Sunday, July 26, 2009

Financial Markets Review : Equity Market Rally Lifts UK Yields and Swap Rates

Financial market review - foreign exchange

A powerful rally in equity markets and rising oil prices bolstered demand for commodity currencies and caused the dollar and the yen to weaken. The dollar index slipped close to the 2009 low as participants moved decisively into the C$, A$, NZ$ and sterling. The C$ was also underpinned by the decision by the Bank of Canada to reduce the duration of its liquidity operations from 12months to 9 months, and the Bank's statement that 'the recession is ending early'. Speculation that the BoE may draw a line under QE in August helped to bolster sterling and lifted £/$ to a 3-week high at 1.6586, though disappointing gdp figures sparked profit taking on Friday.

Stronger global economic data spurred hopes that the economy is recovering and helped equity markets to extend gains for a 2nd successive week. Key levels were breached to the upside in the S&P-500 and the FTSE- 100 and boosted positive momentum in commodity currencies and sterling. This caused currency volatility to fall further, especially in the shorter dates. The VIX index continued its decline and may test 20.0 if current trends prevail over the coming weeks. Demand for G10 currencies like the C$ and A$ surged as participants sought exposure to commodities. The South African rand and Colombian Peso were the best performers in emerging markets. The dollar was the principal causality during the rush for carry as participants increased exposure to risk. This led the dollar index to slump to 78.420, just 0.1% above the 2009 low of 78.334.

£/$ returned to the upper end of the 6-week trading range as the dollar fell. The BoE MPC minutes, comments by MPC member Sentance and strong UK retail sales data for June added positive impetus and helped £/$ to overcome resistance at 1.6550. Retail sales rose 1.2% in June and fuelled hopes of a positive surprise for Q2 gdp. The report on Friday of a 0.8% q/q contraction in Q2 gdp vs consensus of a 0.3% drop put paid to expectations of an imminent return to positive growth, but sterling selling was limited as participants concentrated on rising equities and mulled over the possibility that the BoE may not expand Quantitative Easing (QE) in August. The details of the MPC minutes and MPC member Sentance earlier in the week hinted that the Bank may decide against buying additional gilts or commercial paper. This helped to put a floor under £/$.

Stronger than expected data from the euro zone - the German IFO index rose to a 9-month high in June, caused the rally in £/€ to stall above 1.1656, but helped €/$ to close the week 0.59% higher at 1.4196, below Thursay's 6-week high of 1.4291. Stronger than expected French consumer spending and business confidence data underpinned optimism that the worst of the contraction in gdp has passed and may lead the ECB to adopt a cautiously more upbeat view about the prospects for recovery.

The Colombian peso and S. African rand gained 2.7% and 1.4%, respectively against the dollar, testifying to the inflow of investment flows in emerging markets as hopes grow of global economic recovery. Surprisingly, the Korean won failed to draw any strength on the report that the economy rebounded 2.4% q/q in Q2. $/ won ended the week flat at 1249.55

Interest rate market review - bonds, cash and swaps

Positive Q2 earnings surprises from a handful of US blue chip companies and stronger than expected economic data weighed on government bond prices this week and caused yields and swap rates to rise sharply. The decision by the Bank of Canada to reduce the term of liquidity operations and speculation that the BoE is moving closer to drawing a line under its £125bn QE programme compounded the squeeze upwards in yields. The shift in flows from bonds into equities was particularly painful for UK gilts where yields surged 16bps along the curve and 5y swaps rose above 3.70% to a one-month high. UK 3-month libor fell 3bps to 0.92%. Yields also edged up in the euro zone where stronger than expected outcomes for the German IFO survey and the euro zone PMIs buttressed confidence that the economy is on the mend.

Upward pressure on yields was relentless for most of the week until Friday when disappointing UK Q2 gdp data and profit taking in stocks helped yields and swaps to ease back. Market participants stepped up their purchase of equities, spurred by the report of a 3rd successive rise in US existing home sales in June (off a very low point) and enthusiasm over Q2 earnings. This pushed global equity indices to new 2009 highs and precipitated a sell-off in government bonds (higher yields and swaps, wider spreads), led by the UK where 2y and 10y yields shot up around 15bp.

UK June mortgage lending and retail sales data surprised to the upside and alongside the MPC minutes were important catalysts for the jump in gilt yields to the highest level since June 11. Mortgage loan approvals rose to 35,235 from 31,929, the highest since March 2008. Retail sales surged 1.2% on the month, lifting the annual growth rate to 2.9%, a 6-month high. Optimism about recovery quickly cooled on Friday, reinstating a bid in gilts (lowering yields) when the ONS reported a 0.8% q/q contraction in Q2 gdp, topping estimates for a 0.3% decrease. Annual gdp dropped to -5.6% from -4.9%. The 2016 gilt auction was covered only 1.70 times; not reflective of great investor support considering that this issue is part of the BoE's asset purchase programme (APF). Speculation about an end to the APF programme in August could dissuade some participants of bidding at auctions that precede the August MPC meeting, putting pressure on the DMO to offer the paper at a discount (higher yield). 5y swaps closed the week up 16 bps at 3.70%, leading to a steepening of the 3-month/5y swaps curve to 276bps.

US treasuries got a lift early in the week when Fed chairman Bernanke played down speculation that the Fed could soon implement an exit strategy from QE. Bernanke reiterated in his testimony to Congress on Tuesday and Wednesday that interest rates are likely to stay low and that inflation will stay subdued for some time. The Fed though later in the week decided to reduce the size of its auctions of cash to banks under the TAF to $125bn from $100bn. This is a consequence of a further improvement in funding conditions and is illustrated by a narrowing in the 3-month Libor/Ois spread to 30bps, the lowest since January last year. A 3rd consecutive gain in existing home sales and for the leading indicator in June supported the view that the economy is slowly improving. Participants are looking for a marked improvement in next week's release of Q2 vs Q1 gdp. 5y swaps fell 1bp to 2.98%.

Yields in the euro zone caught up with gilts and treasuries late in the week following a stronger than expected German IFO survey and euro zone PMIs for June. 5y swaps hit a 2.95% high. Euro zone 3- month libor fell 3bps to 0.92%, helping the libor/Ois spread to fall back below 50bps. Overnight deposits with the ECB remain stubbornly high and rose to 192bn euros on Friday.

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