Sunday, July 5, 2009

Financial Markets Review : Pound Falls on Weak Q1 GDP Data

Financial market review - foreign exchange

Range-trading continues to be the dominant theme in foreign exchange, with volatility gradually falling further in G-10 currencies. GBP/EUR is closing today at €1.1670, firmly within the 3-week range of €1.16-€1.19. Weaker economic data (Q1 GDP growth and current account reports) had helped to trigger a move below €1.16 earlier in the week, however this was short-lived with the euro unable to sustain the gain. The pound managed to briefly record a new high for 2009 against the USD. After trading up to $1.6743, GBP/USD fell back following weaker data. It closed today at $1.6338, which is within the $1.62- $1.66 range that is currently dominating. In other G- 10 currencies, the Australian and New Zealand dollars have weakened the most against the USD (falling 1.1% and 2.3% respectively) this week. This reflects the move lower in commodity prices. Oil is back below $70/barrel and soft commodities, such as corn and wheat, have weakened sharply. In Sweden, the central bank surprised the market by lowering the repo rate to 0.25%, providing some short-term selling pressure on the Swedish Krona. The central bank expects the repo rate to remain at this level for some time, although quantitative easing has not yet been introduced. Instead the economy will be supported by offering banks loans to a value of SKr100bn at a fixedinterest rate for 12 months. Whilst not physically intervening in the foreign exchange market this week, the Swiss National Bank has warned of further intervention to fight deflation should the franc appreciate further.

In emerging markets, the Brazilian Real and Russian Rouble have both weakened against the USD. The fall in equity markets and commodity prices, have highlighted growth concerns, supporting the move lower in these currencies. The Polish Zloty has been the best performer against the USD this week, rising by 2.9%. The Zloty's strength has been triggered by improving economic data and the approval of a $4.5bn lending programme from the World Bank.

Economic data have been mixed this week, with a number of reports unable to hold up to the high expectations that the markets had begun to discount. The weaker UK Q1 GDP and current account reports weighed heavily on sterling, reversing strength observed in the early part of the week. The service sector PMI was reported at 51.6, this failed to arrest the downward pressure on GBP/USD. On the whole, economic data have also disappointed in the US. Consumer confidence and non-farm payroll reports were weaker than expected. The negative correlation between equity markets and the USD (triggered by flight-to-quality) means that the USD was well supported after both of these data releases.

The ECB kept the refinancing rate unchanged at 1% this week. President Trichet's statement at the accompanying press conference was relatively neutral, having little direct impact on the euro. However a flight to safety, triggered by the US non-farm payroll report (which was released at the same time), weighed heavily on EUR/JPY, which fell by 1.8%.

Interest rate market review - bonds, cash and swaps

Weaker than expected US employment data and a slight decrease in the UK services PMI caused pessimism to resurface over the recovery prospects of the global economy. This helped bond yields and swaps to extend last week's decline as market participants moved away from equities. UK 5y swaps fell 3bp to 3.57% but a test of the June 18 low of 3.56% could set up a further drop depending on what the BoE announces next week with regard to the APF and the purchase of gilts or commercial assets. The gilt curve 2s/10s flattened to 249bp. US 2yr yields dropped below 1% and euro zone 3-month libor pursued its decline to 1.06%, squeezing the spread over the refi rate to just 6bp.

Weak UK economic data underpinned demand for gilts this week and demand for gilts at the DMO auctions did not disappoint. Consumer credit and mortgage lending data for May from the BBA were weaker than expected and the final downward revision of Q1 GDP to -2.4% q/q caused gilt prices to reverse and yields to fall back from intra-week highs. The services PMI fell only marginally in June to 51.6 from 51.7 but the drop, led by a decrease in the new business index below 50, was enough to rekindle concerns that the stabilisation in the economy in Q2 may still fall flat in the second half of the year as demand tails off. The data, supported by a 6% drop in crude oil prices, also helped inflation expectations - captured in UK 5y5y forward inflation rates - to fall back to a 6-week low below 4%. The record £5.25bn 2014 gilt auction was covered 2.56 times. The longer dated 2039 auction of £2.5bn was covered only 1.75 times, slightly better than the 1.59 bid/cover in April. 5y swaps closed the week down 3bp at 3.57%. UK 3-month libor dropped 4bp to 1.16%.

US economic data surprised to the downside this week and this played a major factor in the price action in government bonds. Consumer confidence and the June employment report came in decidedly weaker than expected and caused market participants to exit stocks and rush into Treasuries. The front-end outperformed and this pushed the 2y yield back below 1% for the first time since June 5. Consumer confidence fell to 49.3 in June from 54.8 in May, posting the biggest drop since February. The 20-year average is 96.9. The monthly non-farm payrolls report surprised to the downside with news that 467,000 jobs were lost in June. The unemployment rate edged up to 9.5%. A 0.3% decline in hours worked and a fall in annual earnings growth to 2.7%, the lowest since September 2005, underlined the benign inflation outlook and this supported the case to hold government bonds. Futures markets pared back expectations that the Fed will raise interest rates this year. The December futures contract now discounts a probability of only 26% that interest rates will rise by year end, down from over 50% one month ago. 5y swaps fell to a one-month low of 2.80%, but closed the week down 9bp at 2.83%. The 10y yield closed the week at 3.50%. The US Treasury also announced it will auction $73bn in bonds and notes next week. Nearly half of the auction size, or $35bn, will be taken up by 3y notes.

The ECB left the repo rate on hold this week at 1%, but bunds drew some strength from comments by president Trichet that 1% is not necessarily the lowest level. Economic data has recently turned out pretty much in line with the ECB's own projections for growth and inflation, but the possibility that leading activity indicators start levelling off and a potentially longer episode of below-target inflation could still lead the ECB to lower interest rates or consider additional unconventional measures to support credit growth. Data this week showed a rise in euro zone May unemployment to 9.5% and a 0.4% decline in May retail sales. Moody's downgraded Ireland's government debt rating to Aa1 from Aaa, but 10y Irish/German spreads responded with no change (229bp). However, Ireland's sovereign CDS rose 7bp to 193. Euro zone 5y swaps ended the week 7bp lower at 2.81% and 3- month euribor fell back to 1.06%

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