ANNUAL REPORT 2008 - Polymer Bank Notes of the World

September onwards, amid the great unrest onglobal financial markets. At this time of the year,following the unravelling of a number of largeactors in the financial system and the consequentflight to safety and to liquidity, bond marketvolatility reached particularly pronouncedlevels in the United States. However, by the endof September, when financial instability becamemore severe in Europe as well, bond marketvolatility rose also on this side of the Atlantic(for further details, see Box 3).In the first two months of 2009 euro arealong-term government bond yields increasedmoderately by about 10 basis points, whilethe increase in US bond yields was morepronounced and equal to around 80 basispoints. On 27 February euro area and US tenyeargovernment bond yields stood at around3.7% and 3.0% respectively. Developmentsin long-term bond yields on both sides of theAtlantic were influenced by the weakeningeconomic outlook, heightened risk aversion andthe associated flight-to-safety flows, as well asincreasing concerns about the financing needsof sovereign issuers. While the first two factorswould tend to push yields down, the third one,which apparently dominated the other two,especially for the United States, would tend topush yields up. Over the same period, in theeuro area, yields on long-term inflation-linkedbonds increased as well, probably reflectingcontinued strains in the inflation-linkedbond market.Box 3VOLATILITY AND LIQUIDITY IN EQUITY AND GOVERNMENT BOND MARKETSStock and bond markets have become increasingly volatile in the course of the financial crisis,as can be seen from Chart A. 1 This high degree of market volatility stems from a combinationof the unwinding of leveraged positions, the large number of information shocks impactingmarkets, great uncertainty and elevated levels of risk aversion among market participants. Thisheightened risk aversion is likely to have compounded the impact that the information shocksand the uncertainty have had on price developments, with the result that price fluctuations havebeen larger than would have been the case given lower levels of risk aversion.For long periods during the crisis there has been a strong negative correlation between stockand bond returns (see Chart B). This negative correlation may be interpreted as evidence ofsafe-haven flows from stock markets to the most liquid segments of the government bond markets.Such a pronounced negative correlation was last observed around the time that the stock marketbottomed out in 2003. During the final months of 2008 the negative correlation between thesemarkets became less pronounced as the bond markets also became more volatile. This followedincreasingly clear evidence of significant spillovers from developments in financial markets to thereal economy. In addition to the increased variability of inflation expectations and risk premia,large revisions to market participants’ expectations regarding future developments in monetarypolicy rates are likely to have contributed to the increased volatility of long-term bond yields.The increased volatility in the government bond market has generally made market participantsless inclined to provide continuous liquidity to each other by posting tradable quotes for largeamounts in limit order markets. Although the most liquid government bonds, such as those issued1 See the box entitled “Abnormal volatility in global stock markets” in the November 2008 issue of the ECB’s Monthly Bulletin.ECBAnnual Report200843