NEWS / Foreign Exchange

Expect no surprises from the BoE or ECB

Recent events will keep attention focused on financial market developments in the US this week, with the potential for further sharp swings in equity prices and downward pressure on the dollar. Crude oil scaled a record $96 last week and could break $100 on ongoing supply fears and speculation. Interest rate decisions in the UK and euro zone on Thursday are the highlights of the economic calendar this week (rates expected to remain on hold at 5.75% and 4%, respectively), closely followed by Fed chairman Bernanke's testimony on the US economic outlook to Senate later that day. The RBA could hike interest rates to 6.75% on Wednesday.

• Although the Fed duly cut interest rates by 0.25% to 4.5% amid further dollar weakness, US economic data last week were robust. US Q3 gdp growth was estimated at 3.9%, the fastest pace since Q1 2006, while non-farm payrolls rose by 166,000 in October, the highest since May. Although the outlook is clouded by uncertainty around the housing market and developments in credit markets, these figures show the real economy is holding up well and so caution against any further reduction in interest rates. We expect Fed chairman Bernanke to underline the risks to growth but also to highlight the inflation risk posed by higher commodity prices and capacity pressures in his testimony to the Senate Joint Economic Committee on Thursday. He may also be asked about the economic risks posed by a weaker dollar. US economic data releases this week are not as prominent as last week and so unlikely to elicit strong market reaction and may be overshadowed by news and rumour from credit markets. We believe the prevailing credit market uncertainty could persist well into 2008, with the prospect that conditions could deteriorate further before improving.

• The Bank of England cautioned in its latest Financial Stability Report that although there had been signs of recovery in credit markets, some aspects of it remained illiquid and the financial system was vulnerable to further shocks. The MPC also discussed the merits of a precautionary cut in base rates in October on fears of slower output growth. However, while concerns about the UK economic outlook in 2008 thrive, recent indicators have remained firm, notably with economic growth hitting a three-year high of 3.3% in Q3 (0.8% q/q) and the unemployment rate falling to a two-year low of 2.6% in September. We expect UK data this week to show that while economic growth still remains underpinned, signs of a slowdown are becoming more visible. The services PMI fell sharply to 53.1 in October, from 56.7 in September - still above the key breakeven 50 level but the weakest outcome since May 2003. More surprisingly, there was a fall of 0.4% in industrial production in September, and the annual growth rate fell to -0.2%, the weakest since March. Although weak data will raise tensions ahead of the interest rate decision, we believe the risk of a cut in base rates to 5.5% on Thursday is fairly small. We believe the MPC can still afford to wait for clearer signs of slowing economic growth and downside inflation risks, which we expect to increasingly emerge in the coming months, strengthening our argument for a cut in base rates in early 2008, possibly as soon as February.

• Recent data from the euro zone will have made uncomfortable reading for the hawks on the ECB, with EU-13 CPI spiralling to 2.6% in October, from 2.1% in September. However, other indicators such as weaker PMI and confidence surveys (compared to ahead of the credit market crisis) and continuing high money market interest rates are likely to keep calls for higher official interest rates on Thursday fairly muted. The accompanying press conference will be closely listened to by market participants eager to hear Mr Trichet's views on the latest market trends.