By Quentin Webb
LONDON (Reuters) - Financial markets are set for a rougher ride in 2007 and risk a re-run of this May's turmoil, as more dollar weakness helps spur a rise in volatility, Standard & Poor's chief European economist warned on Wednesday.
"We see 2007 as a year of temporary re-adjustment as far as real growth is concerned, but we also see financial markets experiencing much higher volatility in general, with more bumps along the way," Jean-Michel Six told a news conference.
"Those bumps could be specifically created by developments on two areas: foreign exchange markets and real estate."
After spiking earlier this year, measures of equity volatility have since fallen to their lowest levels in years. The Chicago Board Options Exchange Volatility Index, or VIX <.VIX>, dubbed Wall Street's fear gauge, hit a 12-year low in November.
S&P forecasts U.S. gross domestic product (GDP) growth will slow to 2.3 percent next year and the dollar will drop to an average of $1.37 against the euro
A combination of a high number of housing starts and slowing demand could cause housing market problems in European countries such as Spain, mirroring the housing slowdown in the United States, Six said.
"I would see increased volatility on the long end of the curve, as far as interest rates are concerned," Six said. "That is partly to do with how far the dollar is going to go down, and what will be the reactions in the U.S. to this situation.
Six said global financial markets were "still exposed" to a situation like the "emerging markets crisis" of early 2006. "That is something that could very easily repeat itself," he said.
Worries that U.S. policy-makers would have to raise borrowing costs sharply to quash rising inflation spurred a steep correction in stock and bond markets in May and June.
Emerging markets were among the hardest hit, as investors unwound "carry trades" that are based on borrowing in low-yielding currencies such as Japanese yen and investing in higher-yielding arenas like Iceland.
The MSCI index <.MSCIEF> of emerging market stocks shed 25 percent between May 10 and a low on June 14, although it has since regained almost all that ground.
In a report released simultaneously, S&P warned European credit quality would suffer in 2007 as companies continued to reward shareholders with buybacks, dividends and acquisitions.
Debt and leverage levels would rise, credit rating downgrades would again outstrip upgrades and defaults would tick up from very low levels, the rating agency warned.
"Abundant liquidities have led markets not to price credit risk in the same way they did in previous cycles," Six said.
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