Throughout much of 2003, stimulative monetary policies and strengthening fundamentals contributed to a strong rally in asset prices and a compression of credit spreads on both mature and emerging market bonds (see chart, this page). But in some cases, the increase in asset prices appears to have been motivated as much by the push of abundant liquidity as by the pull of fundamental valuations. In such an environment, assets could become overvalued if investors boosted leverage to high levels in the expectation that interest rates would remain low indefinitely.
In 2004, changing interest rate expectations have served as the main driver of global financial markets. Early this year, investors, adjusting to the prospect of a tighter U.S. monetary policy, became more cautious. In the process, some investors partly unwound positions encouraged by last year's abundant global liquidity. The resulting adjustments in April and May, though pronounced in some emerging and higher- risk markets, produced fewer disruptions than had been feared, and all markets remained orderly.
A number of factors contributed to this relatively calm transition. First, the U.S. Federal Reserve Board gave abundant warning to investors and financial institutions to prepare themselves for a tightening of monetary policy. As a result, markets widely anticipated, and reacted calmly to, the first U.S. interest rate hikes in June and August. Second, the Federal Reserve's message that the pace of interest rate increases will be measured is consistent with market expectations that inflationary pressure is likely to remain subdued. Finally, higher global economic growth is supporting the credit quality and earnings prospects of corporations in the mature markets and of emerging market borrowers.
The calm with which financial markets have adjusted to the anticipated gradual increase in interest rates is welcome. It is also encouraging that leveraged positions seem to have declined and that financial institutions appear well positioned to withstand the move to a higher interest rate environment. Moreover, option prices suggest that markets do not expect large changes in asset prices.
Amid widespread optimism, however, a number of potential risks stand out, with geopolitical concerns representing an imponderable one. In recent months, security concerns have affected oil...