The US market is pricing in substantial rate cuts but no clarity from the ECB at this point according to Bank of Ireland

"The picture portrayed by market prices at the moment is an oddly disjointed one; the US market is effectively pricing in a recession, yet oil prices are close to $100. Closer to home, the ECB remains concerned about upside risks to inflation, implying that some council members favour an increase in interest rates, yet is clearly worried about the liquidity squeeze in money markets, and has pledged to inject more cash in to the system. We suspect that a more consistent picture will emerge in the coming months, but if so, it implies some sharp market moves, as these inconsistencies are ironed out", said Dr Dan McLaughlin, Group Chief Economist, Bank of Ireland in its Global Markets November research bulletin published today (Friday 30 November '07).

According to Dr Dan McLaughlin: "In the US, the market has been pricing in lower rates for some time now, an expectation which has undermined the dollar, but November saw a marked acceleration of this trend; the September Fed Funds contract is under 3.50%, or more than 100bp below the current rate. This implies a recessionary or near recessionary environment, which is neither supported by the data nor Fed rhetoric. The former certainly points to further weakness in the housing market but not to a broader-based slowdown, at least for the moment. The Fed also expects the housing market to remain a drag on activity for some time, but forecasts US growth of around 2% in 2008, albeit with downside risks. The implication is that those downside risks will have to materialise to validate the current market expectation, as the Fed's forecast is more consistent with a rate of 4%, or so.

"The sell-off in equity markets, led by bank shares, is also illustrative of this market expectation of an economic slowdown, yet commodity prices in the aggregate have risen sharply over the past two months, including oil. Again, this appears inconsistent, and we suspect that the oil price increase, in particular, is speculatively driven and could unwind sharply, just as it did in the latter months of 2006, when crude prices fell from $75 to $50.

"The economic data has softened appreciably in the euro area, where there has been a notable decline in sentiment and confidence indices such as the PMI's and the Ifo. This, and the rise in interbank rates, has prompted the ECB to acknowledge that there are now downside risks to growth, but it still feels that these are matched by upside risks to inflation. Consequently, the market is not fully pricing in any rate cuts in the first half of 2008, despite the trends seen in other interest rate markets. Indeed, the Bank of England has done a complete about-turn, and is now effectively signalling that UK rates may fall by up to 75bps over the next eighteen months. The ECB is therefore the 'odd man out' and we still expect a change in tune from Frankfurt over the coming weeks, with the Bank expressing more concern about downside risks to growth and hence indicating that the next rate move will be down. If so, that would also cap the euro's advance, both against sterling and the US dollar", added Dr Dan McLaughlin.

Click here to download November's bulletin(PDF format, 391KB)

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