendums held in France and the Netherlands in May and June with the subsequent political crisis hurt the European currency. In the early weeks of September, the euro lost positions.
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In terms of the dollar, the euro showed swings in the early weeks of September. On September 2, it was running at 1.254 dollars, a level not seen since May. Nevertheless, the single European currency moved down going to the level of 1.20 dollars.
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The pound sterling showed a cumulative increase of 1.6% as of August in terms of a broad basket of currencies. In the early weeks of September, the British currency rose slightly in overall terms following the failure of the Bank of England official rate to repeat the cut which took place in August and the cooling off of prospects of further decreases. So far this year, however, while the pound has appreciated against the euro it has dropped in terms of the dollar.
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The yen fell by 4.1% in the first eight months of the year in terms of the main group of currencies as it was weakened by an unfavourable differential in interest rates in terms of other currencies with Japan’s official interest rate continuing at 0%. In the early weeks of September, the Japanese currency tended to rise as a result of the victory by Koizumi in the early elections held on September 11 thus opening the way to suitable structural reforms. Nevertheless, it later lost ground in view of the rise in the dollar. In the fourth week of the month, the yen stood considerably below its initial level for the year in terms of the dollar although it was showing appreciation against the euro.
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Yield on German bonds marks up low for recent decade
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Notable flattening out of US interest rate curve in 2005.
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The yield on US 10-year Treasury bonds fell to 4.02% on September 1, the lowest level since the end of June, with the appearance of figures which indicated lower economic growth than expected. Nevertheless, the bond yield later tended to move up slightly with the disappearance of prospects that the Fed would take a pause in its upward path. It should be pointed out that the interest rate curve has flattened out substantially so far this year with the rise in short-term interest rates, whereas long-term yields stand at levels similar to the end of 2004. The enigma with regard to bonds still hangs over the world economy seeing that, given international economic conditions, the yield on US bonds is exceptionally low.
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Yield on long-term European bonds could still reach new lows.
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The interest rate on German 10-year government bonds fell to 3.02% in the fourth week of September, recording the lowest level in recent decades as it played the role of refuge asset in view of the uncertainty about the effect of hurricanes in the southern United States on oil supply and refining. While in coming weeks the yield on European long-term government bonds could still mark up further lows over the medium term, it likely will rise to levels more in keeping with economic fundamentals moving up from the unusually low current figures.
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Stabilization of oil prices eases stock markets
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Better-than-expected corporate profits and low interest rates driving stock markets...
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Better-than-expected corporate profits and low interest rates continued to boost stock markets in the summer in spite of the high oil prices reached. As a result, many stock market indices marked up new all-time highs in September (or highs for recent years) following some moderation in oil prices. As a result, most of the main stock markets ended the summer showing sharp revaluation for the year (higher than forecast at the beginning of the year), with the exception of the US markets.
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...although US markets showing mediocre trend in 2005.
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The exception was in the United States where the stock markets are showing a mediocre trend. Following the major gains recorded in 2004, US shares were showing some over-valuation compared with other markets. Furthermore, the continuing rise in Federal Reserve interest rates has hurt the US stock market. In September, the effects of hurricane Katrina were compensated by speculation that the Federal Reserve might not raise its interest rates as much as expected. The Standard & Poor’s 500 index showed a modest rise over December in the final week of September. On the other hand, the traditional Dow Jones Industrials index and the Nasdaq general index (which is representative of hi-tech shares) are showing slight losses so far this year.
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In the energy sector, due mainly to the increase in oil prices, the oil companies and public utility companies marked up major capital gains over December. On the other hand, companies in telecommunications, materials and cyclical consumption showed notable cumulative drops.
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Substantial capital gains in European stock markets so far this year.
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On the other hand, the DJ Eurostoxx 50, which includes the largest companies in the euro area, in the final week of September showed a rise of two digits over December. Depreciation of the euro in the course of 2005 and maintenance of European Central Bank interest rates at very low levels, along with big increases in European company profits and corporate take-over operations in various sectors, such as electricity, boosted share markets on the Continent. At the end of the second week of September, the Xetra Dax index for Frankfurt marked up its highest level since May 2002 spurred on by the prospect of progress in structural reforms. The expected victory of the Christian Democrats on September 18 opened the prospect of significant changes in economic policy. Nevertheless, these prospects later faded and, as a result of the tight election result which complicates matters of government, the Dax index lost ground although it showed a sharp increase over the end of 2004. Most of the main stock markets in the euro area also showed substantial gains during the year, headed by the Paris Bourse.
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With regard to the Spanish stock exchange, the IBEX 35 index continued to move up in September, to which the takeover bid for Endesa by Gas Natural at the beginning of the month made its contribution. At the beginning of the fifth week of the month, the IBEX 35 index marked up its highest level since October 2000. It should be pointed out that in the final week of the month, only three of the 35 shares in this selective index stood below par for the year, whereas some shares showed spectacular gains of more than 50% as in the case of Metrovacesa, Sacyr Vallehermoso, Ferrovial and Abertis.
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Recovery of Japanese stock market aided by Koizumi’s election victory opening way to reform.
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Outside the euro area, the Financial Times 100 index for the London stock exchange marked up its highest level in the past four years at the beginning of the final week in September. The SMI index for the Swiss stock exchange also showed a high trend in the first three quarters. In addition, the Japanese stock market continued to improve positions in September and in the fifth week of the month the Nikkei 225 index showed its highest level in the last four years thanks to the better economic climate and optimism with regard to progress in economic reform following the victory of the party led by ex-prime minister Koizumi.
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Many emerging stock exchanges, including those of India, Brazil, Mexico and Argentina mark up new all-time highs.
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With regard to emerging markets, these generally showed a bright performance during the year reflecting the current good economic situation and the flow of international funds going to those markets. A number of stock exchanges in emerging countries continued to mark up all-time highs in September, as was the case in India, Brazil, Mexico and Argentina.
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