Monday, July 13, 2009

Financial Markets Review : BoE Decides Not to Expand QE, for Now

Financial market review - foreign exchange

Foreign exchange markets have been marked by another week of range trading. GBP/USD, closing today at 1.6184 has held in the $1.58-$1.6750 range for 6 weeks now. Likewise EUR/GBP remains firmly within its (£0.84-£0.8870) 6 week range. The Bank of England has maintained the Bank Rate at 0.5%. The Bank's decision to delay any change to the size of its quantitative easing programme, leaving it at £125bn, surprised the market. Expectations had built that the Bank would increase the amount spent on purchasing assets (mostly gilts). As such the surprise decision provided a boost for sterling, with GBP/USD subsequently rallying up to $1.6380 which marked the high for the week. EUR/GBP faced strong selling pressure following the Bank's decision, recording the week's low at £0.8537. Overall short term (2-year) eurozone over UK interest rate spreads have moved against sterling, providing support for EUR/GBP during most of the week.

A weakening of the macroeconomic outlook (since last week's US non-farm payroll report) has left commodities and equities under pressure. The CRB (a broad based commodity index) is 12% below the 2009 high recorded in June. This environment is positive for the USD, which has outperformed against all G-10 currencies except the Japanese yen. The Australian dollar (a high yielding commodity-linked currency) was the worst performer, falling 2.8% against the USD. The yen, a defensive currency has outperformed in a period marked by flight-to-quality, rose by 4% against the USD.

The Russian ruble was the worst performing emerging market currency this week, falling 4.7% against the USD. Much of the weakness occurred on Friday when the central bank reduced the refinancing rate to 11%. Additionally the selling pressure on oil, which has fallen towards $58 per barrel, has also weighed heavily on the ruble. The USD has generally outperformed against most emerging market currencies this week, as falling equity markets have led to large capital outflows, leaving these currencies under pressure.

Industrial and manufacturing production, in the UK, weakened further in May, recording a 0.6% and 0.5% monthly decline in output, respectively. The report left EUR/GBP supported, which rallied by 0.5%. The UK's trade balance continues to improve, with the deficit narrowing to £2.17bn in May. The improvement in the latest trade balance report is due to a fall in imports as the level of exports remained largely unchanged. This suggests that domestic demand in the UK remains weak. The mixed outcome of the report left little impact on sterling. PPI output prices fell by 0.2% in May, bringing the annual rate down to -1.2%. The report was negative for sterling, helping to reverse GBP/USD strength, pushing the currency pair back below $1.62.

The US services ISM showed a further improvement, rising to 47.0. The series continues to suggest contraction in the service sector, however the pace of decline is slowing sharply this year. The above consensus ISM report helped to mildly lift growth expectations, providing short term support for GBP/USD. The US trade balance also improved in May, with the deficit falling to $26bn. These improvements are a structural positive factor for the USD.

Interest rate market review - bonds, cash and swaps

The decision by the BoE not to expand its programme of gilt purchases beyond £125bn caught markets by surprise on Thursday and initiated a sharp sell-off in gilts, causing the 2y/10y yield curve to steepen. Treasuries and bunds out performed gilts as yields fell, especially in the longer maturities, due to strong demand at the US treasury auctions, lower equity markets and a fall in crude oil prices below $60pb. In the money markets, euro zone 3-month libor fell to 1%, on par with the ECB repo rate. Libor rates also continued to fall in the UK and the US, causing spreads over central bank rates to narrow. 3mth Libor/5y swap curves flattened most in the US, followed by the UK and the euro zone.

The BoE took the view, for now, that further gilt purchases once the £125bn purchase programme expires are not necessary. The BoE will review its decision at the August MPC meeting when policy will be formulated on the back off the next Inflation Report. Market participants concluded that exiting gilts was the best strategy before the BoE makes its views known in the MPC minutes in two weeks time. The sell-off pushed 5y swaps up to a high of 3.60% and 10y yield spiked to 3.87%, a 3-week high. Weaker than expected producer prices data for May on Friday tempered some of the selling in gilts and a 3-month low for the FTSE-100 helped 5y swaps to fall back below 3.50% and 2y yields to cross back below 1.15%. The 3.50% level remains pivotal and the next move could depend on the outcome of the June CPI data next week. Annual PPI output prices inflation fell to -1.2% and annual PPI input prices inflation dropped 11.0%. The NIESR reported that the UK economy contracted by 0.4% q/q in Q2, but a downward revision to - 1.3% for the rolling 3-month period to May curbed optimism about an imminent return to positive output growth. The 18% slump in oil prices in July could keep downward pressure on producer prices over the summer.

Gilt auctions were well received overall this week, but the fact that the BoE will from next week reduce gilt purchases from £6.5bn and the uncertainty regarding an increase in QE above £125bn could make it more difficult for the DMO to fund future issuance. The new 2019 gilt with a 3.75% coupon was covered 1.96 times. Demand for the 2027 index-linked issue with a 1.25% coupon was on the low side of 1.64 but this still topped the 1.57 bid/ cover of February. UK 3-month libor fell 9bp this week to 1.05%. 5y swaps closed 11bp lower at 3.46%.

US treasury yields fell sharply throughout the week breaching key support levels as market participants reacted to disappointing economic data and moved out of equities and credit. A fall in the S&P-500 below 890 triggered further selling to a 2-month low of 869. The Michigan confidence survey fell to a 4-month low in June to 64.0, posting the biggest monthly drop since last September. Continuing claims rose above 6.8 million, an indication that the labour market continues to struggle and employment levels are still falling. Treasuries were also bolstered by very strong demand at the respective 3y, 10y and 30y bond auctions. The 10y auction recorded the highest bid/cover rate since 1994. This put treasuries on course for a fall below 3.40% by Friday. 5y swaps closed the week 23bp lower at 2.60% and 3-month libor fell 5bp to 0.51%. 3-month T-bills were steady within a range and ended the week at 0.17%.

Price action in the euro zone was dominated by a marked widening in 10y spreads between member states, partly led by the OECD warnings for the need for consolidation of pubic finances. French 10y yields over Germany rose 9bp to 45bp, the highest level since early May. The 10y spread for Belgium over Germany rose above 62bp. In money markets, 3-month euribor fell to 1, on par with the ECB repo rate. 5y swaps fell back to 2.78%.

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