Highlights

  • Central banks take interest rates down – ECB and BoE to follow

  • IMF gives loans to Hungary and Ukraine; offers short-term credit facility

  • Stock markets stabilize at low levels


Tentative recovery

Financial markets are still under the spell of the credit crisis and its impact on the global economy. The extensive bank support measures announced by governments in the industrialized countries and numerous government capital injections have to some extent allayed fears of further collapses in the financial sector; the main worry now is a vicious circle with the problems in the financial sector and the economic downturn reinforcing each other. Almost all market participants now believe that the industrialized countries are in the grip of recession and that the emerging markets are being dragged down too.

The stock market sell-off continued initially at the start of the week. The Dow Jones dropped below 8200 temporarily, thus approaching its lows of 2002-2003. The DAX only managed to remain above the 4000 mark because of a massive surge in Volkswagen shares. Simultaneously, the euro lost further ground against the dollar and the yen. However, the panic that had gripped foreign exchange markets a few days earlier subsided somewhat. USD-JPY remained close to its 13-year low of below 92, which it had hit last Friday. EUR-USD fell to 1.2330 for a time, EUR-JPY to 113.64. Most of the major currencies suffered a similar fate. Emerging market currencies only fell moderately, if at all, compared to the previous Friday.

Towards the middle of the week, equity markets rose again, and the currencies which had plummeted previously also staged a modest recovery.

EUR-USD climbed to almost 1.33 for a time, only to drop back again later, and towards the close of the week it is around 1.27. Thus there has been a slight improvement on balance at the end of the week. The currencies of other European industrialized countries, such as GBP, SEK, DKK, CHF, followed a similar pattern. On the other hand, AUD, NZD and CAD, and in particular emerging market currencies such as PLZ, HUF, TRL, ZAR and BRL, which had taken a battering the previous week, posted higher gains.

There are several reasons why the situation has stabilized. With regard to equity markets, the valuation levels reached are bound to have played a part; share prices around the lows of 2002-2003 have upside potential, at least in the longer term. Markets might now have already priced in a lengthy contraction period with negative growth both in the US and in large parts of Europe.

Furthermore, economic policy institutions are pulling out all the stops. In addition to the stabilization schemes for the financial sector, most industrialized countries (European countries and Japan, as well as the US) are now putting together economic stimulus packages. Simultaneously, the International Monetary Fund has agreed to provide Iceland, Ukraine and Hungary with loans, and is in talks with other emerging markets. Additionally, a credit facility of around $100bn has been created, in order to provide basically “sound” economies with liquidity without conditions regarding economic policy.

Apparently, the central banks in the industrialized countries no longer have reservations about an aggressive easing of monetary policy. Liquidity is being provided on an unlimited scale and now central bank rates are falling too: this week, the US Fed cut the Fed funds rate by a further 50 basis points to 1.00%, and is explicitly keeping the door open for further rate cuts. The Bank of Japan has lowered its money market rate from an already low 0.5% to 0.3%. There were also further interest rate cuts in Sweden and Norway (50 bp respectively) and in China. During a speech last Monday, ECB president Jean-Claude Trichet revealed that the ECB will lower refinancing costs further next Thursday. A 50 basis point cut to 3.25% seems to be on the cards. And it looks very much as though the Bank of England is set to make a significant interest rate cut next week too – possibly even bigger than the generally expected reduction from 4.50 to 4.00%.

Market expectations are now far ahead of monetary policy, however. Based on Eonia swap rates, interest rate cuts to below 2.50% have been priced in for the eurozone for the next six months. Given the expected economic slowdown, we consider this realistic. However, the potential for interest rate cut expectations is probably more or less exhausted for now: the expectations for macroeconomic development are already so negative that there is hardly any scope for additional negative surprises. In this environment, we are not expecting the euro to continue falling, at least not for a while. A volatile sideways movement within a trading range of perhaps 1.25 to 1.35 is more likely.