While the financial market in the UK is amongst the most developed of any country in the world, there are still only a handful of factors which can really impact upon UK rates of interest, UK rates of return and UK base rates. However, this small band of factors can often have a massive influence over the direction of the economy , stock market and returns available in the UK.

Money Markets
As we have seen over the last few months, in the aftermath of the US sub-prime market fallout, the world wide money markets can have a massive impact upon the cost of borrowing for both private individuals and businesses. As the sub-prime situation in the US continued to deteriorate we saw the start of what has become a long and prolonged credit crunch. But what is actually happening?

As the debt crisis in the US worsened we saw many companies pulling in their liquidity (i.e. “free money”) which they would normally have made available to the world wide money markets – the markets which allow companies to borrow money overnight, short term, medium term and longer term at a cost. As debt instruments which had been created using an array of debt exposure began to unravel (with many ending up virtually worthless) we saw the asset base of many companies shrink substantially. A trickle of reduced liquidity soon turned into a flood and before long we saw borrowing rates rise sharply due to a lack of “liquidity” in the markets – i.e. fewer people willing to lend money, which meant more risk to those staying in the market. This increased risk led to the need for a greater return to offset the added risk, hence the sharp rise in borrowing costs. How does this affect the economy?

The expansion, and often day to day running of many businesses, is highly dependant on the cost of financing such actions. As finance costs began to rise many companies were forced to cut back on their investment programs and look to make savings elsewhere – with job cuts the only option for many. As each cost saving exercise was announced, each redundancy meant less money for the UK retail sector which is now leading to a slow down in the UK economy. Indeed UK money market borrowing rates are still higher than UK bases rates (which are governed by the Bank of England) leading to central banks around the world looking to inject liquidity into the markets to bring money market rates more into line. This situation cannot go on forever and many central banks have taken the decision to let the market suffer some pain from “the over exuberances” of the past, in the hope that it will teach them a lesson to be more careful – whether this message hits home remains to be seen.