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Monetary and capital markets
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Federal Reserve maintains upward trend in interest rates
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US reference rate reaches 5%.
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As widely expected, the US Federal Reserve Board raised the objective level for overnight interbank interest rates by 25 basis points to 5% at its meeting on May 10. Something not so clear was the sign coming from its press release and whether it was suggesting a pause in or the end of the upward cycle.
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Further increases possible…
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In its press release, the Federal Reserve Board indicated that, while inflation prospects were still contained, there were inflationary risks arising from the level of utilization of production facilities and the high prices of energy and other raw materials. As a result, it repeated that it might still be necessary to again tighten monetary policy but that, in any case, this would depend on developments in the economic situation.
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…but Fed could take break before continuing to raise rates.
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The money market reacted with an increase in upward expectations. The figure for underlying inflation for April, which was worse than expected, also had an influence in this respect. Nevertheless, later on there was some easing of inflationary prospects due to signs of an easing off in the economy and a decrease in raw material prices. In any case, the market is continuing to discount that the Federal Reserve official interest rate will stand at 5.25% in the summer but the big question is whether the Fed will take a pause before embarking on a further move following 16 consecutive increases.
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Trichet indicates a rise in Eurosystem interest rates in June.
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The European Central Bank (ECB), in turn, kept its reference rate at 2.50% at its May 4 meeting. Nevertheless, at the later press conference, the chairman, Jean-Claude Trichet, indicated a rise in June and speculated a that the increase could even be 50 basis points. Later on, other ECB executives indicated that, in fact, the ECB had no predetermined calendar of increases and that it would decide on the course of interest rates according to economic trends, without giving any clear signs to the market. The strength of the euro in recent weeks would suggest an increase of only 25 basis points in June. This increase would be followed by others in the second half-year thus putting the rate slightly above 3% at the end of the year.
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Bank of England suggests its next move will be a rise.
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The quarterly report on inflation prospects published by the Bank of England drew a rate above the objective of 2% in the next two years working on the supposition that the official interest rate held at 4.50%, which indicates a possible increase in the interest rate. Along the same lines, the minutes of the last meeting of the Monetary Policy Committee of the Bank of England indicated that, for the first time since it began to reduce reference rates in August 2005, a member of the committee voted in favour of a rate increase. This increased expectations in the market that the next move by the monetary authorities would be upward, as opposed to what was expected only a few months ago.
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In Japan, the central bank is continuing to drain off excess liquidity. While the governor of the central bank, Toshiniko Fukui, has stated that no date had been set for the next move, the market is already anticipating an increase in the reference rate in the summer, up from the current level close to 0%. At the same time, it is not expected that the rate will go above 1% in 2007.
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Furthermore, other central banks joined the upward moves in May. On May 3, the Bank of Australia raised the official interest rate by 25 basis points to 5.75%. And on May 24 the Bank of Canada also raised its reference rate by a quarter-point to 4.25%.
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Dollar halts decline
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Dollar marks up lowest level in overall terms since 1997.
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In the early weeks of May the dollar continued the downward path begun early in 2006 and sharpened it drop from mid-April on. As background to this downward move there is the pressure to correct the enormous foreign current account deficit of the United States which reached 7% of the gross domestic product in the fourth quarter of 2005. The pronouncement by the Group of the seven most developed countries (G-7) in the fourth week of April was interpreted as giving support to the drop in the greenback. On May 11, the US currency marked up its lowest level since 1997 in terms of a broad basket of currencies.
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Nevertheless, the dollar later bounced back to some extent aided both by statements by Japanese and European political leaders that they were not in agreement with any excessive appreciation of their currencies in terms of the dollar and by the increased upward prospects for interest rates in the United States. Furthermore, the dollar also benefited from the withdrawal of investors from high-risk assets. In any case, at the middle of the fourth week in May the US currency showed a drop of 3% since the beginning of the year compared with a broad group of currencies. However, the drop of the dollar against the euro was notably higher (8%) and against the Japanese yen (4%), whereas against the Chinese yuan it was barely 1%, which shows the unequal adjustment taking place, something which was not in proportion to the size of the bilateral trade deficits.
