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Financial Markets Report *

-- Heightened Uncertainty Stemming from the Fiscal Problem in Europe
-- Developments in Domestic Financial Markets in the First Half of 2010
-- Points to Be Noted in the Financial Markets for the Foreseeable Future

* This is an English translation of the Japanese original released on July 30, 2010.

August 31, 2010
Bank of Japan

Executive Summary

Heightened Uncertainty Stemming from the Fiscal Problem in Europe

In the international financial markets, from spring 2009, investment in risky assets continued against the background of the gradual recovery in the world economy, especially in emerging economies and resource-rich economies and the heightened expectation of a continuation of the low interest rate policy in the developed economies. In the beginning of 2010, however, due mainly to the growing fiscal problem in Europe that started in Greece, uncertainties about the international financial markets increased, and investors became cautious about investment.

The fiscal problem in Greece worsened due mainly to the skepticism about the feasibility of fiscal restructuring in Greece, and this spread to other peripheral European countries where the fiscal conditions were also deteriorating. Decline in government bond prices of peripheral European countries, due to the decrease in confidence in the public sector, made market participants' views more cautious toward European financial institutions that held a large amount of such claims, leading to heightened anxiety about the financial soundness of these financial institutions. Reflecting the growing fiscal problem in Europe, the strains in U.S. dollar funding markets increased, and together with the announcement of new financial regulations, market participants' uncertainties mounted.

In particular, from late April 2010, when developments surrounding the fiscal problem in Europe became increasingly tense, the financial market environment -- which had been generally stable -- changed significantly, and the prices of risky assets became unstable, often fluctuating widely. The growing fiscal problem in Europe deeply shocked the financial markets, which had grown used to a stable environment. As market participants strongly believed that it was not easy to resolve the structural problem in the euro area, investors became cautious in taking on risks.

Developments in Domestic Financial Markets in the First Half of 2010

Although the effects of the heightened uncertainty in overseas financial markets on Japanese financial markets were relatively limited, nervousness was seen in some domestic markets, such as stock markets.

Effects from abroad on each domestic market varied depending on the supply and demand conditions and activities of foreign investors. For example, short-term interest rates remained stable at low levels reflecting the Bank of Japan's provision of ample liquidity, and credit spreads on corporate bonds were generally on a decreasing trend in the first half of 2010 given investors' steady demand for investment. Although some adverse effects were seen in the corporate bond market from May 2010, these effects were limited compared with those in the United States and Europe. On the other hand, stock prices fluctuated widely in both directions and showed unstable developments, as they were directly affected by risk aversion among foreign investors amid growing concern about the fiscal problem in Europe. In foreign exchange markets, the yen appreciated substantially against the euro due to the fiscal problem in Europe. The yen's exchange rate against the U.S. dollar had been more or less flat, but then appreciated to below 90 yen and heightened instability toward the end of June 2010, as an expectation of a rise in interest rates in the United States was further reduced.

Points to Be Noted in the Financial Markets for the Foreseeable Future

Financial markets at home and abroad are facing increased uncertainties. As for the outlook, financial markets are likely to remain nervous, fluctuating widely depending on the economic indicators and information on the financial system. In particular, the following warrants attention: whether actions taken by governments in the euro area and the European Union will help alleviate concerns about the fiscal problem in Europe; whether ensured confidence in the European financial sector will prevent an adverse feedback loop between economic and financial activities from operating; and, while major developed economies are expected to recover only moderately, whether emerging economies will achieve a sustainable growth path by conducting appropriate macroeconomic policies and continue to play the role of the engine for the world economy.

Attention should also be paid to long-term interest rates of major developed economies that have recently declined significantly. Long-term interest rates of major developed economies, excluding peripheral European countries, generally have followed a declining trend in the second half of 2009 and the first half of 2010, due to the growing expectation of continued low interest rate policy and to increased risk aversion of global investors reflecting the credit problem in Europe, respectively. In this regard, some market participants have expressed concern that a decline in long-term interest rates might imply the prolonged stagnation of the real economy. Based on Japan's experience after the bursting of the economic bubble, it has been pointed out that the recovery of major developed economies might be very slow for an extended period since they face balance-sheet adjustment pressure after the financial crisis. On the other hand, as fiscal conditions of major developed economies have significantly deteriorated, it also continues to be pointed out that a risk remains that government bond prices might peak out and start to drop (i.e., that government bond yields might rise).

Therefore, careful attention should be paid to the developments in long-term interest rates in countries around the world as well as the mechanism behind these developments.

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Financial Markets Department, Bank of Japan