• The Paulson plan is likely to be passed, but uncertainties remain.
  Market moves last week were dominated by the waxing and waning of sentiment about the likely passage and content of the Troubled Asset Relief Programme (TARP). The legislation is very likely to be passed in some form, but the two uncertainties remaining at the time of writing were details of how the purchase price of assets will be decided and whether the US federal government will take an equity stake in the financial firms that use the TARP and, if so, how much.
• A prompt passage would help ease liquidity conditions at quarter end.
  The approaching quarter end this Tuesday adds a tight deadline to the negotiations taking place in Washington. Money market participants that are required to produce quarter-end accounts are reluctant to lend cash into the coming quarter, preferring to keep their balance sheets looking extremely liquid. A passage of the TARP-enabling legislation would remove a significant source of uncertainty and, along with increased liquidity injections by central banks, would prevent a further sharp worsening of credit conditions during the quarter end. Developments will have to be followed closely over the early days of this week.
• The US economy shows signs of renewed weakness, with data deteriorating...
  With investors’ eyes focused on the progress of the TARP legislation, a number of worsethan-expected data releases from the real economy have almost slipped under the radar. In the US, new home sales showed an unexpectedly large dip in August, and durable goods orders for the same month also showed a spreading of the weakness in manufacturing from those sectors which are most immediately associated with consumers to capital goods and the wider economy.
• ...and it's a similarly bleak picture in the eurozone.
  In Europe, the expectations component of the widely followed IFO index declined to its lowest level for 15 years and is now consistent with flat to slightly negative GDP growth in Germany. Rather than being led by the housing and consumer sectors, as is the case in the US, the German slowdown is currently concentrated in manufacturing. The German export sector is particularly exposed to demand conditions in Eastern Europe, a region that is particularly dependent on external financing and so prone to slowing growth as a result of the credit crunch.
• That should lead the ECB to cut rates, though not as soon as the Bank of England.
  Policy-makers from the European Central Bank have continued to emphasise their commitment to fighting inflationary expectations in Europe, but investor expectations have moved to price in around 50 basis points (bps) of interest rate cuts in the eurozone over the next year. In the UK, Sir John Gieve, a member of the Bank of England’s Monetary Policy Committee, gave a speech in which he suggested that worsened conditions in financial markets and their likely feed-through to the real economy increased the possibility of a rate cut. We now expect a cut in the UK before the end of the year, most likely in November to accompany the Bank’s Quarterly Inflation Report. However, an earlier move at their 9th October meeting cannot be ruled out.
• Markets are also pricing in a US cut, as inflationary pressures subside.
  Over recent weeks, the short end of the US dollar yield has also moved to price out the rate rise that was previously expected and to price in a further decline of 25 bps. In part, this reflects increased concerns about the stability of the financial system, but it is also a function of the reduction in stagflation concerns, which peaked during the summer months along with the oil price.

Indices, Interest rates and Inflation

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