Sterling put in another solid performance this week despite the 0.50% cut in UK base rates to 1%. The pound continued its recovery from recent lows and was buoyed by faltering confidence in the euro. £/ € hit a 2-month high of 1.15 and £/$ strengthened to 1.47. The rebound also helped £/chf to rally above 1.72, marking a 14% gain since the start of the year. The decision by the ECB to keep interest rates on hold at 2% did the euro no favours and sparked a broad based weakening of the single currency against its major counterparts. East European Emerging market currencies came under pressure once again this week, led by the Russian rouble and the Polish zloty.
Major currencies traded in a fairly orderly fashion this week despite ongoing questions about the financial system and concerns about the corporate outlook. Levels stabilised as the week ended, with participants awaiting the announcement of a US ‘bad bank’ plan sometime next week. Volatility fell and this kept major currency crosses within recent ranges. Sterling stood out for its gains against its principal counterparts, despite the BoE rate cut on Thursday to 1%. The quarterly Inflation Report is due next week Wednesday and will reveal the Bank’s latest forecasts for gdp growth and inflation. The publication may also offer some clues on whether base rates could fall below 1%, and how close the Bank is to implementing a policy of quantitative easing.
Data this week showed a tentative stabilisation in leading UK economic indicators in January, albeit at very low levels. The manufacturing and services PMI surveys edged up in January, but still remain well below the 50-level separating contraction from expansion. A sharper than expected contraction in UK industrial and manufacturing output in December underlined the pressures in the economy and the risk of further disappointing data in the weeks and months ahead as domestic and overseas demand stay weak and a negative earnings outlook forces companies to cut back investment.
US economic data showed further declines in employment and shrinking activity in manufacturing and service sectors in January. The monthly employment report revealed a decline of 598,000 jobs in January and a rise in the unemployment rate to 7.6%. The dollar posted its biggest gain this week against the C$ following the report of 129,000 job losses in Canada last month. The C$ also weakened after NY crude oil prices fell below $40pb.
Talk of a new US bank stabilisation plan next week helped to calm global equity markets and this bolstered demand for the A$ and NZ$. The A$ and NZ$ rose more than 2% against the dollar. Emerging market currencies were mixed, with worries about external imbalances leading East European currencies to under perform Latin American and Asian currencies. $/zloty rose above 3.60 and concerns about falling central bank reserves squeezed $/rouble above 36.40. The South African rand and Brazil real strengthened vs the dollar by 2.5% to 9.8270 and 1.9% to 2.2620, respectively.
Interest rate market review - bonds, cash and swaps
The major economic data release last week was US non-farm payrolls, which fell more than expected in January by 598,000, while the unemployment rate soared to a 16-year high of 7.6% from 7.2%. Moreover, the number of jobs lost in 2008 was revised up by 385,000 to nearly 3 million. Yet bonds sold off, concerns rose that weakening economic growth will lead to further rises in the budget deficit. The US Treasury said it expects to borrow $493bn this quarter, about 34% more than previously projected. Other data showed the manufacturing ISM rose to 35.6 from 32.9 and the non-manufacturing ISM rose to 42.9 from 40.1. Hence, both surveys pointed to ongoing contraction in economic activity in January, albeit at a slower pace than in the previous month. Personal spending fell 1% in December, while factory orders plummeted 3.9%. Markets will look towards Treasury Secretary Geithner's announcement next week on a new financial recovery plan, with speculation that a so-called 'aggregator bank' may be created to remove toxic assets from banks' balance sheets. US 10yr bond yields peaked at 2.98% this week, the highest for more than two months, while 30yr yields rose to 3.70%. 3m libor increased for the third consecutive week to 1.24%.
The ECB left interest rates on hold at 2%, as expected, but the poor economic data flow means rates are likely to fall further at the next meeting in March. Indeed, ECB President appeared to agree with market expectations of a 50bps cut to 1.5% next month, though he remained tight-lipped regarding outright purchases of commercial bills and government paper. German industrial data confirmed a very sharp fall-off in activity in the final quarter of 2008, with December manufacturing orders plunging 6.9% on the month and 25.1% on the year, while industrial output was 12% lower than a year ago. In addition, euro zone retail sales fell 1.6% on the year, while producer price inflation dropped to 1.8%. In the bond markets, 2yr yields fell to a low of 1.36%, but 10yr yields rose 7bps to 3.37% and 30yr yields rose 5bps to 3.92% at the close, hence the yield curve steepened. 3m libor fell 7bps to 2.02%, while 5yr swaps wounded up little changed at 3%.
In the UK, the Bank of England cut interest rates by 50bps to 1%, in line with expectations. The statement accompanying the rate announcement left the door open for further rate cuts, but obviously the scope for doing so is falling as rates head nearer zero. Hence, the focus is increasingly moving towards 'unconventional' measures to support the flow of credit in the economy, with the Asset Purchase Facility expected to start buying high quality corporate paper next week. The data flow in the past week was mixed. Manufacturing output was down more than 10% in the year to December. More forward-looking indicators showed a slight improvement in January, with the manufacturing PMI up 0.9 at 35.8 and services PMI up 2.3 at 42.5, though they still point to a significant pace of contraction in economic activity. House prices rose unexpectedly by 1.9% in January, according to HBOS figures, but they were down 17.2% on the year.
Ultra-long gilt yields fell, in contrast to bunds and treasuries, perhaps partly reflecting strong investor demand for long-dated debt at the auction of the 2049 issue this week. Ahead of the BoE Inflation Report and auction of £3.25bn of 2019 bonds next week, 10yr gilt yields hit a high of 3.81%, before closing up 3bps at 3.74%, the fifth weekly rise. However, 30yr yields fell 10bps to 4.30% at the close, down from a peak of 4.70% a fortnight ago. 5yr swaps edged back above 3% this week to close at 3.09%, while 3m libor fell 5bps to 2.12%.
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