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European Central Bank and Bank of Japan take a pause
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In spite of oil price drop in recent months, central banks still concerned about inflation risks...
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The international money supply continues abundant and, in spite of the recent drop in oil prices, the upward stage in interest rates is still being maintained in view of inflationary risks. This would seem to be confirmed by the recent increase in official interest rate by the Bank of England which probably will not be its last this year.
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...and upward stage in interest rates being maintained as confirmed by increase in Bank of England official rate to same level as the Fed.
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On January 11, the Monetary Policy Committee of the Bank of England decided to raise its reference rate by 25 basis points putting it at 5.25%. This was the third increase since August and it caught most of the market by surprise seeing that, although further increases had been discounted, they were expected to come later. The British monetary authorities justified the measure because of the increase in inflationary risks, given the limited margin in utilization of production capacity. In fact, just a few days later, the figure for inflation of consumer prices in December was published showing an increase of 3.0%, substantially above the 2% objective which explained the central bank’s concern.
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On the other hand, on the same day the European Central Bank (ECB) decided to maintain the Eurosystem interest rate at 3.50%. Although no change was expected, the less belligerent tone adopted by chairman Jean-Claude Trichet at the following press conference was somewhat surprising. As a result, doubts that existed about whether the next increase would be in February were resolved in favour of a further rise in March.
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In fact, the relatively low current level of the official ECB interest rate, the run-away growth of the broad M3 money supply figure (with a year-to-year change of 9.7% in December, the highest since 1999) and some risks for increased inflation point to further tightening of monetary control. Nevertheless, if we take into account that the euro has appreciated substantially in recent years, monetary conditions would suggest that there is not much further up to go, so that the level reached by the Eurosystem interest rate will possibly stand at 4% in coming months.
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Bank of Japan not sure about economic horizon and fails to raise reference interest rate in January.
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In addition, the market had clearly discounted the new increase in the official interest rate by the Bank of Japan at the monetary meeting held on December 18. Nevertheless, in the end political pressure possibly prevailed and the Japanese monetary authorities made no move, leaving the reference rate at 0.25%, the vote in favour being 6 to 3. It is true that the situation of the Japanese economy is not without its good and bad features as shown, for example, in a very modest growth in bank credit, although what is most likely is that the gradual normalization of Japanese interest rates has only been postponed.
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European Central Bank could again raise Eurosystem interest rate in March.
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With regard to the US Federal Reserve, we could not expect changes at its meeting at the end of January. In fact, the objective level of the interest rate on US 1-day interbank deposits will probably continue at 5.25% for some months, given that the Fed is caught between fear of a sharp slowdown in the economy and the danger of inflation shown, for example, in the recent rise of industrial and consumer prices.
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Pound sterling strengthens with wider interest rate differential in its favour
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Pound sterling marks up highest level against yen since September 1992.
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The pound sterling has taken a leading role in foreign currency markets in recent weeks with substantial appreciation as a result of the increase in official interest rates by the Bank of England on January 11 and the expectation of further tightening of British monetary policy.
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As a result, the Bank of England reference rate became equal to that of the Fed going up to 5.25%. Interest rates on the pound went above those for the dollar for both short and long terms within a picture of upward expectations in the United Kingdom and downward prospects in the United States.
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In 2006 dollar again follows downward trend begun in 2002.
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In 2006, the dollar returned to the downward trend it began in 2002, pushed down by the massive foreign deficit. In terms of a broad group of currencies, the dollar depreciated by 4.4% in the course of last year after having risen 3.5% in 2005. It should be pointed out that the depreciation of the dollar in 2006 was unequally distributed. Against the pound sterling the decrease was 12.0%, in terms of the euro it was 10.4% and 3.3% against the yuan while it rose by 1.0% against the Japanese yen. This shows that, in general, the European currencies bore the brunt of the depreciation of the dollar.
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Euro marks up all-time high against yen at beginning of 2007.
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Nevertheless, in the early stages of the year the US currency recovered strength with the disappearance of fears of a sharp slowdown of the US economy and the lessening prospect of a decrease in the Fed official rate. In any case, as the year wears on, downward pressures should predominate as interest rate differentials are reduced against the euro and the yen and because of possible moves to diversify the currency reserves of various countries, such as China.
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The improvement of the European economy and the rise in the European Central Bank reference rate meant that the European currency advanced by 5.1% in 2006 in terms of the basket of currencies of its main trading partners. Right at the beginning of 2007, the euro continued its tendency to appreciate. Nevertheless, the euro later lost its shine with an easing of expectations regarding increases in Eurosystem interest rates. In any case, the European single currency recorded a new all-time high against the yen when it ran at 158.1 yen to the euro in the second last week in January.
