Saturday, April 11, 2009

Financial Markets Review

Major currency markets traded in a fairly narrow range this week, reacting to corporate news but also heeding developments in the global economy. As the dust settled from the G20 meeting, optimism over bank earnings and hopes that some parts of the US economy are stabilising bolstered demand for emerging market and higher yielding or commodity currencies. The Mexican peso and Indonesian rupiah were among the biggest emerging market gainers against the dollar. Sterling fell 1.3% against the dollar and rose 0.7% against the euro. A second emergency budget in 6 months in Ireland and comments by a member of the ECB governing council that euro zone interest rates could fall below 1% caused €/$ to drop 2%. The yen weakened markedly and pushed $/Y above the 100.0 barrier as the Bank of Japan issued another bleak statement on the economy and unveiled new measures to ease credit to regional lenders.

Sterling started off in positive fashion after better than feared UK manufacturing data and a report by the NIESR that gdp growth stabilised at -1.5% q/q in the 3-month period to March vs February. This added to hopes that the UK economy may be stabilising. The gilt auctions were on the whole well covered and helped to assuage fears of waning investor confidence in sterling. £/$ rallied to a 1.4859 high early in the week and subsequently settled back above 1.47. One-month £/$ volatility fell to 14.685, the lowest level since the end of September last year. Positive sentiment vis-a-vis sterling also squeezed €/£ below 0.90 for the first time in 4 weeks to 0.8961. Onemonth €/£ volatility fell for an 8th consecutive session on Friday to 14.185, the lowest since October last year.

Comments by ECB governing council member Provopoulos that interest rates could fall below 1% and worries about the euro zone economy were blamed for the weak euro. Irish 5y CDS spreads spiked back above 200 after the Irish government unveiled a second emergency budget in six months and imposed tax increases and public spending cuts to prevent the budget deficit from spiralling above 10% of gdp this year.

An upward revision to Q1 earnings estimates for Wells Fargo and Wal-Mart and a fall in the US February trade deficit to $26bn, the lowest since 1999, helped to bolster confidence in the economy and equity markets. This is helping to lift commodity and emerging market currencies, but we also believe that this should eventually support the dollar against other G7 currencies. The rapid decline in the US trade deficit in particular, supported in February by higher exports and lower imports, should bode well for the US current account and may help to mitigate some of the downward pressure stemming from concerns about foreign exchange reserve diversification in developing economies and sovereign wealth funds. The S&P 500 rose to 850 on Friday for the first time since February, extending gains to 28% since hitting the March low of 666. Where the index goes from here may be influenced by the raft of US Q1 earnings results in April. The A$ shook off the 25bp interest rate cut by the RBA to 3.0% and strengthened against the dollar to within a whisker of 0.72. The Mexican peso strengthened 3% against the dollar and $/rand fell below 9.0 to a 6-month low.

Interest rate market review - bonds, cash and swaps

The Bank of England left interest rates on hold at 0.5%, as expected. Indeed, this is likely to be the low for rates and the focus in the coming months will be on quantitative easing policy. There were concerns about Governor King's previous comment that the scale of quantitative easing could be scaled back, but the press statement following the interest rate announcement contained no new information and merely reiterated that the Bank will continue with its initial programme of £75bn of asset purchases. In terms of economic data, industrial production fell 1.0% in February and was down 12.5% compared with a year ago. However, it was the smallest monthly fall for six months. The National Institute for Social and Economic Research estimated that Q1 GDP fell 1.5% q/q, similar to the 1.6% fall in Q4, with the worst of the downturn during December and January. Other data showed tentative evidence that the trade position may be improving. The trade deficit in goods fell more than expected to £7.3bn in February, compared with £7.8bn in January, with non-EU exports rising strongly. Annual producer input price inflation fell to -0.4%, the first negative figure since August 2007. Factory gate inflation was also moderating. Over the week, benchmark 10yr gilt yields fell 13bps to 3.29%, with the fall helped by the Bank of England's ongoing gilt purchases. 2yr gilt yields and 5yr swaps were slightly lower at 1.37% and 3.20%, respectively. Sterling 3m libor fell 5bps to 1.56%.

The Reserve Bank of Australia cut interest rates by 25bps to a 49-year low of 3%, despite a majority of analysts expecting no change, and left the door open for further reductions. The Bank of Japan left kept rates unchanged at 0.1%, as expected, but broadened the range of collateral it will accept to encourage more lending in the economy. In the US, the minutes of the March 17-18 FOMC meeting revised down growth forecasts for the second half of this year and in 2010. The minutes said that the sharp fall in foreign economic activity was one of the most notable developments, while credit conditions remained tight and financial markets remained fragile. Fed member Fisher said that US unemployment could surpass 10% by the end of the year and that inflation is unlikely to be a serious threat. However, treasury yields were pulled higher by the unexpectedly sharp fall in the trade deficit to $26.0bn in March from $36.2bn in February, which may lead to a smaller decline in Q1 GDP than previously expected. US 2yr treasury yields were little changed on the week at 0.96%, but 10yr yields rose 10bps to 2.94%. Dollar 3m libor fell for the fourth consecutive week to 1.13%, but 5yr swaps rose 10bps to 2.48%.

Euro zone bond yields were weighed by weak economic data and comments from some ECB officials that benchmark interest rates could fall below 1%. Euro zone retail sales were down 4.0% in the year to February, while German factory orders and industrial production slumped 38.2% and 20.6%, respectively, over the same period. Eurostat also revised down Q4 GDP to -1.6% from -1.5%. Acknowledging the risk of an even deeper recession than in the ECB's current staff forecasts, Council members including Nowotny and Provopoulous, talked openly about the possibility that interest rates could fall below 1%, though ECB President Trichet reiterated that the discount rate has reached a low at 0.25%. ECB speakers also confirmed that an announcement of further nonstandard policy measures will be expected at the next meeting in May. Such measures could include purchases of corporate paper and lengthening loans provided to banks to 12 months. German 2yr bund yields fell 12bps to 1.38%, 3m libor fell 5bps to 1.43% and 5yr swaps were little changed at 2.89%, though 10yr bund yields rose 4bps to 3.26%, supported by slightly higher equity prices.

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