Sharp falls in global equity markets and weak economic data spurred demand for safe haven assets this week, underpinning the dollar and gold. The pound fell 0.8% to 1.43 against the dollar but strengthened above 1.13 vs the euro as fears over the exposure of euro zone banks to Eastern Europe hit confidence in the single currency. The yen and Swiss franc were unable to capitalise on risk aversion flows and were equally sold against the dollar. Emerging market currencies fell in Asia and Latin America as fears over equity market valuations led participants to shift out of risky assets. Eastern European currencies fell initially but subsequently recovered later in the week on hopes of EU assistance and speculationof central bank intervention.
A combination of weak activity data in the US and the euro zone, and fears about the stability of the financial sector sparked heavy falls in global equity markets and bolstered demand for the dollar. The US Fed revised down its forecast for 2009 gdp growth and revised up its forecast for 2010 growth. It also phased in a de facto inflation target by forecasting a ‘long run’ PCE inflation estimate of 1.7%-2%. Declines below key levels in the major benchmark equity indices - the Dow dropped below 7,800 and the FTSE-100 sank below 4,000 - sparked a rush into government bonds, gold and other precious metals. Gold touched $1000 on Friday, marking a gain of 25% since mid-January. Repatriation flows from emerging markets and worries about the exposure of the euro zone economy to banks in Eastern Europe helped to bid up the dollar.
Sterling held up relatively well, supported to some extent by stronger than expected UK January CPI and retail sales data. Annual CPI fell to only 3% in January from 3.1% in December. Retail sales rose 0.7% m/m in January (3.6% y/y), marking a second successive increase. The data was met with a degree of scepticism considering the weak anecdotal evidence of late from high street sales surveys including the BRC and CBI. The MPC minutes revealed on Wednesday that the BoE voted 8-1 to cut base rates to 1% in February. MPC member Blanchflower preferred an immediate reduction to 0.50%. The minutes also indicated that the Bank could soon move to quantitative easing in a an effort to boost money supply and support the economy.
The euro was one of the leading G7 currency decliners this week as fears intensified of another sharp contraction in euro zone gdp in Q1, after the report of a fall in the composite PMI to a new low of 36.2 in February. Concerns about losses for euro zone banks from their exposure to Eastern Europe and widening sovereign CDS spreads also weighed on the single currency. A summit is scheduled to take place this weekend in Berlin where new measures could be discussed to support the ailing economy.
In emerging markets, Asian currencies and the Russian rouble suffered heavy losses as market participants fled into safe haven assets. $/won cleared 1500 and $/rouble rose 4.5% to 36.19.
Interest rate market review - bonds, cash and swaps
Declines in major equity markets and broadly weak economic data weighed on bond yields and swap rates in the major economies over the past week. However, short-dated sterling yields were supported by economic data and the Bank of England minutes, while supply concerns next week helped push longdated US yields higher. But overall, further weakening economic prospects provided a broadly positive backdrop for bonds. In the UK, annual CPI inflation declined less than expected in January, falling to 3% from 3.1%. The RPI measure remained positive, but only just, falling to 0.1% from 0.9%. Petrol prices and air fares pushed headline CPI lower, but this was partly offset by smaller-than-usual price falls because significant discounting had already taken place in December. Nevertheless, inflation will continue to fall in the coming months. The inflationdata helped pushed 2yr bond yields off lows of 1.29%.
Further support for short-dated yields came from the Bank of England minutes, which suggested some reluctance to reduce interest rates further from the current 1% level, though Blanchflower voted for a larger rate reduction. The minutes suggested that alternative policy measures would be needed to boost money supply in the economy, including purchases of government and corporate paper. Further, official data showed an unexpected rise of 0.7% in January retail sales, supported by further discounting. On the flip side for yields, the CBI industrial trends survey pointed to further weakening of demand, with the total orders index falling to -56 in February from -48. Moreover, public finance figures for January, a month where significant tax revenues are collected, showed a surplus of only £3.3bn compared with expectations of £7bn and £13.9bn a year ago. In the financial year to date, the deficit has soared to £67.2bn compared with £23.1bn over the same period of the previous financial year. 2yr bond yields peaked at 1.64% and ended the week up 13bps at 1.46%. Further out on the curve, 10yr yields fell 14bps to 3.42% and 30yr yields were down 2bps at 4.11%. 5yr swaps edged up to 3.03% from 2.88% and 3m libor were little changed at 2.07%.
In the euro zone, economic data were mixed, but intra-euro spreads widened out again. The German ZEW survey of investors rose to -5.8 in February from -31, the highest since July 2007. This led to a modest rise in German bond yields, but the Dax equity index remained under pressure, pulling yields lower. The euro zone PMI business surveys deteriorated to record lows, with the manufacturing index falling to 33.6 and the services index declining to 38.9, arguing in favour of an ECB interest rate cut at its next meeting in March. Debt issuance this week from France and Spain received decent demand. German 2yr yields ended the week down 6bps at 1.25% and 10yr yields fell 10bps to 3.01%, but 30yr yields rose slightly to 3.72%. Euro 5yr swaps closed on Thursday at 2.74%, the lowest since September 2005, and ended the week down 7bps at 2.78%. 3m libor fell 6bps to 1.88%. Intra-euro spreads over German 10yr yields widened earlier in the week, with Spain peaking at 128bps and Greece reaching a high of 299bps.
In the US, the Philly Fed survey fell to an 18-year low of -41.3 in February, while housing starts and industrial production figures were also weaker than expected. Moreover, initial jobless claims remained above 600k and the FOMC minutes downgraded growth projections. However, downward pressure on bond yields were mitigated by a massive $94bn of issuance due next week. Moreover, unexpectedly strong producer price data also pushed yields higher. 2yr and 10yr bond yields hit 1% and 2.87%, respectively, following the PPI data, but they ended the week lower at 0.92% and 2.74%. Slightly stronger-than-expected CPI inflation provided only limited support for yields. US 5yr swaps fell 12bps to 2.41% and 3m libor rose slightly to 1.25%.
Lloyds TSB Bank http://www.lloydstsbfinancialmarkets.com
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