Sunday, June 7, 2009

Financial Markets Review : Dollar Rebounds after US Jobs Data Surprise

Financial market review - foreign exchange

The pound had a volatile session this week, as rising political tensions in the UK eventually outweighed the positive impact of a series of promising economic data. After strengthening to fresh 2009 highs, past 1.66 and 1.165 versus the dollar and euro respectively, a cluster of high profile ministerial resignations saw the pound ultimately end the week lower against both. Tensions are likely to persist into next week, as the results and implications of Thursday's European and local elections unfold. £/$ closed the week 0.9% lower at 1.6011, while £/€ ended 0.27% up at 1.1444. The US$ was buoyed by data showing non-farm payrolls declined by a much smaller than expected 345,000 in May, the least since September, indicating that the pace of the recession may be easing. This saw the US$ close higher against all its G10 peers this week, with the exception of the Australian $, which was lifted by the surprise news that the Australian economy had managed to avoid falling into technical recession after growing by 0.4% in Q1 2009. Aud/$ pushed through 0.80 for the first time since September. The worst G10 performer against the US$ this week was the yen, with $/Y driving through 98 on Friday after the US jobs data. After rising above 1.43 for the first time in 2009, €/$ closed the week 1.01% lower at 1.3991.

In emerging markets, there were strong gains this week for the Indonesian rupiah and Colombian peso, as foreign funds boosted purchases of domestic assets. Eastern European currencies were under selling pressure on concern that the Latvian central bank may remove the peg to the euro and devalue the Lat.

UK economic data this week provided further support to the view that the worst of the contraction may have passed. The closely watched PMI surveys all showed solid rises in May, with the services index indicating expansion in activity for the first time since April 2008. However, while there is a strong possibility that Q2 GDP growth will be significantly less negative than the 1.9% rate in the first quarter, it is premature to expect a return to outright growth. The Bank of England this week maintained Bank rate at 0.5% and kept the asset purchase programme at £125bn. The MPC expect the announced programme will take another two months to complete.

News that sharply fewer than expected US jobs were lost in May saw the US$ rally to its intra-week highs against its main trading counterparts on Friday. However, the unemployment rate rose to 9.4% in May, from 8.9% in April, the highest since 1983, underlining that the economic outlook remained poor. Data earlier in the week showed consumer spending fell for the second consecutive month in April, in spite of a sharp rise in incomes after recent government fiscal measures, as households bolstered their savings.

As expected, the ECB maintained interest rates at 1%, with ECB president Trichet describing the current level as 'appropriate' at the press conference. He also said that the pre-announced purchase of covered bonds would start in July. However, there were downward revisions to both GDP and inflation forecasts, indicating that further policy easing cannot be discounted.

Interest rate market review - bonds, cash and swaps

Optimism that the global economy is on the path to recovery triggered a sharp sell-off this week in government bond prices and so caused a sharp rise in global yields and swap rates. Fears over soaring government deficits and selling of US mortgage securities exacerbated the move upwards in US treasury yields and led 5y swaps to close the week up 49bp at 3.31%. A steeper rise in short dated yields led to a flattening of UK, US and euro zone yield curves. UK 5y swaps rose above 3.50% for the first time since last December. Libor rates in the UK, the US and the euro zone were little changed.

Gilt yields and UK swaps started their move higher on Wednesday after the report of a surprise increase in the UK services PMI to 51.7 in May. This marked the highest level since March last year and added to hopes that the worst for the economy is over. A rise above 50 signals expansion. The UK manufacturing PMI increased in May to a one year high, improving for a 3rd consecutive month to 45.4. Yields extended their upward move on Thursday and Friday, led by stronger US economic data and duration adjustments in the market of mortgage securities. A sell off in global government bonds on Friday squeezed 2y yields to a weeky close of 1.31%, up 23bp on the week. 10y yields increased 18bp to 3.92% and could target a move to 4% if economic data next week shows improvement in exports and manufacturing output. 5y swaps accelerated their move upwards on Friday, by clearing 3.50% and closing the week above 3.60%, the highest since December 1st last year. The DMO gilt auctions attracted strong demand this week. The 2019 auction was covered 2.3 times. The 2049 sale was covered 2.51 times, a substantial improvement in bidder participation compared to the failed 2049 sale in March.

The BoE kept base rates on hold at 0.50% on Thursday as expected. The Bank said it would look to complete the £125bn APF purchase programme in two months but also said that it would keep the scale of the purchases under review. The Bank has to date bought £77bn worth of gilts, leaving another £48bn to buy. However, with yields on 10y paper up nearly 100bp since the start of QE in March, some participants may start to wonder whether the BoE will need more than the £150bn agreed with the Chancellor. Despite the rise in nominal long term, 5y5y break evens were stable around 4%, showing no undue concern about rising inflation expectations.

US treasuries under performed gilt and bunds throughout the week and extended losses on Friday in the wake of the US May employment report and the rally in the Dow above 8,800. The US economy lost 345,000 jobs in May, the smallest decline in 8 months. However, the underlying picture tells a more sobering story and shows a still very depressed labour market situation characterised by a falling employment ratio and reduced working hours. The fact that there were no treasury auctions this week failed to stabilise investor demand and yields. The sale of $65bn of treasury notes next week could cause yields to extend their climb and put additional upward pressure on mortgage rates. 2y yields shot up above 1% on Friday to close the week above 1.20%, the highest in 6 months. 5y swaps surged 49bp to 3.31%, reaching the highest level since 18 November last year.

Euro zone bunds also sold off with some of the weakness credited for the ECB. The Bank left interest rates on hold at 1% on Thursday, and never gave the impression that interest rates will be lowered further. President Trichet was careful not to rule out a further reduction but emphasised that interest rates were now 'appropriate'. The Bank revised down its growth forecasts for 2009 and 2010 and said it will buy up to 60bn euros of covered bonds starting in July. 5y swaps rose 26bp to 3.10%.

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