Financial Market

On Thursday the Bank of England cut interest rates by a quarter of a percentage point to 5.25%, the second cut that the BoE has made in three months.

The monetary policy committee that votes on interest rate changes, voted to reduce the BoE’s interest rate in the face of the countries economic slowdown. The quarter point reduction was widely tipped following the decision of the FED to cut rates by three quarters of a percent in January in an attempt to stave of economic recession.

The quarter point cut did not however match that of the FED due to increasing food and fuel prices pushing inflation above the two percent target the BoE sets.

According to David Kern, “Global and domestic conditions have worsened since the MPC met last month.”

Since the last meeting of MPC members the situation had changed to a point where a rate cut was now urgently needed, and a further cut to five percent may be planned as part of a two tier rate reduction. A half point cut in one meeting may well have looked like a panic move.

With the rate reduction made yesterday cost for consumers and businesses who rely on credit will be cut, boosting confidence and act as a catalyst for economic growth. At the same time however the cut will hit savers.

Following the quarter point rate cut the BoE rejected calls from a group of influential MP’s to publish a breakdown of the voting of the MPC with each meeting.

The Treasury Select Committee recommended on the ten year anniversary of the MPC that financial markets would benefit if they could see the support for any one decision.

The BoE rejected this idea saying rate setters publish the logic behind any particular vote two weeks after the decision on interest rate changes.

‘Releasing the vote at the time of the decision runs the risk of encouraging media speculation on the reasons for an individual’s vote and increases the simple-minded tendency to portray members as ‘hawks’ or ‘doves’,’ the BoE said.

 With the world market feeling the effects of the global credit crunch, Financial Market takes a look at how a booming 2004 economy deteriorated as it was hit by the sub prime mortgage crisis.

Wall Street is the very epicentre of the world financial system, a place where bankers and economists decide who to lend money to and how to make money in doing so. In 2004 the economy was strong, business was booming and low interest rates meant borrowing money was about as cheap as it had ever been. Coupled with this there was the demand for borrowing which was soaring.

At this time the US economy was strong, and banks were in a position where they were accepting applications for money from applicants who would have otherwise been turned down in the past.

This low interest rate was also seen in the Euro zone and UK, reflecting a positive economies that were not just state side. House prices were going up, inflation was low and banks outside the US felt confident in lending too.

In 2005 there were changes to the world financial system. Interest rate rises meant that some sub-prime loans started to fail, and people who borrowed couldn’t afford to pay the banks back. On the back of this banks went to books to access how much equity was tied up in sub-prime loans in order to evaluate the risk and their potential losses. The money tied up in sub-prime loans however wasn’t so easy to calculate due to securitisation.

Securitisation is the creation of asset backed finances, debt securities that are backed by a stream of cash flows. In essence the conversion of an asset into a marketable security.

In terms of sub-prime loans securitisation is the process of banks packaging loans together in order to sell them on the market. An investment is then backed by cash flow or the value of the underlying asset, typically real estate. As the original sub-prime loan is at this point mixed with other debts, it is hard to see the exact figure of sub-prime specific cash that was at risk.

With the international nature of the financial market system these liquid assets had been sold across the world, with a percentage of the sub-prime debt residing up in UK. What originally had looked like a US problems turned out to have global consequences.

At this point in time there was an air of panic around and subsequently there was a break put on lending until the full potential cost of the crisis could be calculated. In summer 2007 inter-bank lending effectively dried up over night and the fifth largest UK lender Northern Rock was forced to ask the Bank of England for financial support.

Central banks responded by cutting interest rates with the aim of restoring confidence in borrowing amid fears that the knock on economic consequences would be far worse.

Soon to follow were numerous high profile institutions revealing billions of dollars of losses after one another, resulting in market fears leaping a potential slowing down of the US economy to the very real threat of recession, a situation the current financial market system finds itself in today.

Leaked minutes today confirmed that the Bank of England’s Monetary Policy Committee voted 8-1 in favour of keeping interest rates on hold in January, although the Bank of England is still widely tipped to make a quarter point cut to 5.25% next month.

The leaked minutes demonstrate the Banks reluctance to follow suit after the FED’s three quarter point cut on Tuesday, with increased concern about the risk of spiralling inflation in the UK.

A reluctance to follow suit not only being shown by the Bank of England, but by other European central banks as well. Suggestions that European central banks are also reluctant to slash interest rates in a similar style to the FED created knock on effects in Wednesdays trading which saw US and European stocks fall further.

The worry is that slower economic growth will hurt corporate earnings, and stocks fell accordingly across all sectors. With Central Banks ruling out immediate rate cuts to boost economies, it means that slowed economic growth could be the trend for early 2008 as the US and UK fight to stave off recession.

