Sunday, March 8, 2009

Financial Markets Review : BoE Cuts Base Rate to 0.50%, Will Purchase Gilts

Financial market review - foreign exchange

Sterling was one of the main fallers in currency markets this week after the BoE cut base rates to 0.50% and decided to phase in the policy of quantitative easing to boost liquidity in the economy. Sterling fell against all G10 currencies except the Swedish krona. The euro resisted selling pressure despite the 0.5% reduction in ECB interest rates to 1.5%. Sharp concerted falls in global equities, except China, spurred demand for safe haven currencies like the Swiss franc. This may force the Swiss National Bank (SNB) to consider taking steps to weaken the franc when it meets next week.

Plunging UK government bond yields and uncertainty about the economy undermined confidence in sterling. Weak figures for the February PMI surveys of manufacturing and services activity underscored the likelihood of another quarter of negative gdp growth in Q1. Lower house prices in February were reported by the Halifax and BoE statistics showed no improvement in January mortgage approvals compared to December. The weak data caused £/$ to hit 1.3958, a 5-week low. £/€ fell to 1.1097. The BoE cut in base rate to 0.50% was discounted, but sterling took the Bank’s decision to implement quantitative easing relatively well. In doing so, the BoE will be the first of the major central banks in the current cycle to buy medium and long-term government debt. The size of the purchase is initially set at £75bn but this could be increased to a £150bn maximum if the results prove unsatisfactory. The aim of the purchases is to increase money supply, revive economic growth and prevent deflation.

The dollar weakened only late in the week after US employment data showed the biggest drop in non-farm employment since1949. The US economy lost 651,000 jobs in February, but there were also downward revisions to January and December. The unemployment rate rose to 8.1% from 7.6% in January. $/chf was one of the biggest movers, falling to 1.1486. The data also helped gold to rally to $944, recovering from a $900 low

The change of sentiment vis-a-vis the yen was underlined when sharp falls in global equity prices - the S&P 500 fell below 700 and the Dow sank below 7,000 - were unable to support the yen. Evidence of further overseas selling of yen securities lifted $/Y to within a whisker of 100 on Thursday.

The euro was fairly static against other G7 currencies despite the ECB rate cut and the revision to gdp growth and inflation forecasts for 2009 and 2010. President Trichet did not harm the prospect of a fall in interest rates to 1% in Q2. This is now our forecast. €/chf broke below the key 1.4600 level on Friday to 4-month low of 1.4579. The move may prompt a response next week by the SNB. The Swedish krona lost further ground this week, falling to a 11.7896 all-time low vs the euro after Moody’s downgraded the rating of Swedish banks based on their exposure to eastern Europe.

The Turkish Lira was among the worst performing currencies this week in emerging markets. Investor confidence fell as plans to appeal for IMF support may be delayed. £/lira rose above 2.50, increasing its gains since January to 15%.

Interest rate market review - bonds, cash and swaps

UK medium and long-dated bond yields plunged after the Bank of England's decision on Thursday to begin purchasing £75bn of assets in the next three months, mainly gilts, financed by expanding central bank reserves - a form of so-called quantitative easing. The boldness of the move surprised the markets and led to a sharp fall in bond yields, particularly in the 5-25yr part of the curve where gilt purchases by the Bank will take place. Hence, 10yr bond yields plunged to 3.24% on Thursday and fell further on Friday to end the week down a massive 57bps at 3.05%. There were even bigger declines in 15yr and 20yr yields, which fell 71bps and 67bps, respectively. 30yr yields also fell below 4%, erasing the increases above 4.5% earlier in the week following weak demand at the 2039 gilt auction. Swap rates fell across the curve, with 5yr swaps back below 3%.

The Bank of England also cut interest rates by 50bps to a record low of 0.5%, as expected, and signalled that this is likely to be the bottom. Thus, 2yr bond yields fell relatively moderately this week by 17bps to 1.27%, which also partly reflected the unexpected rise in the services PMI survey to 43.2 in February from 42.5, though this is still a weak level. However, there were falls in manufacturing and construction PMI surveys and mortgage approvals remained weak in January. The rationale for the reduction in interest rates and the start of quantitative easing is that CPI inflation is expected to fall below the 2% target in the second half of the year and undershoot the target over the medium term. Moreover, the Bank said that business surveys point to a similar pace of contraction in the current quarter as in Q4 2008 when economic growth fell 1.5%.

In the euro zone, the ECB cut its main refi rate by 50bps to 1.5%, as expected. It also reduced the deposit rate by 50bps to 0.5%. The ECB slashed growth forecasts for 2009 to -2.6% from its previous forecast of -0.5%, while CPI inflation was expected to average just 0.4% this year and 1% in 2010, leaving the door open for a further reduction in the main refi rate to 1% in Q2. President Trichet, however, remained guarded about using 'non-standard' policy measures, including quantitative easing, but said that the ECB was studying its options. Thus, with interest rates near a bottom, the deployment of unconventional policy measures, while not imminent, has drawn closer. The data flow remained poor in the euro zone. Growth was confirmed at -1.5% in Q4 and the PMI surveys point to a similar pace of contraction in the current quarter. February CPI inflaton ticked up to 1.2% from 1.1%, according to the flash estimate, but is likely to trend lower in the coming months. German 10yr bond yields closed below 3%, dragged lower by weaker equities, while 5yr swaps fell below 2.7%.

Falling equity prices and weak economic data pushed US treasury yields lower, with 10yr yields hitting a low of 2.76%, ahead of the official employment report on Friday. In particular, the ADP employment report on Wednesday showed a fall of 697,000, leading to expectations that the official figure would show a fall of more than 700,000. The ISM surveys and Beige Book also confirmed ongoing weak economic activity. In the event, nonfarm payrolls fell 651,000, leading to a slight rebound in bond yields, but employment in the previous two months was revised down by a total of 161,000. Moreover, the unemployment rate rose more than expected from 7.6% to a 25-year high of 8.1%. Hence, despite the $63bn of issuance scheduled for next week, the bleak economic picture helped 10yr yields to end down 21bps at 2.80%, while 5yr swaps fell to 2.52%, but 3m libor edged up 3bps to 1.29%.

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