Financial Markets Review by Lloyds TSB

The financial markets have latched on to some positive signs for economic recovery in recent weeks after an unrelenting series of negative news in previous months.

Summary of main changes to exchange & interest rate forecasts

The financial markets have latched on to some positive signs for economic recovery in recent weeks after an unrelenting series of negative news in previous months. This has led in our view to an overly optimistic outlook, reflected in some exchange rate and interest rate trends. We look for some of this to unwind in the months ahead.

The recent weakness of the US$ may prove only a temporary phenomenon, if early signs of stabilisation continue to strengthen in the months ahead, indicating a swifter return to economic growth in the US than other leading economies. The US economy could emerge from recession as soon as the third quarter of 2009. This would clearly raise speculation of higher US interest rates, albeit from current record low levels. While we currently forecast that the Fed funds rate will be raised within 12 months, well ahead of the ECB refi rate or UK Bank rate, it may be sooner. But quantitative easing is likely to be withdrawn before rates are raised.

Reflecting the recent weakness of the US$, we have accordingly raised out short-term targets for €/$ to 1.30 and £/$ to 1.46 at end 2009. Although momentum appears against the greenback at this time, suggesting the risk of further short-term depreciation, the risk of a stronger rebound should also not be discounted, particularly while generalised financial market uncertainty and volatility remain so high. The appreciation of the UK pound has been checked recently by heightened political uncertainty, which represents a significant near-term risk to our latest forecasts.

Government bond yields have risen aggressively in recent weeks, reflecting a variety of factors including rising inflation expectations and sharply higher projected issuance. The test now for central banks is to show how committed they are to quantitative easing, particularly in the US and UK. We believe major global central banks will be required to do more quantitative easing than originally anticipated.

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