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International financial markets were characterised by abundant liquidity and resulting low risk premiums in 2006 and the early part of 2007. Global equity markets experienced sharp run-ups in valuations during the period, in tandem with sustained and non-inflationary economic growth in the global economy. Aside from two brief, albeit sharp corrections in May 2006 and February 2007, global equity markets posted healthy returns on the back of strong corporate profitability and merger & acquisition activities. The US subprime mortgage market was in the spotlight during the period, as concerns over the cooling housing market and downgrades in subprime mortgage ratings spooked investors about the sustainability of US economic growth.
Equity markets in Asia and the US experienced widespread sell-offs in both May 2006 and February 2007 (Chart 4). The May 2006 episode was triggered by concerns over the possibility of higher-than-expected inflationary pressures in the US. In comparison, the sell-off in February 2007 was prompted by concerns of overvaluation – following a prolonged period of low risk premiums which might have encouraged excessive risk-taking by market participants – rather than any significant shift in real economic fundamentals. Sovereign spreads in most East Asian countries, for example, have remained tight reflecting improved fiscal positions, although the global search for yield also played a part (Chart 5). These recent market developments have underscored both the swift changes in financial market conditions and the growing interconnectedness of financial markets across countries. |
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Long-term government bond yields in developed markets remained at historically low levels in 2006 (Chart 6). While US government bond yields rose to above the 5% mark in June last year, reflecting the ongoing normalisation of short-term rates as well as a heightened sensitivity to upside inflation risks, yields fell back due to concerns over economic weakness. These relatively low levels of long-term interest rates could be attributed to both cyclical and structural factors, including expectations of low inflation, an abundance of liquidity as well as continued demand for long-dated securities from pension and other institutional funds.
While the inversion of the US yield curve in 2006 had raised some concerns about a possible recession, the global economy continued to register strong growth last year. This momentum may have moderated somewhat in the first quarter of 2007, although economic growth remains firmly entrenched.
In the foreign exchange market, the USD weakened against the Euro and the SGD, on heightened concerns over the sustainability of the US current account deficit. Against the Japanese yen, however, the USD was periodically supported by large yen carry trades. The unwinding of some of these carry trades during the sell-off in February this year resulted in a resumption of USD weakness. Nonetheless, the correction in the USD thus far has been orderly and markets have remained resilient (Chart 7). |
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