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Euro and yen carry weight of dollar depreciation while yuan scarcely showing any change.
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In this respect, we should point out that the exchange rate for the euro against the dollar went above the level of 1.29 dollars on May 12, the highest level in the past 12 months. Nevertheless, the euro later dropped in view of the recovery of the dollar. In any case, in terms of the currencies of its main trading partners, the euro showed an appreciation of 4% since the beginning of the year.
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The pound sterling has strengthened considerably in recent weeks with consolidation of the prospect that the next move in Bank of England interest rates would be upward. As a result, the British currency has risen both against the dollar and the euro.
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Slovenia to be 13th country in Euro Area in January 2007.
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Among other matters, Slovenia has obtained the blessing of the European Commission and the European Central Bank in their respective convergence reports for the Slovenian tolar to become incorporated in the euro. If the European Union Council approves, the Euro Area will widen to 13 countries in January 2007. On the other hand, Lithuania did not pass the test due to excessive inflation.
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Safe haven effect moderates rise in yields on government bonds
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Yield on US 10-year Treasury bonds marks up highest level since May 2002 going to 5.2%.
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In the early weeks of May, the yield on US Treasury bonds followed the upward path set in recent months driven by increased upward expectations on Federal Reserve interest rates. As a result, on May 12 the yield on US 10-year Treasury bonds rose to 5.21%, marking up the highest level since May 2002.It should be pointed out that the increase in the nominal yield on government bonds in recent months was due to the increase in real interest rates, which were depressed to an anomalous degree, and to a lesser extent to the higher inflation expected. Nevertheless, later on the yield on long-term government bonds dropped due to the shift from high-risk investments (such as emerging country bonds and shares) toward US bonds.
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In fact, toward mid-May there was an increase in aversion to risk on the part of investors so that the risk premium on emerging country bonds left behind the all-time low marked up on May 1. With regard to the risk premium on corporate bonds, this also rose toward mid-May.
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Increased aversion to risk affecting emerging country bonds and corporate bonds.
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In April, the default rate on high-yield global bonds dropped by one decimal to 1.6%, according to Moody’s rating agency, to stand close to the all-time low. Nevertheless, this rating agency expects that this ratio will stand at around 3% at year-end.
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Sharp correction on stock markets in May
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Many stock markets mark up highs in second week of May only to later show sharp drops.
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In the first week and a half of May the stock markets continued their upward trend and some indices in the United States and Europe marked up the highest levels in the past six years while some emerging country stock exchanges even beat all-time records in a situation of favourable corporate profits. Nevertheless, later on the renewal of upward prospects on interest rates in the United States and concern about inflation risks made a dent in financial markets which underwent substantial corrections.
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Nasdaq index loses par for year.
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After ending the first four months of the year with cumulative gains of more than 5%, the main US stock market indices saw their capital gains being cut back as the following month advanced, although this was quite uneven. The index to best weather the storm was the traditional Dow Jones, whereas the Nasdaq general index, based on high-technology and more volatile shares, ended up losing par for the year. By sector, energy was the one to show the biggest capital gains so far this year while the biggest losses showed up in the pharmaceutical and health sector.
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IBEX 35 briefly hits 12,000 points.
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Corporate operations, such as the attempt by Mittal to take over the Arcelor steel complex, helped to enliven European stock exchanges. Nevertheless, the European markets suffered a substantial punishment and markets in Zurich, London and Amsterdam showed a cumulative negative balance halfway through the fourth week of May.
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In the first week of May, the selective IBEX 35 index for the Spanish stock market went above 12,000 points for the first time since March 2000. Nevertheless, the general move to correction meant it lost this level at the end of the second week in the month. As a result, toward the fourth week of the month 14 shares out of the 35 making up the index came out in the red compared with December.
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Emerging country stock markets undergo sharp punishment.
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In the upsets in May, the emerging country stock exchanges were the ones to suffer the biggest drops. As a result, stock exchanges in Russia, India, Indonesia and Brazil dropped sharply after having marked up all-time highs in the second week of the month.
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