Gains in global equity markets and further declines in volatility provided most of the impetus for currency markets this week. The A$ and NZ$ were among the best performers as equities scaled 4-month highs. Both currencies gained more 3.5% vs the dollar. Sterling firmed 1.4% vs the dollar but sharp gains early in the week vs the euro were unwound on Thursday following the decision by the BoE to increase gilt purchases by £50bn. The euro strengthened against its major counterparts after the ECB cut its benchmark interest rate to 1% and announced plans to purchase covered bonds to help restore credit growth in the euro zone. The Mexican peso posted the biggest gain in emerging markets after fears about a swine flu pandemic eased. The ECB decision also bolstered demand for eastern European currencies, with the Hungarian forint out performing its regional peers.
Confidence that the worst of the global economic downturn may be easing and fears of rising government debt supply were central to the performance of global financial markets this week. On the whole, better than expected economic data from the G10 countries and the muted response to the US bank stress test results helped to underpin demand for risky assets. The FTSE-100 climbed above 4,500, stretching the rally to 28% since March. The S&P-500 climbed above 900, supported by the recommendations of the Fed and US treasury that an extra $75bn in capital should be enough for the 19 largest US banks to get through the recession without further government support. Commodity and emerging market currencies attracted strong demand perhaps as participants punted that the injection of liquidity by central banks and economic recovery will boost demand for natural resources. The C$ and A$ were also buoyed by reports of positive April employment growth in Canada and Australia. A jump in crude oil prices to $58pb, up 40% from the February low, helped $/C$ to fall below 1.16 to a 6-month low. £/C$ fell to a 3-month low below 1.75. The Russian rouble also continued its good performance of late and strengthened to below 32.50 vs the dollar as crude oil and natural gas prices rose. In Asia, $/won fell below 1,250 and $/baht slipped below 35.0.
Sterling drew support from the bigger than forecast rise in the UK services PMI in April to 48.7. This marked the biggest monthly rise since December 1999 and helped to support optimism that the contraction in UK gdp may slow in Q2. The BoE MPC added its support to this view when it said on Thursday that it sees promising signs in the UK and abroad that the pace of decline in activity 'has begun to moderate'.
The dollar was unable to draw support from the improvement in US economic data. The dollar ended the week lower against its major counterparts (except vs the yen) despite smaller than expected declines in April employment and a stronger than forecast rise in the non-manufacturing ISM survey. The US unemployment rate rose to 8.9% in April, but the smallest drop in employment since last October bolstered hopes that the pace of the recession may be easing.
Interest rate market review - bonds, cash and swaps
Further signs that the global economic downturn may be moderating and the release of the stress test results of US banks, which were less negative than expected, supported equities and commodities, and weighed on sovereign bonds. The Bank of England left interest rates on hold at 0.5%, as widely expected, but surprised the markets by announcing earlier than expected the next tranche of its quantitative easing programme. The ECB cut the main refi rate by 25bps to 1%, also as expected, and left the deposit rate on hold at 0.25%, thus narrowing the corridor to 75bps. The ECB announced it would be extending the maturity of its LTROs from 6 months to 12 months, which was anticipated, but it surprised the markets by indicating its intention to buy covered bonds. Elsewhere, the Norwegian central bank cut interest rates by half a point to 1.5%, while the RBA left rates on hold at 3%, both as expected.
The results of the US government's stress tests were widely leaked, but suggested that 10 of the 19 largest banks would require fresh capital totalling $74.6bn to withstand credit losses in a pessimistic scenario. Financial markets were buoyed by the results which were less negative than feared. Economic data releases also lent support to hopes that the world economic downturn was moderating, though activity still remained very weak. The services PMI surveys in the US, euro zone and UK were all better than expected, though still well below the 50 level separating growth and contraction. US nonmanufacturing ISM rose to 43.7 from 40.8, while the euro zone services PMI was revised up to 43.8 from 43.1 and higher than 40.9 in March. In the UK, the services PMI rose to an 8-month high of 48.7 from 45.5, while the construction PMI jumped to 38.1 (though still very weak) from 30.9. In addition, US non-farm payrolls fell less than expected by 539k in April, the smallest drop since last October, though the jobless rate rose to 8.9% from 8.5%. German factory orders increased unexpectedly in March by 3.3% on the month and industrial output was also better than expected.
Medium and long-dated bond yields rose in the US, Germany and UK. US 10yr treasury yields topped 3.30% for the first time in 6 months, while 30yr yields also jumped above 4.30%, partly due to a disappointing auction of the long bond. Yet, US treasuries may find some support in the next couple of weeks, as supply dries up. In the euro zone and UK, bond yields also rose in spite of decent demand in government bond auctions and the comment by ECB President Trichet that benchmark interest rates may not have bottomed. The ECB's decision to buy €60bn of covered bonds was unexpected and is not strictly quantitative easing since the purchases will be sterilised. Bunds fell nevertheless because the measure may help improve the flow of credit to the wider economy, especially in Germany which has a significant Pfandbrief market. Overall, German 10yr bund yields rose to 5-month highs above 3.40%, resulting in the steepest 2s/10s spread since the inception of the euro.
In the UK, financial markets shrugged off house price data from HBOS which showed another monthly fall. The Bank of England's announcement that it would buy another £50bn of assets as part of its quantitative easing programme came earlier than expected, but was less than the additional £75bn maximum that it could have employed. The announcement helped keep 10yr gilts yields below 3.80%, though they were about 20bps higher than last week's close. The Bank's statement on economic prospects was guarded, noting "promising signs that the pace of decline has begun to moderate", but the "timing and strength of that recovery is highly uncertain". Fiveyear swaps rose temporarily above 3.40% for the first time since last December. Interbank rates in the US, UK and Germany continued to decline, with dollar 3m libor falling below 1%.
Lloyds TSB Bank http://www.lloydstsbfinancialmarkets.com
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