Sterling faced considerable selling pressure this week as expectations grew that the Bank of England may move to charge banks for reserves held via negative interest rates. A fall in short-term yields weighed heavily on sterling, with EUR/GBP closing the week at £0.8811, a 12 week high. GBP/USD closed the week lower, at $1.6307. Across markets, the USD index was unchanged on the week and the S&P500 could rally only 0.4% despite a plethora of strong economic data. Commodity currencies (Australian dollar, New Zealand dollar and the Norwegian krone) have remained firmly supported as economic data continue to improve globally. As such, these currencies remain close to their years high. US-Japan interest rate spreads moved in Japan’s favour, leaving the Japanese yen supported. USD/JPY closed the week at Y93.50, resulting in the yen being one of the strongest performing G-10 currency this week.
In the emerging markets, the performance of the USD has been mixed. Latin American currencies have underperformed with the Mexican peso and Brazilian real recording the largest losses over the week, falling 3.3% and 2.4% respectively. Much of the weakness in these currencies occurred in the first half of the week, triggered by the selling pressure in both soft and industrial commodities. Eastern European currencies have generally appreciated against the USD this week, with the Icelandic krona gaining the most (2%). The currency rallied aggressively, shortly after the release of an above consensus consumer price inflation report.
In the G-10 space, sterling is heading into month end with another disappointing week. Sterling fell against every single G-10 currency as the effects of the recently increased quantitative easing programme and concerns that the Bank of England may no longer pay interest on bank deposits it holds, continue to reverberate across financial markets. Signs of improvements in the UK housing market - Nationwide house price index rose by 1.6% in August and British Bankers’ Association data, for July, showed a further increase in the number of loans for house purchases – were unable to provide any support for sterling. On the flip side, business investment data showed investment spending fell by 10.4% in Q2, the most since the second quarter 1985, triggered another slide in sterling.
US data have continued to improve, with Case-Shiller house prices, consumer confidence, durable good orders and new home sales all surprising higher. The impact of the positive data on financial markets has been muted this week. The S&P500 rose by only 0.4% whilst the USD index was unchanged. This most likely reflects quiet trading and thin markets with many investors away during the summer. German data also showed an improvement this week. The Ifo business climate survey moved to its highest since September 2008, showing further improvement in August. This bodes well for the German economy which moved out of recession in the last quarter. Consumer price inflation rose by 0.4% in August, above market expectations. EUR/USD managed to garner some support from the data, eventually closing the week at $1.4370.
Interest rate market review - bonds, cash and swaps
UK government bond yields and swap rates posted sharp falls this week, leading 5y swaps to an intraweek low below 3.30% and 2y yields below 0.90%. Speculation that the BoE could impose negative interest rates on commercial bank deposits sparked a flurry of gilt buying and squeezed yields lower across the curve. UK 3-month libor fell below 0.70%, causing the spread over Bank rate to narrow to 19bp, the lowest level since February 2008.
There was no obvious trigger from economic data or central bank speeches to generate the solid display of buying interest in fixed income paper. With economic data, especially from the US, springing positive surprises and the FSTE-100 breaking above key resistance levels, yields stayed surprisingly soft. Yields were mostly guided by technical flows, month-end portfolio extensions and strong US auction participation, though some rotation out of bonds into equities took place on Friday.
UK economic data came in a tad stronger than forecast for the CBI distributive trades survey and the second estimate of Q2 gdp. The CBI survey for expected September sales rose to -14, the highest since July 2008. Consumer confidence held unchanged in August at -25 and Q2 gdp was revised up to -0.7% q/q, despite a sharp 10.4% contraction in business investment. Household consumption fell 0.7% and inventories dropped by a further £4.5bn. Government spending rose 0.8% and net trade improved due to a sharp fall in imports. The annual gdp deflator accelerated to 1.3% y/y from 1.0%, leaving a still very benign inflation backdrop.
A fall in UK wage inflation data for the May-July period was reported by the Income Data Services and helped to lower yields. A fall in 5y swaps below the 200-day moving average of 3.30% sparked a move to 3.27%, but rates bounced back on Friday to a close of 3.34%. This completes a near 50bps decline from the June top. A 3bp drop in UK 3-month libor caused the yield curve to flatten to 263bp. A fall in 10y swap spreads to 34bp, a near 4-week low, underscores the stronger appetite for riskier assets.
The US Treasury auctioned $109bn in 2y, 5y and 7y notes this week and managed to attract solid overseas demand, despite the fall in yields and rise in Treasury prices in recent weeks. This may have calmed market fears about a surge in government paper issuance in a week where the US Congressional Budget Office (CBO) revised up its public deficit forecast for 2009 to $1.6 trillion or 11.2% of gdp, the highest since World War 2. The CBO calculates that the total deficit could reach $7.4 trillion over the next decade. Yields also managed to shrug of stronger than expected reports of US August consumer confidence, July durable goods orders and house prices and new home sales. US house prices have now risen for the last two months and rising home sales have boosted hopes that supply will soon fall from still elevated levels. US 10y yields spent most of the week below 3.50% and closed 9bp lower on Friday at 3.44%. US 3-month libor fell to 0.35%, dropping below the Japanese libor rate. 5y swaps fell 13bp to 2.82%.
Stronger than expected German CPI data and a 5th successive rise inthe German IFO survey in August were equally unable to lift yields in the euro zone. The ECB is likely to revise up its 2010 gdp forecast next week but is not expected to change its bias on interest rates. EU-16 consumer and indutry confidence also improved, but the long end of the bund curve rallied on the report of a new record low in euro zone consumer price expectations. In contrast to the UK and the US, the 2y/10y bund curve steepened, led by the front-end. 5y swaps dropped 6bps to 2.78% and 3-month euro libor slipped to 0.80%.
Lloyds TSB Bank http://www.lloydstsbfinancialmarkets.com
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