Daily Insight

The Pound sank to a fresh record low against the Euro yesterday, recording a low of 1.1504 at the end of the session, while the UK currency also declined heavily to the weakest level since 2002 versus the Dollar after the Bank of England cut UK interest rates to the lowest since 1951.

An element of risk aversion crept back into the market yesterday, as the Pound also slumped against the Yen and Swiss Franc following the Bank’s decision to lower interest rates by 100 basis points to 2%, as the economy drifted into a recession in the third quarter amid the collapse in lending that has curtailed the pace of spending.

The decision was largely in line with analyst expectations and the reaction in Sterling reflected an air of disappointment in the market because although a 1% cut was fully priced into the market, a decline in UK fundamentals increased speculation of an even bigger reduction.

Central Banks around the globe are in the middle of an aggressive easing in monetary policy and the governor of the Bank of England Mervyn King even discussed the possibility of lowering the UK interest rate to zero per cent for the first time in November and insisted that the biggest challenge facing policy makers is renewing the flow of credit.

According to a recent estimate from the Organisation for Economic Cooperation and Development, the UK economy may contract by 1.1% in 2009, the most since the last recession in 1991, and policy makers may continue cutting interest rates over the coming months to the lowest level in at least 70-years.

The UK benchmark interest rate is currently at the lowest level in the Bank of England’s history and the last time that borrowing costs were 2% was when Winston Churchill’s victory in the general election made him Prime Minister for the second time.

However, the Central Bank can only cut interest rates so far in attempt to spur lending and revive growth in the economy but once rates reach zero per cent, policy makers will have to resort to other initiatives such as expanding money supply and using it to plug government deficits as the economy enters a period of deflation.

In the accompanying statement, the MPC said that “conditions in money markets remain extremely difficult and the committee noted that it was unlikely that a normal volume of lending will be restored without further measures."

That sentiment was illustrated by reports that Halifax, the UK’s largest mortgage lender, defied the Prime Minister’s demand to pass on the full extent of the rate cuts to consumers, saying that its profit margins are under pressure.

The lender said that it would cut its standard variable rate to 4.75% from 5%, despite the Bank’s decision to cut interest rates to 2%, but one of the stipulations in the government’s bailout of HBOS Plc was that higher lending volumes and lower borrowing costs are among the “strings attached” to the rescue package.

The government and the Bank of England are actively trying to soften the impact of the UK’s first recession since the early 90s and with UK mortgage approvals at their lowest level since 1999 and rising unemployment, pressure is mounting on Gordon Brown to force banks to increase lending.

The Pound’s performance against the majors was largely influenced by UK stocks as the FTSE 100 Index swung between gains and losses as the aggressive cut in UK interest rates showed that the economic slowdown is gathering momentum despite the government’s efforts to revive growth.

In terms of economic data, the dwindling sentiment for the economy was further enhanced after UK house prices fell by the most since 1992 in November as tighter lending conditions and a worsening economic climate discouraged potential homebuyers.

Home values plunged 2.6% from October according to the largest UK mortgage lender as prices fell 16.1% from a year earlier to an average of £163,605 and the findings increase pressure on the BoE to continue the pace of monetary easing into the New Year.

Yesterday’s cut in the benchmark UK lending rate was part of a global pattern as the BoE was joined by the Reserve Bank of New Zealand and perhaps more significantly the European Central Bank, who resisted calls for a more aggressive cut by reducing borrowing costs by 75 basis points.

Recent estimates show that the European economy has slipped into a recession in the third quarter and the ECB’s governing council members delivered the biggest cut in its 10-year history, while the Swedish and Danish central banks also lowered their key rates.

The Central Bank’s decision to accelerate the pace of rate cuts signals that policy makers may be prepared to gradually ease rates below 2.0% for the first time since 2005, while the collapse in oil prices may see inflation fall by the most in almost 20-years and provide yet further scope for interest rate cuts.

In the accompanying press conference, the chairman Jean-Claude Trichet said that the Euro-zone economy will contract next year for the first since 1993 but he declined to give clues on further moves, saying that the central bank shouldn’t get trapped by cutting rates too low.

Nevertheless, the ECB will have to implement new measures to bolster growth as reports yesterday indicated that the economic slump is worsening with European investment falling in the second quarter and consumer spending shrinking beyond initial forecasts.

Gross domestic product in the second quarter shrank 0.2% in the three months through September as investment fell 0.6% in the first back-to-back decline since 2002 and household spending dropped 0.2% from the previous 3 months.

The ECB's decision to gradually lower interest rates in a progressive period of monetary easing saw the Euro strengthen against the majors yesterday as the single currency bounced back from a two week low versus the Dollar amid speculation that U.S non-farm payrolls will increase and unemployment will rocket to the highest level since 1993.

The focus today will fall on the monthly U.S employment report and the jobless rate is set to increase to 6.7% and that may hamper Dollar sentiment amid speculation that the Federal Reserve will need to cut interest rates to zero per cent later this month.

However, according to a senior currency strategist at Bank of New York Mellon Corp, the Dollar will extend its gains against the majors through the first half of 2009 as investors take refuge in the U.S currency as a relative safe haven asset amid times of turmoil.

Data Released 5th December

U.S 13:30 Non-Farm Payrolls (November)

- Average Earnings

- Unemployment

U.S 20:00 Consumer Credit (October)

written by Adam Solomon