Uneasy calm as the markets take breath: Bundesbank makes surprise cut in 'repo' rate in what is seen as gesture to European partners

AN UNEASY calm descended over European currency markets yesterday, as dealers took a breath after what was in effect the suspension of the European exchange rate mechanism on Monday.

Trading was relatively light, with profit-taking dominating business. The French franc ended around three centimes stronger at Fr3.4837, five centimes below its former ERM floor. The US dollar remained soft while the Japanese yen was strong.

'The old order has just died and people have not got anything to latch on to. It is now like trying to hit a moving target in a dark room,' David Brown of Tokai Bank said.

Although there is little sign yet of ERM members exploiting their new- found freedom by cutting interest rates aggressively, most economists believe it is just a matter of time.

But the Bundesbank surprised the market with a cut in its 'repo' interest rate, seen as a gesture to European partners hammered by the currency turmoil. The bank said it was cutting the rate in today's fixed security repurchase tender to 6.8 per cent, because of the 'changed currency market situation'.

'The Bundesbank action appears aimed at stabilising currency expectations by following through on reported promises to cut short-term interest rates as a 'sweetener' for the shift to wider bands,' said Kermit Schoenholtz of Salomon Brothers. The markets showed little reaction.

Just last week, the Bundesbank had said it would keep the repo rate at 6.95 per cent, helping to trigger the ERM crisis. Yesterday's repo gesture was made partly with an eye to soothing the meeting later in the day in Paris between German and French finance ministers and central bank heads.

The money market easing was also read by economists as an indication that the key discount rate will probably be cut when the Bundesbank resumes operations after its summer break. The repo rate is now just 0.05 of a percentage point above the 6.75 per cent discount rate.

'This indicates that in September at the latest we shall see another discount rate cut of half a percentage point or maybe more,' said Hans- Jurgen Meltzer at Deutsche Bank Research. The next Bundesbank central council meeting is on 26 August.

But economists warned that the domestic economic background to any rate cut would remain poor, with final July inflation expected to be at a peak of 4.4 per cent, and July/August money supply figures swollen by recent intervention to prop up the weak ERM currencies. Against this, the Bundesbank could argue that an appreciating mark has given it room to ease key rates.

Call-money rates fell to 6.45 per cent from Monday's high of 7 per cent. Mr Schoenholtz said call money was likely to fall below 6 per cent by the end of the year and to 4.5 per cent or below in 12 months' time.

The repo rate reduction was echoed by the Dutch central bank, which cut its key advances rate from 6.6 to 6.5 per cent. The move helped to reduce the yield on benchmark 10-year guilder bonds to 6.23 per cent at one point, its lowest since 1988. The guilder is the only currency other than the mark to retain its old 2.25 per cent variation bands in the ERM. All other ERM currencies are now able to move up to 15 per cent above or below their central rates in the system.

Spain also eased its monetary policy, cutting its key 10-day repo rate by half a percentage point to 10.5 per cent, with another cut expected later this month. There were similar cuts in the prime rates of Spanish commercial banks.

The peseta held up well, closing at 81.75 per mark, from an opening level of 82.9. Profit-taking saw the Portuguese escudo finish at 101.7 to the mark, slightly higher than Monday's close of 104.03. Some analysts expect Portuguese interest rates to be cut today.

The Belgian central bank continued to intervene sporadically to support the Belgian franc, following its failure to secure a retention of 2.25 per cent bands in Sunday's ERM negotiations.

France's constitutional watchdog has censured clauses of the law making the Bank of France independent, saying the Maastricht treaty would have to come into force before the bank could define monetary policy, ensure price stability or be forbidden to seek or receive instructions from the government.

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