Financial market developments

Growing uncertainties over European economic and monetary union and the divergence of interest rates among the major economies were reflected in widespread instability in international financial markets during the third quarter. The overall level of activity in the international bond markets nevertheless remained high. Many investors switched into the 'safe haven' of assets denominated in deutschmarks, dollars, yen and Swiss francs.

The disturbance in European markets was reflected in several financial indicators. Bond prices in some European currency sectors were particularly volatile. Spreads on government bond yields relative to German bunds rose steeply in some countries. The price of Ecu bonds fell further below their theoretical level (constructed from the basket of underlying currency sectors). In the eurobond market, corporate bond yields generally rose relative to government benchmark bonds, as risk premia were marked up in some sectors. Historic and implied volatilities for most European bond futures also rose significantly during September.

Equity prices in a number of smaller European and Scandinavian countries fell by up to 20% during the third quarter. The UK equity market was subdued during July and August, mainly reflecting concerns over the outlook for the UK economy. But, share prices rose markedly following sterling's suspension from the ERM as investors anticipated interest rate cuts. The French stockmarket rose slightly at the end of the quarter, although the intense pressure on the franc helped to keep turnover low. By contrast, turnover in German equities rose towards the end of the quarter, but prices fell, reflecting investors' views that a substantial interest rate cut in the near future was unlikely. The US equity market traded in a fairly narrow range, with concerns over corporate earnings and uncertainty over the outcome of the presidential election only partially offset by lower interest rates. In Japan, the announcement of financial system and fiscal support packages during August helped boost equity prices from their six-year low.

Financial market developments