Introduction

The fourth quarter of 1999 marked the culmination of a year of rising equity prices, climbing bond yields and easing credit spreads. These developments reflected increasingly sanguine market expectations about the global economy. Not only did market participants see improved growth prospects in most regions, they also seemed assured about the ability of monetary authorities to keep inflation in check without pushing economies into recession. Concerns that the millennium date change might disrupt market functioning dampened market activity, but these concerns were allayed once central banks in general took operational measures to ensure that liquidity would be provided if and when appropriate. In the event, the new year arrived without significant market incident.

Spreads on interest rate swaps were among those that eased during the fourth quarter. This particular development was especially notable, because hedging activity associated with a surge in corporate bond issuance during the summer had inflated such spreads to unusual levels. Even after their recent decline, these spreads have remained high by historical standards. The behaviour of the swaps market may have signalled broader changes in market functioning and pricing relationships in private and government debt markets, changes stemming from the market turbulence of the second half of 1998 and current and prospective supply trends in the two types of markets.

The weeks surrounding the turn of the year highlighted how quickly market sentiment can change. By the end of the fourth quarter, stock and bond markets seemed to be brimming with confidence about the ability of monetary policy to engineer a soft landing in the United States and support non-inflationary growth in Europe. The month of January 2000 found the very same markets wavering in their views. European and US bond yields rose sharply on evidence of unrelenting strength in the US labour market and on news of continued increases in oil prices. The prospect that monetary tightening might be more forceful than initially anticipated led to a sell-off in the US stock market and heightened volatility in other equity markets.

Newly released comprehensive BIS data on the international banking market for the third quarter of 1999 show the largest volume of net lending ($188 billion) since the second quarter of 1998. The rebound was driven largely by a resurgence in the interbank market among industrial countries, in which the absorption of unusually large repayments from non-bank borrowers led to a temporary expansion in interbank balance sheets. By contrast, the third quarter saw the sharpest decline in claims on emerging market borrowers since the credit squeeze that followed the Russian debt moratorium in the third quarter of 1998. This time, however, the decline seemed to be driven by a shift in the demand by these borrowers away from bank loans to securities issuance. Aggregate activity in international syndicated loans declined in the fourth quarter in spite of a rebound in merger and acquisition deals.

Notwithstanding the more favourable credit spreads, gross and net international securities issuance declined in the fourth quarter of 1999 after three quarters of record activity. Although an increase in the amount of debt needing to be refinanced supported gross issuance, announcements of bonds and notes still declined by 25% (to $310 billion) relative to the previous quarter. The slowdown reflected primarily a front-loading of activity to earlier quarters and a postponement of other issues to the new year because of concerns about possible market disruptions related to the millennium changeover. Net issuance fell by 37% (to $193 billion), but was still twice as large as that in the fourth quarter of 1998, when activity had slowed amid generally adverse market conditions and in anticipation of the introduction of the euro. The euro's weakness in 1999 did not prevent net issuance in the currency from increasingly outpacing that in US dollars.

The aggregate turnover of exchange-traded financial derivatives monitored by the BIS contracted by 17% in the fourth quarter of 1999 (to $76 trillion), the lowest level since the fourth quarter of 1996. The dominant influence in the fixed income and currency market segments appears to have been the effort by market participants to pare down their positions to a minimum ahead of the new millennium. The main exception to the downward trend took place in the area of equity-related instruments, where the record levels reached by equity indices led to a widespread increase in the value of turnover.

An analysis of spot and forward FX trading volumes suggests that the introduction of the euro has not to date caused major changes in FX market activity. Results from an informal survey among market participants and information from electronic brokers indicate that the importance of the new currency in FX trading roughly matches that of the Deutsche mark before 1999. In particular, the reported share of trading in euros against dollars in October 1999 was about the same as that of dollar/mark trading in April 1998. Furthermore, the share of euro/yen trading still accounts for only a small part of the total market. In emerging market countries, the role of the euro so far seems similar to that of the mark, being confined mainly to eastern Europe. Outside eastern Europe, FX transactions involving the domestic currency are currently conducted mainly against the dollar.