Financial markets

26 June 2006

Conditions in global financial markets remained calm and accommodative during most of the past year. This reflected the surprisingly strong performance of the world economy and still abundant liquidity. Up to the end of 2005, lower term premia - or a narrowing wedge between forward and expected short rates at long maturities - appeared to be responsible for flattening yield curves in the United States and the euro area. The prospect of additional monetary tightening due to higher growth and inflationary pressures resulted in higher long-tem yields starting in early 2006. However, its impact on the prices of other assets was only evident from mid-May, when volatility increased and equity and emerging debt markets fell sharply.

Equity prices and credit spreads benefited from upward revisions to the growth outlook in 2005 and early 2006. In the main industrial countries, changes in firms' capital structure also supported equity markets, on the back of an impressive pickup in share buybacks and merger and acquisition (M&A) activity. Stocks responded more positively to the latest M&A wave than they had to previous ones, rewarding shareholders of both target and acquiring companies. Credit spreads stayed close to their cyclical lows despite the releveraging activity. Investors' high appetite for risk helped to keep spreads down. This was especially evident in emerging markets, where the tightening of spreads in 2005 and early 2006 appeared to proceed more rapidly than the improvement, admittedly sizeable, in fundamentals.