“The uncertainty about corporate earnings growth in 2008 has risen, and not only in the financial sector.” said Matthias Schellenberg, managing director at ING Investment Management.

The Federal reserve today cut interest rates by three quarters of a point to take interest rates to 3.5%, 90 minutes before US trading opened. The dramatic cut was drastic action taken by the FED in order to stop markets falling after Europe and Asia recorded record losses on Monday, when US markets were closed.

The cut failed to work however with US markets recording sharp falls when Wall Street opened for Tuesday trading. Throughout the course of Tuesday trading other markets had closed even further down on yesterday, indicating the US would too open down. The FTSE 100 briefly rallied upon news of the FEDs actions after falling 3% early on, only to fall back again later on.

The actions of the FED are a clear indication of its concern, and weren’t meant to meet until next week, making this cut something of a panic move.

The underlying factor is that the real economy has not changed much in the last week, and as such the FED would not have to act now to make a decision on interest rates. What has ushered this move is financial market developments that are threatening to impact the real economy.

In essence if financial markets panic about what is going on in the real economy it can affect the real economy, leading to a nightmare for economy policy makers, which is a feedback mechanism of the markets being spooked by the economy, feeding back into the economy, sending everything into a tail spin.

Therefore the rate cut by the FED is designed to prevent this tail spin, but at the same time destroys confidence.

For mechanical reasons rate cuts will make it easier to borrow money and buy shares, and therefore can be used to prop up stock markets, but when market is determined to fall it is difficult to stop it. This is a similar pattern to drastic rises what a quarter point rise tends not to have an effect on growth, another cut wont solve the current downturn, but this downward phase for many is seen as a correction of the upward phase seen over recent years.

It is hard to steer and control financial markets, and central banks will say it is there doctrine not to control stock markets but to stop the economy going into a spin and if that means further rate cuts then so be it.

The implications of the FEDs cut on the UK are expected to be minimal. The UK are based in sterling and the Bank of England shouldn’t feel any pressure by the Fed to cut UK interest rates accordingly. Central banks are however looking to perceive that they understand and are in control, which in turn does put some pressure on the Bank of England to act, making the expected cut next month even more of a certainty. A FED style out of hours meeting is unlikely though unless further chaos continues in the market.

In terms of the global volatility of markets witnessed over the past two days many do expect a bumpy year although not on the same levels, and as such many experts expect markets to settle down.

But it is important to understand that this market downturn is not like 9/11, this market downturn has an economic underpinning where world markets are trying to adapt their view of the American economy. World markets have been late in understanding the crisis facing the American economy and its decline over the past year. At the moment world markets are correcting itself in a sense, a process which can be messy. The Economy will settle down and markets will learn to live with where the economy will settle down, which in turn will bring an element of stability back.

The US dollar fell against both the Euro and the Yen and marked a two and a half year low on the Swiss Franc on Wednesday after figures were released showing consumer prices for December in the US were higher than forecasted, increasing concerns regarding inflation at a time of slowed economic growth in the US.

Disappointing retail figures for Decembers have also suggested that the US economy might be facing deeper problems, and falling global stock markets have also fuelled speculation that the Fed could cut rates by as much as 75 basis points soon.

Investment bank Goldman Sachs has already predicted that the US economy will fall into recession in 2008, and December’s retail data will confirm the worst for many analysts’.

As consumer spending accounts for two-thirds of the US economy, the retail figure for December could go a long way to supporting that Goldman’s fears are in fact correct

The high December prices coupled with a slowing economy however, leaves the Fed in a delicate position. Fed chairman Ben Bernanke’s has made comments suggesting that the central bank is willing to take “substantive additional action” to maintain growth which leads many to hold expectations of at least a half percentage point cut in the Fed’s benchmark interest rate, but lower rates cut the attractiveness of dollar-denominated securities and reduce demand for the dollars to buy them.

Citigroup has also reported its first quarterly loss since its establishment in 1998, and being the first bank to release its results for the last three months of 2007, its figures are seen as an indication of the effects the crisis in the sub-prime mortgage sector will have on the rest of the banking sector.

With a further decline of the Dollar brought on by figures supporting more weak bank earnings, inflation could rise further leading many to question and the Feds aggressive rate cuts.

“A rise in the core (inflation) to 2.4 percent could start to question the Fed’s presumed path of aggressive rate cuts — sending equities sharply lower,” said ING in a note to clients.

Figures released toady by the Consumer Prices Index show UK inflation remained steady in December.

The Consumer Prices Index is the governments preferred measurement for UK inflation, and in December the figure held at 2.1% for the third consecutive month.

Putting the most pressure on UK inflation was the continuing high prices of food according to the Office for National Statistics.

