Sunday, March 22, 2009

Financial Markets Review : Dollar Falls on Fed Plan to Purchase Treasuries

Financial market review - foreign exchange

The dollar fell sharply against its G10 counterparts after the Fed announced that it will purchase $300bn worth of treasuries. This expansion of quantitative easing sparked concerns about inflation prospects and pushed market participants into commodity currencies like the Norwegian krone. $/Nok dropped nearly 8% to a 5- month low of 6.2866, supported by a rise in crude oil prices above $50pb. The euro, sterling and Swiss franc also strengthened against the US currency. €/$ firmed 5.3% and £/$ rose 3.4%. $/Chf slumped 6 cents to 1.1250. Sterling weakened nearly 2% against the euro after worse than expected UK data for public finances and unemployment. Positive UK/EU yield differentials failed to arrest the slide as £/€ slipped to a 1.0546 low.

Volatility flared up in currency markets after the US Fed stunned participants on Wednesday with the decision to buy treasuries. The decision triggered a sharp sell-off in the dollar and sparked a rush into gold. By purchasing 2- year to 10-year maturities, the Fed hopes to reduce mortgage rates and restore confidence in the housing market and the wider economy. The Fed also announced it will step up the purchase of agency and mortgagebacked securities. The decision set off a fall in the dollar in a move that would last pretty much all week. The Fed plan propelled £/$ to a high of 1.4596, despite weak UK economic data. Wednesday's labour market statistics revealed a record monthly rise in the UK claimant count of 138,400 in February. The ILO unemployment rate rose to 6.5%, as unemployment rose above 2mn. Figures for UK public finances also disappointed. Data for February revealed a much larger than expected £9bn deficit. This brings the cumulative PSNB figure for the fiscal year-to-date to £75.2bn, up from a revised £66.2bn in January. As a result of the deteriorating public finances, the DMO announced that it will issue nearly £150bn of new gilts over the fiscal period 2009/ 10.

The A$ was among the biggest gainers in the dollar bloc, buoyed by an 8% jump in the price of gold. The NZ$ also soared. £/A$ fell below 2.10 support and from here could test the January low of 2.0753. The rally in equities and bank shares also helped emerging market currencies in Asia and eastern Europe to recover. This propped up demand for the Swedish krona, given the country's exposure to the Baltics. However, the sek dramatically reversed gains on Friday after comments by the Swedish finance minister that quantitative easing in Sweden could not be ruled out. The decision by the EU to double credit lines for eastern European countries to 50bn euros came too late and failed to stem the selloff in the krona. €/sek soared 2.2% on Friday to 11.1318.

Emerging markets benefited from the rise in equity markets worldwide. Benchmark indices including the S&P 500 and the FTSE-100 extended their gains to double digits from the March 6 low. The Korean won was among the best performers in Asia, booking a gain of more than 5%. $/won fell below 1,400 for the first time in 5 weeks. The dollar also lost ground against the yen and the yuan, as the two biggest holders of US treasuries, Japan and China, saw the value of their holdings increase.

Interest rate market review - bonds, cash and swaps

The decision by the US Federal Reserve to follow in the Bank of England's footsteps and begin buying government paper stunned the financial markets. Its decision to buy $300bn of treasuries in the next six months may have been buoyed by the initial success in the UK where 10yr gilts have fallen more than 50bps in recent weeks. The Fed also said it would increase purchases of agency debt and mortgage-backed securities. The fed funds target rate was left at 0-0.25%, as expected, and the Fed stated that rates are likely to stay in that range for an extended period. US 10yr treasuries yields plunged from around 2.95% to below 2.5% following the FOMC statement, while 2yr yields fell from just below 1% to a low of 0.79%. 3m libor also fell to 1.22%, the first weekly decline in five weeks, while dollar 5yr swaps fell 14bps to 2.32%. In terms of economic data, the Philly Fed index remained near cyclical lows, initial jobless claims stayed above 600k and industrial production fell 1.4%, the fourth consecutive monthly decline. On the other hand, CPI and housing starts surprised on the upside.

Unsurprisngly, the slump in US treasury yields dragged euro and sterling bond yields lower. In the UK, short-dated bonds were further supported by poor economic data, including the surge in unemployment and a weak CBI industrial trends survey. Claimant count unemployment soared by 138,400 in February, a significantly bigger monthly rise than the 85,000 expected. The broader ILO measure rose above 2 million for the first time since 1997 and earnings growth slumped to only 1.8% on the year. The CBI survey showed a further fall in the total orders balance to -58, suggesting that the pace of economic contraction is increasing. The IMF now expects the UK economy to contract 3.8% this year, in line with our forecast. In light of worsening growth prospects, the minutes of the BoE's last MPC meeting showed a unanimous vote to cut interest rates to 0.5% and to start quantitative easing. Bond yields were also weighed by the BoE's £5bn purchase of gilts this week. The BoE next week is expected to buy another £6bn of gilts and to start buying investment-grade corporate bonds. However, there will clearly be a significant supply of paper to digest, with public sector net borrowing ballooning to £75.2bn so far in FY 2008/9, compared with £23bn over the same period of 2007/8, while the IMF is predicting the UK's fiscal deficit to rise to 11% of GDP next year. The DMO expects to sell £147.9bn of gilts in the next financial year and this figure may well be revised up when the Chancellor presents his Budget next month. Over the week, UK 2yr gilt yields fell to a low of 1.32%, but 10yr yields rose 9bps to 3.03% and 5yr swaps hovered around 3%, ending the week slightly lower at 2.95%.

The euro zone saw benchmark German 10yr bond yields fall below 3% following the Fed's announcement to start buying treasuries. Dovish ECB comments, which appeared to confirm expectations of further policy easing in April, also weighed on bond yields, while euro zone CPI for February was confirmed at 1.2%, below the ECB's target, and industrial production in January slumped 3.5% on the month. Earlier in the week, yields found some support, after an unexpected rise in the headline German ZEW index of investor sentiment, which rose to -3.5 from -5.8. However, the current situation component of the survey continued to deteriorate. Thus, the question now is how the close the ECB is to following the BoE, BoJ and the Fed in buying government bonds, notwithstanding potential practical difficulties surrounding which euro zone country's debt to purchase. The pressure on the ECB to follow suit has risen, with President Trichet reiterating that non-conventional policy measures were being studied. Ahead of key PMI and IFO business surveys next week, German 2yr bond yields ended little changed at 1.33% and 10yr yields fell 7bps to 2.98%.

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