The US election may have knocked the financial crisis off the front pages last week but there is precious little evidence the new wave of political optimism will be matched in the markets.

Many in the City have spent months agitating for a cut in rates, only to send shares plummeting when the Bank of England finally gave them what they wanted with a shock 1.5% drop in the base rate. Apparently, it was the magnitude of the cut that spooked markets. They may have wanted a cut but taking rates to 3% – their lowest level since 1955 – suggested the UK economy was in pretty horrible shape.

Mervyn King, the Bank’s governor, said the UK was “in all likelihood” entering a recession – though presumably this can’t have been news to anyone. He added the financial crisis had had a more significant impact on the wider economy than initially thought, though again, after months of dismal economic data, can the markets really have been surprised by this?

It’s not as if the Bank of England has the strongest track record of accurate predictions – after all, it must take some responsibility for creating the free-and-easy lending conditions that ultimately led to the credit crisis. It also failed to see the significance of the crisis for the wider economy. While the US Federal Reserve was busy cutting rates aggressively to stave off economic gloom, the Bank of England was still fretting over inflation.

So why did markets react so badly? Most likely this is classic bear market behaviour – the prevailing mood in markets is pessimistic and the Bank of England’s move merely confirmed all the worst fears of investors. It showed things really could be as bad as billed. By last Friday, however, there were signs the market was re-thinking its early reaction. After all, markets have already priced in a severe recession – having this confirmed by Mervyn King really shouldn’t make any difference.

That said, investor fears are not without some foundation: There remains the possibility these rates cuts will send the worst possible message without actually doing anything to shore up the economy. If lenders fail to pass on the cut, the move will have scared investors without the desired outcome of kick-starting consumer and corporate lending.

The Government has gently ‘encouraged’ the banks to pass on the rates, but many are still digging in their heels. If they do react it is more likely to be in response to the drop in the LIBOR inter-bank lending rate – the most encouraging financial indicator of the last week – than pressure from policymakers. Still, it looks like it will be some time before the optimistic political mood that swept Barack Obama to victory will be seen in the financial markets.

Source – Marketing Hub 12-11-2008