Sterling strengthened 5.4% against the US dollar and 5.6% against the euro on rising UK bank shares and a growing perception that the pound has been oversold ahead of next week' BoE meeting. The US dollar appreciated against most of the major currencies, except for the pound. €/$ fell to 1.2795 at Friday' close after reaching a high of 1.3329 on Tuesday, in a knee-jerk reaction to the better than expected German IFO survey. The New Zealand and Australian dollars were among the biggest losers as the NZ central bank cut interest rates by 1.5 percentage points to 3.5% and hinted at further rate cuts to come. The A$ also depreciated as bank lending fell for the first time since 1992, raising expectations that interest rates will be cut by another full percentage point to 3.25% next week. The Russian rouble extended its losses as speculators tested the central bank' new target floor of 36 against the dollar.
Rising bank stocks, supported Friday by better than expected UK mortgage lending figures, provided support for sterling. The pound traded at a weekly low of 0.9519 against the euro on Monday, but by Friday had broken through the key 0.90 level. However, downside risks to sterling stem from industrial production and very poor labour market data, which may keep volatility elevated in the weeks ahead. The IMF' comments that the UK economy will contract by 2.6% this year (close to our own forecast of a decline of 2.5%) - the largest contraction in the G7 and the weakest performance since the 1980s recession - suggests that Bank rate will be cut by 0.50% to 1% at next Thursday' BoE meeting.
€/$ traded within a wide range of 1.2787 and 1.3329 and the dollar appreciated against almost all the major currencies, except sterling. It strengthened following the Fed' vote to keep the fed funds rate target range at 0-0.25% and it plans to keep interest rates exceptionally low for ‘some time’. The Fed also said it is prepared to ‘purchase’ rather than just ‘evaluate’ purchases of longer term treasuries. However, the better than feared Q4 2008 US gdp annualised contraction of -3.8% (the market median forecast was for a fall of 5.5%), left the dollar virtually unchanged against its major counterparts. A slump in consumer spending was partially offset by a buildup in inventories, a reversal of which could be a drag on the economy in Q1 2009. The dollar weakened following the publication of a rise in US weekly claims to 588,000, 3,000 up from last week. This points to further employment losses of over half a million in January. December' 3.6% contraction in durable goods excluding transportation, a good proxy for business investment, was also dollar negative.
There was no major impact on the euro from the release of a fall in the eurozone CPI inflation rate to 1.1% in January from 1.6% in December and a rise to 8% in the unemployment rate. This is partly because there is a widespread view that these numbers will not influence the ECB' decision to keep interest rates at 2% next week. Instead the ECB is expected to cut rates in March, when its revised inflation and growth forecasts for 2009-10 are available, but a surprise is possible.
Interest rate market review - bonds, cash and swaps
Divergence among the major government bond markets occured this week, with UK and the euro zone yields decoupling from the rising trend in the US. Fears about the size of upcoming US government supply to fund public spending offset weak economic data and squeezed yields broadly higher, especially on longer dated maturities. This caused the treasury yield curve to steepen. Yields fell in the UK and were relatively rangebound in the euro zone. Libor rates stagnated in the UK and the US, but fell in the euro zone, where the 3-month spread over the ECB refinance rate narowed to just 9bp. This compares with a 3-month Libor spread of 67bp in the UK and 93bp in the US. 5yr swaps fell in the UK but rose in the US on heavy corporate bond supply. Euro zone swaps were virtually unchanged.
It was a fairly quiet week for UK economic data. Weak UK house prices and consumer confidence data, and a bleak survey of UK retail sales by the CBI, underlined the grim outlook for the economy. The data reinforced the prospect of a cut in base rates by the BoE next week. We look for a reduction to 1% from 1.5%. The Nationwide reported a 1.3% m/m and 16.6% fall in UK house prices in January. Consumer pessimism increased in January according to the Gfk despite the raft of new government measurses announced over the last month to support the economy. The CBI distributive trades survey warned of lower retail sales ahead. The negative news flow and volatile equity markets helped to anchor 2yr yields below 1.50% and 10yr yields below 3.70%. This week' gilt auctions were poorly subscribed and underlined lacklustre investor interest. The 2047 index-linked auction was subscribed 1.62 times. The 2020 conventional auction was subscribed only 1.37 times. This marked the weakest demand for UK government paper in nearly three months.
Separately, the BoE exchanged letters with the Chancellor setting out the procedure for additional asset purchases under the Asset Purchase Facility to improve credit conditions in the economy. Of more relevance to the setting of interest rates, the BoE said that it will keep under review whether asset purchases could be made for monetary policy purchases. This is an implicit reference to the use of quantitave easing to combat low levels of inflation by expanding money supply. 5yr swaps ended the week down 5bp at 2.97%. 3-month Libor fell 2bp to 2.17%.
US treasuries stayed under pressure for a second week running despite weak economic data and the Fed' announcement that it is prepared to buy long-term treasuries to improve conditions in the credit markets. Home sales data in particular fell sharply in December and there was no let-up in consumer pessimism in January. Labour market anecdotes and corporate announcements point to further heavy job losses in the months ahead. The advance estimate of Q4 2008 gdp revealed that the US economy contracted by 3.8% annualised (0.95% q/q). This was better than feared, but a surprise positive contribution from inventories last quarter makes it likely that growth will again contract in Q1 2009 as companies run down stocks. However, market jitters about govenment issuance of treasury paper had the upper hand this week and squeezed yields higher along the curve. The long end, including 10yr to 30yr maturities, saw yields increase by about 20-25bp. This pushed the 30yr yield back above 3.50%. 5yr swaps jumped17bp to 2.44%.
In the euro zone, the report of a sharper than expected fall in annual CPI to 1.1% in January, the lowest since 1999, anchored 10yr yields around 3.25%. 2yr yields rose back above 1.50% in a reaction to comments by ECB president Trichet which hinted at no change in interest rates next week. A surprise increase in the German IFO survey also triggered some selling in shortdated bunds. 5yr swaps closed the week below3% at 2.98%.
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