Nervous investors were unsure where to turn on Tuesday as the balance of expectations for the direction of US interest rates shifted.
The dollar fell to a fresh low against the euro and a 26-year low versus sterling ahead of Wednesday’s interest rate decision from the US Federal Reserve.
Meanwhile, oil and gold prices retreated as investors took profits from the bull run in commodities.
Government bonds failed to capitalise from this weakness, amid some uncertainty over US rates policy, while equity markets remained in sight of recent highs.
In recent days, the market had fully priced in a 25 basis point rate cut from the US central bank to 4.5 per cent, and some even suggested the possibility of a 50bp cut. However, sentiment retreated a little as some economists expressed doubts about the Fed moving at all.
“Annual growth in the third quarter is likely to be in excess of 3 per cent,” said James Knightley at ING. “High energy costs and rising food prices could push US inflation above 4 per cent in the fourth quarter. It is easy to understand why economists are more guarded than the markets.”
Economists at Deutsche Bank said: “Last quarter is old news, especially considering the fact that the dislocations in the credit markets would take some time to show up in the data.” The bank expects the economy is likely to produce growth close to 1 per cent this quarter followed by 2 per cent growth at best next quarter.
The uncertainty over policy was highlighted by the pricing in options for Fed funds futures which showed a 70 per cent of a 25 basis point cut, 12 per cent odds of a 50 bp cut and an 18 per cent probability of no change in rates.
“While the majority of market participants gravitate towards an expected 25bp rate cut, a combined 30 per cent appear to see the possibility of a surprise move by the Fed,” said Fidelio Tata, derivatives strategist at RBS Greenwich Capital.
Further gloom for the US housing market and consumer confidence, which hit a two-year low in October, helped Treasury yields fall back from highs set in early trade. Late in New York, the yield on the 10-year Treasury was steady at 4.38 per cent, while the two-year note yield was up 0.8bp at 3.805 per cent, down from a peak of 3.84 per cent.
The 10-year UK Gilt was little changed at 4.92 per cent. However, the rate-sensitive two-year Gilt yield rose 5.3bp to 5.08 per cent as prices dropped after expectations of lower UK interest rates were dealt a blow by comments from Kate Barker, a member of the Bank of England’s monetary policy committee. Ms Barker questioned the need for UK policy to follow that of the US considering economic conditions in Britain had not changed much since the Bank’s last inflation report in August.
On currency markets, the dollar set a record low of $1.4441 against the euro. Sterling rose to a 26-year high of $2.0694 against the dollar following Ms Barker’s comments. “Sterling and UK yields are benefiting as expectations for a November rate cut by the MPC are damped,” said Marc Chandler at Brown Brothers Harriman.
Sweden’s krona climbed 0.3 per cent against the dollar and 0.2 per cent versus the euro after the country’s central bank lifted its base rate from 3.75 per cent to 4 per cent, its third quarter-point increase in a row.
Equity markets traded cautiously ahead of the Fed decision and were undermined by events at US investment bank Merrill Lynch and its Swiss rival UBS. Merrill Lynch said chief executive Stan O’Neal was leaving following the bank’s largest ever quarterly loss. The appointment of board member Alberto Cribiore as interim chief executive to lead the search for a replacement raised fears of a disruptive boardroom wrangle at the 93-year-old brokerage.
Meanwhile, UBS reported that massive writedowns on its subprime holdings had led to a SFr830m loss in the third quarter and said it would remain in the red in the final quarter of the year.
In the US, the S&P 500 closed 0.7 per cent lower at 1,531.02, while the Dow Jones Industrial Average fell 0.6 per cent to close at 13,792.47. The Nasdaq Composite settled a fraction lower at 2,816.71.
The FTSE Eurofirst 300 index fell 0.4 per cent to 1,581.69.
Most Asian equity indices gave up some of their recent gains, although Hong Kong’s Hang Seng edged 0.2 per cent higher to 31,638.22, its fourth-straight record close, and China’s Shanghai Composite remained in a gravity-defying mood, advancing 2.6 per cent to 5,897.19.
Tokyo’s Nikkei 225 Average slipped 0.3 per cent to 16,651.01.
Commodity markets were weaker and Nymex West Texas Intermediate fell $3.15 to close at $90.38 a barrel, and extended those losses in after-hours trade. WTI reached a record $93.80 a barrel on Monday. Brent crude in London lost $2.88 to $88.44, down from Monday’s peak of $90.49.
“Although prices have fallen back, we see little sign as yet suggesting that the upward march has come to an end,” said Kevin Norrish at Barclays Capital.
Spot gold fell 0.9 per cent to $783.40 an ounce, as speculative long positions were trimmed ahead of the Fed’s decision.