Financial Market

This week Gold slumped to a three month low to $850 an ounce after the US dollar continued to show further signs of recovery against the Euro after increasing optimism that the worst of the global credit crisis is over.

The yellow mental that has seen record highs in recent months has slumped by $25 since reaching $881.65 overnight. This overnight high was brought as a result of a temporary stalling of the dollars resurgence after the FED made a further interest rate cut.

Since the FEDs rate cut the US economy has been filled with an air of cautious optimism that the worst of the financial crisis has been weathered, helping push the dollar upwards. As a result the price of gold has seen a steady decline as its appeal to an alternative to the greenback has been diminished.

“The pace of decline, suggests gold will remain at risk to further corrections in the coming sessions, potentially testing below the psychological $850 an ounce mark before finding sufficient demand from bargain hunters and the physical sector.” - James Moore at TheBullionDesk.com

Although many had predicted a .25% rate cut by the FED to 2.0%, many were surprised by statements suggesting that further cuts could follow, weakening the dollar. US interest rates have now fallen from 5.25% since September 2007.

On Thursday however core inflation was higher than expected which many expect will halt any further rate cuts planned by the FED.

The resulting rise in confidence in US markets has seen an increase in the appetite for risk, which has further pressured gold, with investors redirecting money ploughed into commodities at the start of the year back into equities. A trend much expected with gold’s reputation as a safe store for wealth in times of economic uncertainty.

To FED boss Ben Bernanke added to the concerns of already strained financial markets by warning that contraction of gross domestic product (GDP) in the first six months of 2006 is a distinct possibility.

Speaking to congress Bernake said “It now appears likely that real GDP will not grow much, if at all, over the first half of 2008 and could even contract slightly”

With two consecutive three month periods of negative growth generally accepted as the definition of recession the US could be heading towards that mark.

The announcement came as Mr Bernake begins two days of testimony to US congress, at which it is thought he will be questioned on the FED’s decision to rescue Wall Street investment bank Bear Sterns.

“We did what we did because we felt it was necessary to preserve the integrity and viability of the American financial system, which in turn is critical for the health of the economy,” Ben Bernake

Mr Bernake has also said that it will take up to two years to determine whether or not the economy technically hits recession status, based on an the judgement by the non-profit economic research institute, the National Bureau of Economic Research (NBER).

He went on to predict that after a tricky first half in 2008 the economy would see an upturn in the second half of the year, which will continue throughout 2009.

It is thought that the expected up turn will be helped by the cuts the FED has made in interest rates and the government’s $168bn (£85bn) stimulus package that involved tax rebates to individuals and tax breaks to businesses.

The FED has cut interest rate has by more than half since 2007 which now stands at 2.25%. The next review is due to start on April 29th.

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.

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.