Apart from Obama Barack's clear win in the US presidential elections, widespread interest rate cuts - by the Bank of England, the ECB, the Danish Central Bank, the Swiss National Bank and the Reserve Bank of Australia - provided focus for financial markets. Sterling spiked to near 1.25 against the euro and broke below 1.60 against the dollar on the surprise of a 1.5% cut in UK base rates to 3%, their lowest level since 1955 as the cut was initially perceived as a positive, but on Friday hit a weekly low of around 1.2206 against the euro and 1.5535 to the US$ as the interest rate reduction was not seen to be enough. €/$ peaked at 1.3116 following the release of a bleak US ISM non-manufacturing survey for October, but ended the week at 1.2767 as a comparatively modest ECB interest rate cut of 0.5% failed to instil confidence in the flagging eurozone economy. The yen benefited from declining investor appetite for carry trades as Asian stocks continued to fall, appreciating against the dollar and sterling to end at 98.01 and 154.42, respectively. The Swiss franc depreciated against the euro, which peaked at 1.5172 mid-week.
£/€ traded in a wide band of 1.2207 and 1.2750 and £/$ 1.5535 and 1.6399, but the pound depreciated over the week as a whole on mounting fears about recession and job losses, which culminated in a 1.5 percentage point cut in base rates by the BoE on Thursday. But this was not deemed enough to restore economic confidence and a further cut to 2.5% is now possible by the end of the year and rates may fall as low as 1% in 2009 should economic conditions require it. The BoE justified the cut by highlighting the substantial risk of undershooting the inflation target at prevailing market interest rates in their accompanying press statement. We will find out the economic rationale for this decision when the quarterly inflation report is published next Wednesday. Although the MPC’s minds may have been made up before, this week’s publication of contraction in the manufacturing and services PMI confidence indices to 41.5 and 42.4 in October, respectively, will have cemented the view that rates were set too high and needed to be cut rapidly. HBOS house price data brought more bad news for the housing market, as prices fell more sharply than expected, by 2.2% in October compared with 1.3% in September.
Despite the US Democrat's congressional gains, increasing its ability to take radical policy action against the current crisis, it is evident that there is no quick fix. Economic data continues to come in to the downside - the ISM manufacturing survey dropped to 38.9 in October from 43.5 in September and the ISM services survey declined to 44.4 from 50.2, both significantly below forecast. US jobs data, including the key non-farm payroll figure of 240,000 was the worst since 9/11 and brings the total number of job losses this year to 1.179m. Moreover, the unemployment rate has reached 6.5%, the highest level since 1994, fuelling speculation that the Fed will need to cut interest rates below 1%. In the eurozone, having discussed cutting interest rates by 0.75 percentage points, the ECB went with just 0.5%. However, President Trichet made clear that he does not exclude cutting rates again, a very likely prospect as the eurozone economy continues to weaken.
Interest rate market review - bonds, cash and swaps
The Bank of England slashed interest rates by 150bps to 3%, the lowest level for more than fifty years. The scale of the move was a surprise, as markets had expected a reduction of 100bps at most. Indeed, markets did not expect rates to come down to 3% until early next year, so the intention by the Bank was to get ahead of the curve. The extraordinary move was justified by the marked deterioration in economic growth prospects and the sharp fall in commodity prices. The UK PMI surveys earlier in the week confirmed that growth prospects had weakened further at the start of Q4 and, crucially, that upward price pressures had eased signficantly, paving the way for the Bank to ease policy more aggressively. Data from the statistics office showed manufacturing output fell 0.8% in September, confirming two consecutive quarters of contraction.
UK 2-year bond yields fell to a low of 2.435% this week and 10-year yields were also dragged lower, though to a lesser extent. Hence, the bond yield curve continued to steepen. Swap rates at the front end of the curve fell even more than underlying bond yields, with 2-year swaps down 67bps to 3.61% and 5-year swaps down 49bps to 4.10%. This narrowing of swap spreads at the front end in part reflects lower short-term rates, increasing the incentive to receive fixed. Sterling 3m libor fell more than 100bps on Friday, the day after the Bank of England interest rate announcement, and has declined 134bps over the week. Further declines in interbank rates are expected, as money market tensions ease and as the Bank of England leaves open the possibility of further rate cuts, perhaps by another 50bps in December.
Unlike the Bank of England, the ECB did not feel the need to reduce interest rates more than the expected 50bps to 3.25%. However, a bigger reduction was discussed and suggests that interest rates could come down again next month. For the first time since the ECB's inception, eurozone interest rates are now higher than their UK counterparts. In justifying the half-point reduction, the ECB now believes that eurozone CPI inflation will fall back to its target of 'below but close to 2%' in 2009. Previously, the ECB did not expect inflation to fall back to target until 2010. Economic data confirmed that downside growth risks had intensified. German manufacturing orders and industrial production were very weak in September, while the more forward-looking eurozone PMI surveys for October confirmed further weakening of economic activity and easing of inflationary pressures. German 2-year bond yields fell to a low of 2.24% just ahead of the ECB rate announcement, but ended the week at 2.40%. Five-year swaps fell to 3.81%, the lowest weekly close since December 2006.
In the US, optimism following Barack Obama's landslide victory in the Presidential election gave way to the big economic challenges that face him ahead. The economy lost 240,000 jobs in October, while the losses for August and September were revised up by a total of 179,000. The unemployment rate also rose to 6.5%, the highest since 1994. The ISM surveys mirrored their European PMI counterparts, pointing to a further deterioration of economic activity and a sharp fall in price pressures at the start of Q4. The Fed has already slashed interest rates to 1%, so it has used up most of its monetary policy ammunition, but a further half-point reduction at the next FOMC meeting in December is a distinct possibility. US 3m libor continued to fall sharply, down more than 200bps in the past month to 2.29%. Two-year bond yields fell to a low of 1.24%, but the impact of increased government debt has kept 10-year yields within a broad 3.50-4.00% range in recent weeks and 30-year yields in a broad 4.00-4.50% range. Hence, while the government financial bailout is helping to reduce interbank rates, it is also contributing to narrower swap spreads at the longer end of the curve. Indeed, 30-year swap spreads turned negative this week.
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