Monetary policy and sovereign debt concerns drive markets

In the period from late August to the beginning of December, two themes dominated global financial markets. Through early November, the perceived slow pace of economic recovery in the major advanced economies helped intensify investor expectations that central banks would introduce further accommodative measures. Since early November, concerns about sovereign risk in several euro area economies have resurfaced and become the dominant theme.

Much of the focus during the initial period was on the US Federal Reserve and its early November announcement of a second round of large-scale Treasury bond purchases. The Fed's ultimate announcement followed a prolonged period during which senior officials gave speeches combined with other public statements in an effort to prepare markets. As a consequence, US real and nominal bond yields dropped significantly while equity prices rose strongly between August and early November as investors increasingly priced in the expected actions. At the same time, market indicators suggested that bond investors were revising upwards their US inflation expectations.

The Fed's anticipated monetary easing had a visible impact on market prices well beyond the United States as well. The US dollar depreciated against most other major currencies. Together with even lower US interest rates, this made the dollar the funding currency of choice for FX carry trades and intensified capital flows to emerging markets. The result, which was reflected in higher equity and bond prices in the faster-growing emerging market economies, prompted a number of these countries to introduce policy measures aimed at dampening the rate of capital inflows.

Since early November, attention has shifted to the euro area, with market participants becoming increasingly concerned about exposures to Ireland and other economies. Once again, credit spreads increased significantly on government bonds issued by affected countries. This time concerns were driven by two factors: the deteriorating fiscal situation in Ireland that resulted from continued government support for troubled banks; and consideration of EU treaty changes that would make it possible to impose losses on holders of bonds issued by governments in financial distress. Even as an EU support package for Ireland was agreed in late November, the stress persisted, with attention turning first to Portugal and Spain and later to Belgium and Italy. The situation did, however, stabilise in early December in anticipation of possible ECB support.