Germany leads the way down

Interest rates: Markets believe that UK interest rates have peaked as 'new atmosphere' spreads across Europe

The German Bundesbank yesterday cut its key discount rate, which sets the floor to money market rates, from 4.0 to 3.5 per cent, writes Paul Wallace. The German monetary easing, which was followed in Austria, the Netherlands, Belgium and Denmark, has intensified the City's belief that interest rates in the UK have peaked at their present level of 6.75 per cent.

"It sets an atmosphere of interest rate reduction across Europe which plays into the Chancellor's hands," said John Shepperd, chief economist at Yamaichi International. The Banque de France is expected to follow suit with further rate cuts when it meets next week.

The German central bank also cut the Lombard rate from 6.0 to 5.5. per cent. This rate, which sets the ceiling to money market rates, had been left unchanged when the German central bank last cut the discount rate on March 30th.

The repo rate at which the Bundesbank supplies liquidity to the banking system was unchanged at 4.39 per cent but is now expected to fall further to around 4 per cent in the weeks ahead.

German bunds fell on fears that the reduction in rates marked the bottom of the cycle.

This view was backed by economists at Salomon Brothers who said that this was likely to be the last in the current interest rate cycle. However, Richard Reid, chief economist at UBS in Frankfurt, said that he anticipated further cuts by the end of the year.

The German central bank said that "continued weakness in monetary growth was a decisive factor in cutting interest rates."

Earlier this week, the key monetary aggregate it tracks fell back below its average for the fourth quarter of 1994, compared with the 4-6 per cent growth target set by the bank for the end of the year.

Although the Bundesbank always maintains that its policies are dictated by monetary considerations, the improved inflation outlook will have weighed heavily with the Council.

Its decision was taken on a day when three German states revealed particularly encouraging inflation figures with a fall of 0.1 per cent in the consumer price index. The market had been expecting a rise.

The Bundesbank was also responding to accumulating evidence that the German economy has been much weaker this year than expected. Next month's release of first-half GDP figures are expected to show that the economy contracted in the first quarter as consumer spending fell.

The dollar strengthened initially by two pfennigs on the news of the German rate cuts. However, it then fell back on indications that the US economy was failing to bounce back as quickly as had been hoped. The twist put on this by the currency markets was that the US Federal Reserve, which left interest rates on hold this week, was likely to cut rates again, reducing the attraction of dollars.

US durable goods orders for July fell by nearly 2 per cent, the largest decline since April. Wall Street had been expecting an increase of nearly 1 per cent. US unemployment also rose by more than had been expected in the week ending 19 August.