by Darrell Jobman, Editor-In-Chief

In a week marked by extreme volatility, conditions and developments within the US and global financial sector continued to dominate market sentiment and currency moves.

Investment bank Lehman Brothers was forced into bankruptcy after it failed to secure a private-sector deal and the government refused to provide support. In contrast insurance group AIG was given a US$80bn bridging loan from the Federal Reserve to stave off collapse. In return the Fed took an 80% stake in the company.

The US currency secured some defensive support as there was a flight to Treasury bonds with yields falling to extremely low levels. There was also evidence of a flow of funds out of emerging-market currencies which supported the US currency.

There were serious tensions within the money markets as banks remained very reluctant to sanction inter-bank lending. Global central banks injected near US$200bn of liquidity into money markets in an attempt to stabilise conditions.

Following the series of bailouts, there were greater fears over the US fiscal situation and there were some warnings that the US sovereign credit rating could be in jeopardy in the medium term. Immediate confidence rebounded on Friday as US authorities met to debate plans for an agency which would buy illiquid holdings from the banks. Treasury yields rebounded as fears eased and Wall Street surged higher.

The US Federal Reserve held interest rates at 2.0% following the latest policy meeting. The statement was generally balanced with unease over inflation offset by a statement that the economy appeared to have deteriorated over the past few weeks.

US Dollar Index
Source: VantagePoint Intermarket Analysis Software

The economic data tended to be of secondary importance given the focus on financial markets, although there were important releases. There was a further decline in housing starts to the lowest level for over 17 years while building permits also weakened further.

The industrial data was mixed with the New York manufacturing index falling back to below zero according to the September survey, although the Philadelphia Fed index recovered. Initial jobless claims also increase to 455,000 in the latest week from 440,000 previously.

Consumer prices fell by 0.1% in August while there was a core increase of 0.2% to give a 2.5% annual rate. The latest capital account data was weaker with net long-term inflows of US$6.1bn for July while there were net outflows of overall capital.

There was a recovery in the latest German ZEW economic sentiment survey, although the impact was offset by fears over renewed pressures in the financial sector.

The ECB maintained a firm tone in pubic comments with a particular focus on the need to avoid second-round inflation effects. The bank is uneasy over the outlook for wage settlements with a particular focus on key unions such as IGMetall.

The dollar weakened in the middle of the week, although it recovered strongly from its worst levels and gained ground on Friday as market fears eased with gains through 1.42 against the Euro. High dollar volatility was a key feature.

The Japanese currency and Swiss franc secured important defensive support as risk aversion increased sharply. The yen peaked close to 103.50 against the dollar and 147 against the Euro as market fears intensified while the franc pushed to beyond 1.58 against the Euro.

Both currencies failed to hold the best levels as markets attempted to stabilise. US plan to form a new bad-debt agency pushed the yen significantly weaker on Friday with lows around 107.80 against the dollar.

The Bank of Japan left interest rates at 0.50% at the latest policy meeting and remained cautious over the domestic economic outlook. In order to ease market stresses, the Bank of Japan and added dollar liquidity to the markets for the first time.

The Swiss National Bank also held interest rates steady at 2.75% following the quarterly council meeting.

Domestic and international financial-market trends remained very important for Sterling over the week. HBOS shares were sold very heavily on fears that the company was facing a collapse and this triggered a rescue bid for the company by LloydsTSB. The Bank of England also announced that its liquidity support measures would be extended.

The latest Bank of England minutes recorded a 8-1 vote for unchanged interest rates at the September meeting with Blanchflower calling for a 0.50% rate cut. The bank had discussed all policy options and was uneasy over the impact of Sterling weakness.

The employment data remained weak with a sharper increase in unemployment of over 30,000 in August after a revised 27,000 increase the previous month. In contrast, the retail sales data was stronger than expected with a 1.2% increase for August, although gains were likely to have been led by price discounting.

The headline consumer inflation rate rose to a 16-year high of 4.7% in August from 4.4% the previous month while the core rate increased to 2.0% from 1.9%.

Following heavy selling pressure over the past three weeks, Sterling was able to regain some composure, although volatility remained very high. Sterling recovered to 0.79 against the Euro with a peak above 1.82 against the dollar before renewed losses.