Financial Markets Analysis by Lloyds TSB

It is clear that the credit crisis will not end until the ‘toxic assets’ issue is resolved. Progress has been made on this in the past month but a clear cut end to the crisis still seems some distance away.

Summary of main changes to exchange & interest rate forecasts

It is clear that the credit crisis will not end until the ‘toxic assets’ issue is resolved. Progress has been made on this in the past month but a clear cut end to the crisis still seems some distance away. However, the trough of the economic downturn appears to be close, if data released in the last month are any guide. However, the recession still has a long way to go, with unemployment likely to rise strongly in most countries for some time yet. Hence, official policy will remain extremely loose.

We remain of the view that the ECB will reduce interest rates to 1% in this quarter, while the continuing weakness of the euro zone economy suggests more unorthodox measures to ease credit conditions also cannot be discounted. A further reduction in interest rates is unlikely in the UK, but we expect quantitative easing to persist until at least 2010. Further monetary measures to help restart bank lending are also likely in the US. However, once clear signs of economic recovery emerge, money supply will need to be reduced aggressively and interest rates raised to maintain price stability. For now, quantitative easing policy will help support government bond prices, in spite of the massive rise in new issuance. However, volatility is likely to remain high, reflecting uncertainty about the inflationary impact of the measures and investor demand.

We continue to forecast generalised US$ appreciation over the next 6-18 months, primarily reflecting the likelihood of economic growth outperformance by the US against the economies of its main trading counterparts over the next two years. Short-term prospects are more linked with developments in credit markets and interest rate expectations and so trading conditions are likely to remain volatile. We forecast €/$ at 1.23 at end-2009 and £/$ at 1.37.

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