Markets Thirst for More After Aussie Rate Cut

Australia stunned markets with its steepest interest cut in 16 years on Tuesday sparking belief among that investors that major global central banks could now choreograph a coordinated set of rate cuts.

The Reserve Bank of Australia's 100 basis point reduction was twice as big as expected, underscoring the belief that increasingly strong financial medicine is now needed, as talk about coordinated rate cuts surfaced in Europe.

Only the Bank of Japan bucked the trend, signalling it may not join any campaign of rate cuts to contain the raging crisis which has put the world's financial system in greater peril than at any time since the 1930s Great Depression.

"I think it is important to coordinate in everything," said ECB policy maker and head of the Spanish central bank Miguel Angel Fernandez Ordonez. "Now the problem is global, it is important to coordinate in absolutely everything."

However, he went on to say that any cuts should take account of inflation risks and not be merely a knee-jerk reaction to the ongoing market havoc.

That did nothing to silence the clamour. Influential investor Bill Gross, who runs the world's biggest bond fund, urged the U.S. Federal Reserve to follow Australia's lead and slash rates by a full percentage point now the inflation threat has receded.

"We are experiencing asset deflation and the threat of headline inflation is long past," Gross, chief investment officer of U.S.-based Pacific Investment Management Co., said in a note that called for a "globally coordinated policy rate cut."

Indeed, Citi analysts said the banking crisis, falling asset prices and volatile markets may provide the justification for emergency rate cuts by the European Central Bank (ECB) and the Bank of England (BoE) in coming hours.

"There seems a growing chance of emergency ECB and BoE easing in the next few days, perhaps even today -- especially if the U.S. Fed is also ready to move," they said in a research note.

Australia's bigger-than-expected cut may have effectively fired the starting pistol in a run of rate cuts, suggested Suresh Kumar Ramanathan, head of strategy at CIMB Bank in Kuala Lumpur.

"It looks to me that the RBA's rate cut was no fluke...the rest of the global central banks may have had a teleconference to up the rate cut story. Bottomline, it's a strong signal to the market that unified action will come after all," he said.

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"I think rates will happen in a parallel fashion but probably not in a coordinated way," said Tullett Prebon economist Lena Komileva in London.

Fed Cut

Investors expect the BoE to cut rates at its policy meeting this week and are pricing in cuts from the U.S. Federal Reserve and the ECB.

"Reducing interest rates is no longer excluded," said ECB policy maker Guy Quaden in comments backing up what President Jean-Claude Trichet said last week.

Fed fund futures have priced in a probability of a 75 basis-point cut by the U.S. central bank this month and traders see a 100 percent chance of an ECB rate cut in November and 70 percent chance it could be as much as 50 basis points.

Federal Reserve Bank of Dallas President Richard Fisher, considered an inflation hawk, said capital markets were in "semi-panic."

"What I'm more worried about is how dysfunctional the system has become and what we, as the lender of last resort, need to do to encourage the liquidity to flow," he said.

Australia's central bank Governor Glenn Stevens said the RBA's unusually large rate cut was justified by a severe deterioration in the outlook for global growth, combined with a sharp rise in funding costs for banks.

ECB's Trichet signalled last week the bank was warming to the idea of lower rates when "contracting domestic demand and tighter financing conditions."

Among the world's largest central banks, the Bank of Japan struck the only discordant note.

"Policy coordination that would involve measures unsuitable for each nation's economic and price conditions would be undesirable," Governor Masaaki Shirakawa said at a news conference after leaving rates on hold at 0.5 percent.

With its interest rates closer to zero than any other central bank in the Group of Seven rich nations, the BOJ could lose room for manoeuvre by cutting interest rates too early.

Japan's banking system has been largely spared the financial carnage triggered last year by a meltdown in the U.S. mortgage market that is now forcing Washington and European governments to either bail out banks or allow them to collapse.

The BOJ has joined the Fed and other central banks in the industrialised world in pouring cash into money markets to prod banks into lending to each other again after a freeze triggered by U.S. bank failures.

Market Strain

Those operations have done relatively little to bring down the cost of borrowing dollars.

In London three-month dollar and euro funding on the interbank market, which now extends over the illiquid year-end holiday period, remained substantially higher than anticipated official interest rates, a key measure of financial market stress.

The interbank cost of borrowing overnight dollars (Libor) jumped over 150 basis points on Tuesday while in euro markets Euribor rates scaled new multi year peaks.

The spread of three-month London interbank offered rates over OIS rates for dollars was 294 basis points, with euros at 154 basis points and sterling at 190 basis points.

Earlier in the day overnight dollar deposit rates were indicated around 2.5 percent, fairly close to the Federal Reserve's 2 percent target rate.

In September after U.S. investment bank Lehman Brothers collapsed, these rates jumped above 10 percent.

Copyright 2008 Reuters. Click for restrictions.