Andrew Twells

Market Commentary

For the week ending 28 September 2018
Report by Andrew Twells
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Andrew Twells

Two weeks ago was the tenth anniversary of the insolvency of Lehman Brothers Bank in the US. This was not the cause of the Great Financial Crisis, nor was it the first symptom – Northern Rock in the UK went bust several months earlier. However, it marked the start of a period of emergency action by Governments and Central Banks. Interest rates, already very low, fell further, Quantitative Easing followed shortly after, and the US Government started injecting money to rescue failing financial institutions (and later, car makers).

Ten years on, can we say that the Crisis is over? The answer to this is “definitely maybe” as Noel Gallagher would say. On Wednesday this week, the Federal Reserve (Fed) raised US interest rates to 2.25%. This puts them higher than the pre-Lehman figure of 2%. There are signs that interest rates will rise further towards 3%, over the next few quarters.

The fact that the Fed has been able to do this, without the stock market taking fright, is encouraging. It suggests that the economy is strong enough to withstand higher borrowing costs. Furthermore, it gives the Fed some “ammunition” it could use in the form of rate cuts, should the economy weaken at some point in the future. The risk is that, with the economy growing strongly and unemployment low, rising inflation could force the Fed to increase interest rates further than it otherwise would, and that this could be the trigger for the next economic slowdown or market setback. It is a difficult balancing act.

America is a long way ahead of the rest of the developed World in this regard. Although we had an interest rate rise in the UK in August, the Bank of England base rate stands at just 0.75%. Base rates remain negative in Japan and the Eurozone. The latter remains a mixed bag, with tensions between the needs of different member states. Whilst the German economy has continued to perform reasonably well over the last ten years, Italy continues to struggle and the financial markets are starting to punish the high-spending budget of its new populist government.

Ten year Italian Government bond yields have recently spiked to 3.15%. The equivalent German yield is 0.5%. The difference between the two can be thought of as the credit risk associated with lending to Italy. If the problems with Italy start to turn into a crisis, then bold action may be needed, as happened in 2012 when European Central Bank President Mario Draghi promised to do “whatever it takes” to save the Euro. This time, however, he seems to have less “ammunition” than his counterparts in the US.