Volatile week ahead for financial markets

FINANCIAL markets are bracing themselves for a volatile week, with monetary policy meetings looming in both Britain and the US and continuing uncertainty about politics on one side of the Atlantic and trade negotiations on the other.

Most analysts expect no change in interest rates in either case after the respective mid-week meetings. But financial markets are coming round to the view that interest rates will start to fall - the only question is when, with several commentators predicting a cut in British rates before the end of this year.

In a report out today, Roger Bootle, chief economist at HSBC Markets in London, forecasts a one-point fall in the US Federal Funds rate to 5 per cent by December, along with a reduction of half a percentage point in both German and Japanese interest rates within the next few months and no increase in UK base rates.

Bond and currency markets are likely to be extremely volatile in the next few days. In the US, market reactions to news have been unusually sharp, which thin trading around the 4 July holiday will exaggerate.

In Britain, traders have reacted strongly to political developments. The pound has lost about 1 per cent of its value since John Major announced the leadership contest, briefly revisiting its all-time low. Sterling, gilts and shares could all come under attack again during the next few days.

Earlier expectations that the Fed might this week reduce the key Federal Funds rate from its current level of 6 per cent have receded. Recent economic statistics have, on balance, been stronger than anticipated.

Most striking was a sudden leap in sales of new homes in May. This indicator is traditionally considered forward-looking because of the impact on suppliers to the industry, and sales rose 19.9 per cent last month - the biggest rise in three years. Meanwhile, initial unemployment claims for the week ending 24 June were down 28,000.

These latest statistics suggest the slowdown may not be as dramatic as first feared. As the holiday weekend started, most Wall Street analysts predicted that rates would be left unchanged, at least until after publication of the June employment report on 7 July. Noting that the policy-makers will be looking beyond any short-term spell of low or negative growth, Jon Lonsky at Moodys noted: ''The Fed will be well aware what happened to those home sales in May.''

A consensus is building, however, that US interest rates will fall significantly before the end of the year. Fed officials have acknowledged that there is an increased risk of a modest recession - although chairman Alan Greenspan has also emphasised both the difficulty of judging the current state of the economy and the importance of long-term price stability.

Ed Yardeni, chief economist at CJ Lawrence, is among those advocating a rate cut: ''How much more bad news do they need to convince themselves that the economy is in bad trouble? April and May's pathetic employment reports convinced me that something is going wrong with the economy.''

Neil MacKinnon, chief economist at Citibank in London, said: ''The authorities here should keep an eye on what's happening across the pond. Our economy is much closer to the US than to the rest of Europe.''

City economists see the Bank of England facing a dilemma this week. Although there has been more evidence that the recovery in Britain is slowing, sterling is even weaker than it was two months ago when the Bank first clashed with Chancellor Kenneth Clarke by recommending a rise in base rates.

David Miles at Merrill Lynch said: ''The Bank would normally push for higher rates again. They want to establish a track record of low inflation.''

But there was unanimity among analysts that an increase now - even if the Chancellor happened to agree - would be virtually impossible in the current political circumstances.