While the rise in the cost of food was offset by falling electricity and gas bills in December (7% annual decline in - the steepest such fall since comparable records began in January 1997), preventing annual CPI inflation moving higher still, energy companies are starting to rise their prices once again.

The Retail Price Index inflation measurement, which includes mortgage interest payments, eased to 4% from 4.3% in November.

Although holding at 2.1% the UK inflation figure still holds above the Bank of England’s 2% target figure, which continues to highlight the dangers of rate cuts in order to boost economic growth.

The figures were released at the same time as additional figures which showed annual factory gate price inflation running at its highest rate for more than 16 years.

The MPC cut base rates from 5.75% to 5.5% on December 6, and economists are forecasting a further quarter-point reduction next month. This data will however provide the MPC with food for thought as it weighs worrying price pressures against the increasing danger of a sharp economic slowdown.

The World Bank released its Global Economic Prospects report for 2008 today, in which it predicts 2008 will be a year that developing countries will play a crucial role in preventing global markets suffering heavy landings as they suffer slowing economic growth at a time when the credit crunch continues to hit world economies.

In the report the World Bank has stated that the resilience in developing economies such as China and India will help to soften the impact of the current economic slowdown, and lead world markets in terms of growth in 2008.

The report from the World Bank was reiterated by Lord Jones who has encouraged medium sized British firms to actively look for opportunities in these high growth markets.

The prediction of a weakened landing however could be threatened by a continued weakened dollar and increasing volatility in world markets.

‘External demand for the products of developing countries could weaken much more sharply and commodity prices could decline if the faltering US housing market or further financial turmoil were to push the United States into a recession,’ World Bank

2008 growth predictions
The report outlines that slowed world economic will slow to 3.3% in 2008, from 3.6% in 2007. The growth of developing countries however is projected at 7.1% for 2008. US specific growth is tipped to slower even more to 1% in the first half of 2008, whilst China is tipped to record more than 10% growth.

‘strong spending by oil-exporting countries and firm expansion in China and India will keep developing country growth at 7% or more this year and next.’ World Bank

After news last week about the FED plans to inject liquidity into financial markets through a series of below market rate inter-bank loans totalling $20 million dollars, the European Central Bank has taken further steps pumping a record 348.6 billion Euros ($502 billion) into financial markets.

The emergency move follows last weeks co-ordinated action, and resulted in short term markets rate reducing at the quickest rate for ten years on Tuesday 18th December. The amount invested by the ECB was twice the amount first indicated, and came as a result of 390 private sector banks in the eurozone requesting the emergency funds.

The funds were offered for two weeks to boost liquidity in financial markets at a rate of 4.21%, short of previous market rates and with the intention of easing tightened credit markets. The loosening of those markets will then relieve fears of a Christmas period meltdown, a time of year when banks in particular need more cash to balance increased retails spending.

The loans made available by the ECB are 25 times larger than those the Bank of England previously made available, through a series of three month credits at 5.95% totalling £10 billion.

With the ECB making funds available to banks over a short term period, the aim is that these funds will be passed onto companies and individuals at cheaper rates. Indeed on news of the ECB’s actions the short term lending rate dropped, with the two week euro libor rate falling to 4.4%.

The fact that these short term cash funds were offered at 70 basis points less than the commercial cost of short term money sends out a clear message that things are so grim in the money markets that the ECB will do anything to unblock the system.

The offering of unlimited money at below market rates by the ECB through this immense cash injection is not a magic cure, but is more a step that will tide markets over the holiday period. It seems more an admission that central banks have failed to thaw freezing money markets of the last three months, and the problem still remains more about credit worries than market liquidity.

Toady on the 13th December 2007 a joint plan has welcomed by global financial markets that involves a $20 billion cash injection from a consortium of five world central banks to stave of the growing likelihood of US recession and ease the credit crunch in other financial markets.

The cash injection will be made available in the form of ten of billions of dollars of short terms loans to banks, aimed at lowering inter-bank lending rates. The program called a “term-auction facility” will be available alongside additional expanded lending facilities available from the Canadian and European Central Banks.

The move was welcomed by Banks who reacted negatively to what they called a timid quarter point cut on Tuesday 11th December. On news of the new lending schemes being released U.S. stocks began to show signs of recovery, after late drops on Tuesday following the cut by the FED.

“News that global central banks are pledging liquidity was a positive for the market early in the trading day, but, upon further reflection, some might be pondering if it’s really a solution, or further evidence of just how deeply embedded the problems in the financial system have become,” said Frederic Ruffy, analyst at Optionetics.

News of co-ordinated action with Europe’s top banks demonstrates that the FED is taking additional steps, after lowering the federal funds rate on Tuesday did not accomplish enough in terms of unclogging credit markets.