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Yen at lowest level since October 1998 following Bank of Japan decision to maintain interest rates.
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In the fourth week of January the yen collapsed to its lowest level since October 1998 following the decision of the Bank of Japan to maintain its official interest rate at 0.25%. The wide difference in interest rates not in its favour again hurt the Japanese currency. In real terms, in December 2006, the Japanese currency dropped to its lowest level since October 1985.
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Increase in government bond yields
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Bond yields show ups and downs in 2006 but end year with slight increases.
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In 2006, the yield on US 10-year Treasury bonds rose by 31 basis points and ended the year at 4.71%. The high for the year, however, was 5.24% reached toward the end of June. From then on, the slowdown in the economy and the halt in the upward pattern of the Fed since August brought about a drop in long-term rates. Nevertheless, in the early weeks of 2007 the yield on US government bonds rose again to some extent with disappearance of the prospect of a cut in the Fed official interest rate in the first half of the year.
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Differential in long-term interest rates between dollar and euro to narrow in 2007.
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In the Euro Area, yields on long-term government bonds followed in the wake of similar bonds on the other side of the Atlantic but rose slightly more in the course of 2006, some 66 basis points in the case of German bonds. As a result, the differential in long-term interest rates between the dollar and the euro narrowed to 75 basis points whereas at the beginning of 2006 it was 110 basis points. The reduction of this differential is logical if we take into account that expectations for the differential in short-term interest rates and economic growth also went down. In this situation, it is likely that the long-term interest rate differential between the United States and the Euro Area will continue to decrease in 2007 in spite of the slight increase seen in the early weeks of January.
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On the other hand, it is worth noting that in 2006 international bond issues expressed in euros were again greater than those in dollars, according to the International Capital Market Association. Total bonds issued in euros amounted to 45% of the world market as against 36% in dollars and nearly 10% in pounds sterling. Apart from issues by European governments, a more extensive and liquid market for corporate bonds following the launching of the euro in 1999 increased the attraction of issues expressed in the European single currency.
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Euro stands in top place in international bond market.
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The risk premium on emerging country sovereign bonds recorded a new all-time low in the third week of January 2007 when it dropped to only 165 basis points. The risk premium on high-yield corporate bonds also dropped to low levels. In fact, according to Moody’s rating agency, the default rate on low credit rating corporate bonds dropped to 1.7% in 2006 as against 1.9% the year before, marking up the lowest figure since 1996. Nevertheless, it is likely that in coming months the risk premium on high-yield bonds will go up with an increase in the default rate.
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Stock markets begin 2007 moderately optimistic
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International stock markets show capital gains for fourth consecutive year with best results since 2003.
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In 2006 the international stock markets made gains for the fourth consecutive year, marking up the best year since 2003. Excellent corporate profits, continuing ample liquidity and lively activity in mergers and acquisitions boosted the international markets. The stock market year, however, was not without its scares but in the second half it enjoyed a strong recovery fanned by the drop in oil prices and the end of the upward course of Federal Reserve interest rates.
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Emerging countries head classification of most profitable stock markets in 2006.
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Generally. the results in emerging markets were greater than markets as a whole, thanks to the rise in raw materials prices and a favourable economic situation. In fact, the emerging countries headed the classification of those stock markets with highest capital gains in 2006, including the so-called BRIC group (Brazil, Russia, India and China). Nevertheless, some developed countries in Europe also figured in the list, such as Luxembourg, Norway, Portugal and Spain, as may be seen in the following graph.
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On the other hand, in the early weeks of 2007 things turned around with a relatively worse performance in emerging market markets because of the drop in raw materials prices and some shocks, such as the announcement of nationalization of Venezuelan companies in strategic sectors which had earlier been privatized. North American markets, in turn, were slowed down because of the hold-over of prospects of a cut in Fed interest rates in the first half-year. The Japanese market was helped by gains among export companies as a result of an undervalued yen.
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IBEX 35 marks up new all-time high in January.
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In Spain, the IBEX 35 index ended 2006 with an annual rise of 31.8%, the biggest among the main European stock markets, the highest increase sine 1999. In the early stages of 2007, the selective Spanish index continued to mark up all-time highs going above the 14,400 level in mid-January. Demand for Endesa shares with an eye to the conclusion of the take-over bids underway contributed to the rise in the market.
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