Economic Developments and Monetary Policy

INTERNATIONAL FINANCIAL MARKETS: UNCERTAIN GLOBAL ENVIRONMENT AMID HEADWINDS

Since April 2004, international financial markets have been dominated by uncertainty about the sustainability of U.S. economic growth amidst mixed economic news, profit warnings, higher oil prices and tightening monetary policy. Tighter monetary policy in the U.S. beginning in mid 2004 moved interest rates from historically low levels.

Foreign capital flows into Asia and the belief that Fed tightening will continue to be “measured” supported Asian stock markets last year.

Despite impressive corporate profits, global stock markets have traded sideways since the beginning of 2005 as investors mulled the impact of higher oil prices and interest rates on economic growth and corporate earnings. There were also concerns that the global technology cycle had peaked, with technology-heavy indices underperforming the broader markets (See Chart 14).





Government bond yields in developed markets rose from their year-lows in March 2004 following initial signs that Fed will start to raise interest rates although expectations of a measured pace of tightening amid benign inflationary pressures have since led to lower yields. Nevertheless, yields have backed up since early February this year amidst signs of stronger than expected growth and renewed concerns over inflation (See Chart 15).





After a brief correction during April to May 2004, Asian bonds continued to rally, reflecting efforts by investors to sustain returns in a low interest rate environment. However, bond prices began to correct in February 2005 on the back of concerns over the possibility of more aggressive Fed tightening to curb a rise in inflationary pressures (See Chart 16).





In the foreign exchange market, the USD weakened significantly in late 2004 driven by concerns about the growing U.S. current account deficit. Excessive focus on exchange rates as corrective mechanisms for global imbalances also invited speculative capital flows into Asia that strengthened regional currencies (See Chart 17).