The main problem in credit markets has not been that rates were too high, but that financial institutions have been unwilling to lend after subprime mortgages and other securities had been badly mispriced. The added liquidity that the “term-auction facility” should provide should relieve some of that pressure on financial institutions.

Through this action the Fed is actively forcing liquidity into financial markets, rather than having banks demand it. This extra liquidity will be supplied at whatever price the market deems, rather than setting an interest rate first and letting the amount of the loans be determined by demand from banks.

As part of the plans there are also procedures in place to protect any bank accesses the funds, and so will remain anonymous. The aim here is avoiding any stigma a bank may receive regarding mis-managed liquidity property.

Earlier this month Iran’s President described the US Dollar as a ‘worthless piece of paper’ and at a time when speculative selling of the dollar reaching all time highs, Financial Market examine whether the days of the Dollar as a dominant international trading currency are numbered.

On the 11th of December the Pound rose against the Dollar for the forth consecutive day, creating speculation that the FED will cut interest rates subsequently reducing the attractiveness of Dollar assets further, in order to stave off a looming recession.

In additional news the FED has also announced a 0.25 point reduction marking the greatest easing of borrowing costs since the last recession in 2001.

It is not only against the pound that dollar is low, and across a range of world currencies the dollar has recently reached all time lows. This has gone as far as the currency losing a quarter of its value over the last five years against leading currencies. In one example at one point in 2002 the Euro was marked at 86 cents; today it buys $1.48.

The struggles of the Dollar have sent waves of scepticism throughout world markets, including several over hyped high profile cases when the Euro has been preferred to the Dollar. More realistically there are ongoing debates regarding Dollar dominated reserves being switched to alternate currencies in a similar trend to that of the Pound being replaced 50 years ago when Britain was the worlds greatest trading power.

Although currency values do ebb and flow there is an air of crisis with the current depreciation of the dollar due to the shear volume of reserves that are made up of a deprecating dollar assets. Foreign stockpiles have tripled since the beginning of decade holding $5.7 trillion Dollars and accounting for 65% of world wide stockpiles. The largest two single holders of dollar dominated assets are currently China and Japan holding 1.4 trillion and 1 trillion Dollars respectively.

The effects off holding Dollar dominated reserves over the past five years have meant huge financial loss to those countries, and countries are understandably itchy about how much more they can allow their reserve value to deprecate.

If speculation was true and foreign exchange reserves decide to dump the Dollar as a reserve currency cutting recent losses, it would result in a further slump of currency value. Therefore lure of selling first is also attractive to countries with large Dollar stockpiles as central banks are already overloaded with the currency, meaning those who abandon ship last may loose even more.

A falling Dollar is not a new scenario and America has staved off similar threats in the past, but with a slowing economy too, it makes the current situation even worse. The US housing downturn has had a negative effect on credit markets and the threat of a recession has led to two interest rate cuts, with more predicted. Slowed growth and falling interest rates make for a weakened currency in the Dollar, particularly when growth prospects elsewhere seeming more attractive.

To add to the Dollars woes there is also the threat of oil exporting countries ditching Dollars as the trading currency. This would have a severe impact on the Petro-Dollar cycle which has previously meaning oil trading states are obliged to buy Dollars in order to buy oil. Ditching the Dollar as the world’s oil trading currency would lessen its demand when confidence for the currency is already wavering.

Some experts have stated that here is in fact no reason why currency reserves should be dominated by a single currency. In essence reserves are a fall back, and are held to act as guarantor for a countries trading, reserves aren’t floated in global trading. As the main requirement is that the currency inspires confidence and is easily convertible, both the Euro and the Yuan are tipped to play a large part of financial reserves in the future.

More immediately the Euro Threatens the Dollar as it has additional present day advantages in terms of the reach of the currency and is share of world trade. The Euro only becomes more attractive as it stretches across so an increasing number of individual economies throughout Europe. Additionally the countries making up the euro are less dependent on oil imports than America is and sell more to oil exporters as well as to fast-growing economies such as China and Brazil.

In the short term the Euro looks an attractive substitute, and as huge Dollar dominated reserves are faced with fighting off the cost of US inflation it seems increasingly attractive. Sticking with the Dollar would mean importing the policies of America as she staves of a recession, but alternatively abandoning the Dollar completely would add to increasing pressure on the currency.

Whatever the future holds it is certain that Japan and China as the two largest holders of reserve Dollars will pave the way, and will be big players in avoiding a Dollar crash. As it stands Japan looks certain to stick with the Dollar. If China also retains it, recognising dumping the dollar would be self defeating as she owns such vast amounts of American assets, there may after all be some light at the end of the tunnel for America and the Dollar.