Rising fears saw risk appetite retrench this week, pushing equities and benchmark bond yields to multi-year lows. The bearish sentiment was reflected in currency markets by another solid week for the yen, which rose to a 3-week high against the US$ (93.57), in spite of data showing the Japanese economy in recession for the first time since 2001. In contrast, the biggest G10 fallers were the high yielding Australian and NZ dollars, prompting the RBA to intervene and purchase its own currency as it tested recent lows. Overall, the US$ had another solid week, with the dollar index - its average value against six major world currencies, rising to the highest since April 2006 (88.46). Within this, £/$ eased 0.3% on the week to 1.4784, while €/$ fell 1.4% to 1.2519. The SNB surprisingly cut its target rate by a record 1% this week, reducing it to just 1%, from 2.75% at the start of October. The franc fell to its lowest against the US$ since August 2007 (1.2298), while €/CHF briefly rallied through 1.54. However, the biggest falls this week were again in emerging market currencies, led by the Brazilian real and Mexican peso, as risk aversion spiked up. It may in part have also reflected further selling pressure on commodities, with crude oil falling below $50 for the first time since May 2005. However, gold prices rose for a third straight week.
Economic news in the UK this week confirmed the prospect of further interest rate cuts, however its impact on sterling was relatively limited. Inflation data showed consumer prices rose by 4.5% in the year to October, down sharply from 5.2% in September, with a large fall also in retail price inflation. We now believe that headline retail price inflation may be negative for 2009 as a whole, from 4.5% in October. The minutes of the Bank of England MPC meeting earlier this month provided another surprise, as they revealed that the committee considered cutting rates by more than the 1.5% sanctioned. This was based on projections in the Q4 Inflation Report that implied that a cut in excess of 2% might be required in order to meet the inflation target in the medium-term.
The comments raise the risk of a further cut next month, possibly by as much as 1%. Other UK data published this week showed retail sales were more resilient than expected in October, falling by just 0.1% during the month. Ahead of the Pre-Budget Report next week, public finances data showed borrowing already at £37bn in the first seven months of the fiscal year, compared with £20bn last October and the full year Budget 2008 target of £43bn. A surprisingly sharp 1% fall in US consumer prices in October saw the $ spike to its intra-week lows against the £ and € on Wednesday, at 1.5250 and 1.2814, respectively. However, the rallies proved short lived, as rising risk aversion saw the $ strengthen at the close of the week. The $ remained bid in spite of other data showing a sharp rise in initial jobless claims and some very disappointing housebuilding figures in October.
It was a relatively quiet week for data in the euro zone, however a busy one for ECB speakers. Their comments supported market speculation that further deep cuts in interest rates were likely in coming months. The main data highlight was the 'flash' services and manufacturing PMI estimates, which fell to record lows in October.
Interest rate market review - bonds, cash and swaps
A worsening backdrop for the global economy and the associated falls in equity markets kept intact the downward trend for G7 benchmark bond yields this week. Measures of credit risk widened appreciably as equities accumulated losses in the wake of negative business updates and announcements of job cuts by some of the world's leading companies. The grim outlook for the world economy and the fall in crude oil prices below $50pb also caused deflation fears to intensify. This led to a generalised decline in yields in the US, the UK and the euro zone to historical lows. Yields on the US 10 and 30 yr bonds fell to a record low of 3.06% and 3.61%, respectively. The FTSE-100 closed the week down nearly 11%.
UK economic data was dominated this week by the report of a bigger than forecast drop in inflation in October. Both CPI and RPI inflation fell more than expected last month led by to sharp falls in oil prices and the cost of transport. Annual CPI fell to 4.5% from 5.2% in September and annual RPI fell to 4.2% from 5.0%. Core inflation slowed to 1.9% from 2.2%, the lowest since July. Sharp cuts in interest rates and falling house prices mean that we now expect RPI inflation to fall into negative territory next year. The rapid unwinding of inflation pressures and fears of outright deflation are putting downward pressure on long-dated yields, despite concerns that the Chancellor will announce a steep rise in government borrowing next week. The yield on the 10yr gilt fell to 3.85% this week, a drop of 22bps. The yield on the 30yr gilt fell 35bps to 4.06%. 5yr swaps ended the week down 24bps at 3.73%.
Speculation that the BoE will cut interest rates by 100bps to 2.0% in December was buttressed by the MPC minutes of the November meeting. These revealed that the BoE voted unanimously for the rate cut to 3.0% this month. We now expect the cost of borrowing will be trimmed next month to 2% as the BoE guards against inflation undershooting its 2% target next year. Retail sales figures for October were published on Thursday and showed a smaller than expected decline of 0.1% m/m. UK 3-month Libor fell 14bps this week to 4.04%, reducing the spread over Bank rate to 104bps, a 2-month low.
The biggest falls in bond yields this week were concentrated in the US where worries about the financial system and the solvency of the three largest car manufacturers sparked strong demand for the safe haven of government bonds. The Dow fell below 8,000 and the S&P 500 fell below 750, putting losses so far this year close to 50%. Moreover, US economic data is still not stabilising and this is compounding fears that the recession could be deeper than previously thought, causing ripples across the world economy. The Fed this week revised down its 2009 forecasts for growth and inflation, and turned more pessimistic about the labour market. Initial claims continued their ominous rise this week, climbing to 542,000. At the same time, October inflation data showed the first monthly fall in core CPI since 1982. The 0.1% fall led to a drop in annual core inflation to 2.2% from 2.5% in September. The combination of shrinking output growth and falling inflation led to a steep decline in treasury yields across the curve. 5yr swaps fell to an intra-week low of 2.81%, but closed the week at 2.97%, down an extraordinary 42bps from last week.
New all-time lows for the euro zone manufacturing and services PMI's in November underlined the threat of a more protracted period of negative gdp growth in the region. The resulting rise in spare capacity and expectations of a sharp fall in inflation pulled 10yr bund yields and 5yr swaps below 3.50%. The weak data will inevitably add pressure on the ECB to cut rates decisively when it meets in two weeks time. We expect rates to be cut in December by at least 0.50%.
Lloyds TSB Bank http://www.lloydstsbfinancialmarkets.com
Disclaimer: Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.
