Sunday, February 15, 2009

Financial Markets Review : BoE Prepares for More Rate Cuts and Quantitative Easing

The pound's recent rally was abruptly ended by the latest Bank of England (BoE) Inflation Report (QIR), outweighing some slightly better than expected UK economic data.

The QIR sharply revised down projections for UK economic growth, with the likely contraction in 2009 estimated at over 3%, with the risks to the downside. Based on market implied interest rates, CPI inflation was projected to be well below the 2% target over the forecast horizon. BoE governor King confirmed further easing in monetary policy may be required and that unconventional measures, such as quantative easing, were already being considered. After closing at a 4- week high (1.4947) on Monday, £/$ ended the week down 2.3% at 1.4410. £/€ rose above 1.15 for the first time since early December, however closed the week 2.4% down at 1.1189 only after a rebound on Friday. The single currency was put under pressure by data showing the euro zone economy contracted by a larger than expected 1.5% q/q in the final quarter of 2008, which fuelled speculation that interest rates have further to fall. €/$ closed the week down virtually unchanged at 1.2878.

The dollar and yen were supported by buying activity after new measures announced to support US banks failed to engender wider market confidence. $/Y closed the week higher at 91.95. The worst performer in the G10 was the Swedish krona after the Riksbank cut interest rates by a larger than expected 1%. In emerging markets, the top performers against the US$ were the Chilean peso and Russian rouble, while the Hungarian forint and South African rand fared the worst.

The focus in the UK this week was on the February QIR. Dovish comments from governor King, highlighting serious downside risks to the UK economic outlook and the need for further policy easing, raised the probability of a cut to 0.5% in Bank rate next month and a move to quantitative easing. The BoE for the first time on Friday announced the benchmark interest rate it will purchase commercial paper using its new were better than expected, but still reflected economic weakness. Claimant count unemployment rose by 73,000 in January, pushing the unemployment rate to 3.8% from 3.6%. The ILO jobless rate rose to 6.3%.

Economic data from the euro zone raised the possibility of a sharp cut in interest rates next month and weighed on the euro. Preliminary estimates showed EU-16 gdp contracted 1.5% q/q in the final quarter of 2008, led by a 2.1% drop in German gdp - the most since 1987. German CPI inflation was confirmed at 0.9% in January, underlining that the ECB has room to cut interest rates. We expect the benchmark rate to be cut to at least 1.5% in March.

Financial markets looked towards the US this week to hear about the government's latest package to help the banking sector and the vote on the $789bn fiscal stimulus programme. A lack of clarity and fears that the measures announced may prove insufficient weighed on investor confidence. However, this actually supported the US$ on safe haven flows. The stimulus plan has not been passed at the time of writing.

Interest rate market review - bonds, cash and swaps

A warning by the Bank of England on the outlook for the UK economy and a successful US quarterly debt refunding was supportive of government bonds and helped yields and swap rates to fall this week. Gilts out performed treasuries and bunds, especially at the front end where UK 2y yields plummeted nearly 40bp. UK 5y swaps slipped back below 3%. UK 3- month libor fell 5bp to 2.07% as the BoE Asset Purchase Facility came into operation on Friday and the Bank prepared markets for quantitative easing.

The quarterly BoE Inflation Report was the marquee event in the UK this week and did not go unnoticed after another downgrade to the UK economic outlook sparked an impressive rally in UK gilts. Gilt futures posted their biggest intra-day gain in history on Wednesday after governor King warned that gdp growth could trough at -4% in Q2. Mr King prepared markets for a further reduction in base rate - we expect a cut in March to 0.50% - and also hinted at the likelihood of quantitative easing to boost liquidity. This consists of the outright purchase of gilts to increase the monetary base via commercial bank reserves. An increase in money supply is the result if banks distribute liquidity to the real economy with an offsetting sales of treasuries. The Bank also said it expects CPI inflation to stay below 2% this year before rising to 2.1% at the end of 2010. Gloomy UK labour markets and mortgage approvals data reinforced the Bank's forecasts and added support to the gilt rally and a steeper curve. A rise in the number of unemployed in December to 1.97mn lifted the ILO unemployment rate to 6.6%. 2y gilts fell 30bp to 1.33% on Wednesday, pushing the yield curve 2s/10s to 228bp. Gilt auctions attracted respectable demand for the 2019 issue (bid/cover 1.75), but the index-linked 2027 auction fared less well (bid cover 1.57). 5yr swaps ended the week down 21bp at 2.88%.

US economic data was overshadowed by record treasury auctions and events in Washington where Treasury Secretary Geithner presented a comprehensive financial rescue plan to remove distressed assets from bank balance sheets and boost lending to the private sector and households. The three government auctions, $67bn in total, were all very well received, especially considering concerns about the record amount of funding still to come and government plans to spend $790bn. Markets listened to Mr Geithner when he presented his rescue plan and concluded that the lack of detail left a lot of uncertainty on how the plan will price distressed assets. Markets are also anxious to hear more details - probably next week - about a new Home Assistance plan designed to stop house prices from falling and slow the rate of foreclosures. Economic data were better than expected this week. Weekly claims fell by 8,000 to 623,000. Retail sales rose by 1% in January led by a 2.6% rise in petrol sales. Weak sales in other categories led markets to dismiss the stronger data. Signs of pessimim surfaced on Friday in the much weaker than forecast Michigan confidence survey. The index fell to 56.2 in February, the 4th lowest ever. With government supply out of the way and the Fed not ruling out the purchase of treasuries, 10yr yields out performed, falling back from 3% to 2.85%. 3-month US libor was unchanged this week at 1.24%.

The worst economic performance for Germany since 1987 led to a deepening of the recession in the euro zone at the end of 2008. Data showed a 1.5% q/q contraction in EU-16 gdp growth in Q4 2008, driven by a 2.1% q/q contraction in Germany. Euro 3-month libor fell below the 2% ECB refi rate to 1.94%, and evidence that the ECB's liquidity operations are effectively working were underlined by a sharp fall in bank daily overnight deposits with the ECB below 100bn euros. 5yr swaps closed the

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