September 11, 2006
Bank of Japan
Financial Markets Department

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Executive Summary

During the first half of 2006 in Japan's financial markets, against the background of solid economic recovery, long-term interest rates rose and briefly moved around 2 percent, the highest level in recent years, and short-term interest rates turned to increase or firm up as the quantitative easing policy (QEP) ended in March 2006. The yen was also stronger against the U.S. dollar than it was at the end of 2005. Stock prices in Japan were supported by strong fundamentals but fell after May affected by investors' withdrawal of funds due to global risk reduction, and were lower at the end of June 2006 than they were at the end of 2005.

In the money markets, rates on short-term instruments such as 1-month and 3-month rose reflecting market participants' expectations of the path of monetary policy changes after the end of QEP. Rates on overnight loans also firmed up after May while the outstanding balance of current accounts at the Bank declined. The money markets overall became active in the first half of 2006. Market functioning gradually recovered and transactions in the money market became somewhat smoother.

In the JGB market, long-term interest rates showed a gradual upward trend against the background of improvements in the outlook on the economy and prices, growing expectations of an increase in target interest rates, and an increase in long-term interest rates in the United States. Long-term interest rates briefly exceeded recent 2004 peak levels and temporarily reached around 2 percent.

Stock prices on the Nikkei 225 Stock Average rose temporarily to a high of around 17,500 yen for the first time since July 2000, reflecting strong fundamentals. They declined, however, after May, reflecting global investors' withdrawal from investment in risk assets. Stock prices as of the end of June were lower than at the end of 2005. The stock prices of small and new corporations, after sharply rising in the latter half of 2005, declined as these stocks were sold off throughout the first half of 2006.

Credit spreads, which had been at extremely tight levels, began to widen from around March. Issuance of lower-rated bonds and Fiscal Investment and Loan Program (FILP) agency bonds became less active. The amounts of CPs outstanding declined year on year. Nevertheless, on the whole, credit spreads continued to move stably at relatively tight levels during the first half of 2006, although investors took a more cautious approach as interest rates and their volatility rose, influenced by a number of idiosyncratic events that triggered concerns over certain issuers in the corporate bond market, municipal bond market, and FILP agency bond market.

In the foreign exchange market, the U.S. dollar widely fluctuated against major currencies against the background of issues such as the U.S. current account deficit and global risk reduction. Despite these fluctuations, the trend of U.S. dollar appreciation against major currencies, which continued throughout 2005, came to a halt in the first half of 2006. The U.S. dollar was on the whole weaker than it was at the end of 2005.