Assetz® News - Central banks to drop interest rates ASAP

Central banks to drop interest rates ASAP

4th October 2008 |

If you are reading this on Monday morning then the chances are that the central banks dropped base rates this weekend. As I discussed last weekend ( investors.assetz.co.uk/blog/?postid=100 ) this is a very real possibility in the fast-moving world of central banks and governments attempting to defuse the current financial turmoil.

Mervyn King has stated this week that he will take "all actions necessary to ensure that the banking system has access to sufficient liquidity" and similar comments have come from the ECB ( ECB president stressed the bank's ability to act at "any time" which is quite possibly a coded message for an interest rate drop before the next meeting)and the Fed (Interest-rate futures indicate 94% odds of a half- point cut in the Fed's benchmark 2 percent rate at or before this month's meeting)- expect at least a 0.5% drop in the UK and USA with 0.25% in Europe imminently.

In addition expect to see continued action where central banks and governments take on board risky assets to begin to ease up the lending market and allow banks to trust each other well enough that they don't believe their counter party is going to go bust overnight meaning that interbank lending should be able to commence again. Trust in banks being solvent and liquid is fundamental to the lending market and in particular for the mortgage market strengthening up again and beginning to unfreeze.

There isn't a choice here - whatever action it takes to get the banking markets unfrozen will be taken over the next week or two and all bets are off regarding any previous comments or lines in the sand that have been drawn by authorities.

For example, it is patently obvious to near enough everyone now that there is no inflation risk whatsoever in the near term, over the next one or two years at least. As long as central banks remain vigilant and do not overextend the period that excessively low interest rates are offered then their action will be to fend off any severe economic downturn and put a floor under the value of most asset classes rather than stoke up inflation.

If you doubt that inflation is under control even though it is above target just right now then just look at some typical examples - the oil price is back to where it was 11 months ago and still falling fast. No inflationary effect there then. Wage inflation is non-existent with almost every company considering job cuts and in many cases pay freezes, even eliminating inflationary pay increases that may have been standard in previous years. Even fuel prices at the pumps are not what they first appear in terms of their effect upon inflation as it is well documented that people both in the UK and the US have significantly reduced their mileages and their non-essential travel.

In addition there are further complications with the measuring of inflation. The rapidly changing consumer basket of weekly shopping is evolving too fast for statistics to keep up I suspect. We all know that organics have been hit hard as they were really an optional spend the most people, in addition we know people have moved supermarkets and indeed the makeup of their basket of shopping.

I suspect that the effect of any food price rises or fuel prices at the pumps have already been moderated by reduced expenditure. Low interest rates are unlikely to have any significant inflationary effect and I think we are at that point of realisation with the central banks that will permit them to savagely cut rates almost as fast as you can read this opinion.

In this fast-moving market we are constantly reviewing our forecasts and we now expect base rates to be 4% rather than the current 5% before Christmas rather than our previous expectation of achieving this target by the spring next year. The spring will almost certainly bring further cuts and I would not be surprised at all to see base rates now between 3.5% and 3% early next year.

Base rate cuts themselves won't solve all problems so we need to see the government and central banks de-risking the banking sector as well using coordinated action in order that banks trust each other again and interbank lending commences at sensible levels. This will gradually improve the availability of mortgages and indeed their pricing. The sharp drop in base rates and the resulting drop in LIBOR from the base rate reduction combined with better bank trust will permit mortgage rates not much dissimilar to one and a half years ago but with much greater profitability for the banks. Loan to values are not going to increase much until there is certainty in house prices and a floor has been set and even then won't reach the recent levels for many years when the next credit boom takes hold (and it will, banks are greedy and regulators lax).

We could see a floor set on house prices sooner rather than later but it will require the concerted action detailed above leading to better mortgage availability and a better buyer sentiment. The level of house price falls predicted by a couple of the doomsayers are great enough to destroy our banking system never mind anything else and it is likely that absolutely every possible action will be taken by the authorities to prevent this happening which is just as well really.

Hold your nerve and ride this one out. With no house building due in the future to any great degree existing property is still greatly in demand once finance becomes readily available again. It is fortunate for most of our clients that they have heeded our advice over the years to purchase high income property (such as student halls of residence and student houses and more recently hotel rooms) to balance the barely break even buy to let speculative property. If you've only bought the latter then I suggest you talk to us about the former to get your cash flows back in order !