Sunday, August 16, 2009

Financial Markets Review : Yields Plummet on Dovish BoE QIR and Weak US Data

Financial market review - foreign exchange

Sterling has faced strong selling pressure this week, falling 1.2% against the euro and 1% against the US dollar. Most of the weakness occurred in the first half of the week as speculators sold sterling ahead of the Bank of England's Quarterly Inflation Report (QIR). The trigger for selling sterling had been last week's monetary policy meeting, where the committee decided to increase its Quantitative Easing programme (QE) by £50bn to £175bn. The Bank's central forecast, as reported in the QIR, shows inflation hitting the target (2%) in two years time when assuming nominal interest rates stay at 0.5% and a £175bn QE programme. Despite the risk that the QE programme could be extended further GBP/USD faced very little selling pressure beyond the Inflation Report. However these concerns remain in the background, given the Bank's fears that any recovery in the coming months could be slow and protracted.

The Japanese yen has been the strongest of the G-10 currencies this week. The yen has been supported by favourable moves in interest rate spreads, as Japanese economic data provided positive surprises. Equity-related flow data show a pick up in the trend of net flows into Japan over the past few weeks, supporting the yen. The Norwegian krone has also performed well this week. The currency found support following the central bank's announcement that interest rates may have to rise sooner than expected given the improvement in economic outlook. Commodity producers have benefited from the rise in commodity prices and pick up of Asian growth this year, making it likely that Australia and Norway will be amongst the first when it comes to tightening monetary policy.

Emerging market currencies have slightly depreciated against the US dollar, with much of the weakness occurring prior to Wednesday's US interest rate decision. Risk negative trading had dominated financial markets in the first half of the week, weighing on emerging market currencies. The Turkish lira was one of the under-performers, where the drop in capacity utilisation induced further selling pressure. The lira fell 2.1% against the USD over the week.

Whilst economic data remain at extremely low levels, they do however continue to move on an upward trajectory in the UK, providing some support for sterling. The British Retail Consortium reported further rises in retail sales and the latest survey from the Royal Institute of Chartered Surveyors indicated that the housing market continues to thaw. The UK total trade balance was also reported better than expected, with the long-term trend of increasing trade deficit reversing course providing a structural improvement for sterling.

Improvements in the trade balance are not limited to the UK - the US trade deficit also continues to shrink, which is USD positive. The US Federal Open Market Committee (FOMC) left the Fed Funds Target Rate and the size of the US quantitative easing programme unchanged. Equities and commodities rallied following the announcement and the USD came under selling pressure. German and French Q2 GDP reports (showing a rise of 0.3%) surprised the market this week, inducing a 0.75% rally in EUR/USD.

Interest rate market review - bonds, cash and swaps

Government bond yields and swap rates in the UK, the US and the eurozone posted sharp falls this week, spurred by the dovish BoE Quarterly Inflation Report (QIR) and weaker than expected US and eurozone CPI data. Participants looked past the surprise 0.3% q/q increase in German and French Q2 gdp, whilst treasuries also took comfort from remarkably good demand for US Treasury supply during the quarterly refunding and a lower than expected outcome for consumer confidence. US 10y yields dropped below 3.60% to a two-week low. UK 2y yields plummeted 37bps to end the week below 1% as markets reined back expectations of an early rise in Bank rate. UK 3- month libor fell 9bps to 0.77%.

The BoE IR and a lack of conviction to push equities higher were two important props for the gilt and short sterling markets this week. The BoE said that inflation is likely to stay below the 2% target over the mediumterm, even assuming that the recovery develops in line with the Bank's forecast. Overall, the report sounded the alarm about the intensity of the recession, and noted that the risks to inflation and economic growth were still predominantly downward. The report helped the December 2009/ December 2010 sterling curve to flatten to 203bps as dealers unwound positions speculating on an earlier rate rise, induced by the run of positive UK July PMI and housing market data.

UK labour market data, released on Wednesday, showed a rise of 24,900 on claimant count unemployment, taking the rate on this basis to 4.9%. The previous month's figure was revised down to a rise of 21,500 from 23.800. But ILO unemployment rose by 220,000 in the three months to June, implying a rise of 73,300 a month. The unemployment rate on this measure rose to 7.8%, the highest since 1996. Wage inflation accelerated to 2.5%, from 2.3% in May.

Weaker than forecast US economic data bolstered demand for government bonds and led participants to move out of equities into primarily short-dated fixed income paper, leading to steeper yield curves. Surprise falls in US July retail sales and the August Michigan consumer confidence survey triggered safe haven buying and caused 2y gilt yields to sink towards 0.90% late on Friday. 5y swaps dropped below 3.55% support and could test 3.50% support if UK CPI surprises to the downside next week. The £3.5bn, 2019 gilt auction was covered 1.89 times on Tuesday, evidence of solid investor demand despite the volatility of sterling. UK 5y swaps closed the week 23bps lower at 3.54%. The 3-month libor/5y swap spread narrowed to 277bps.

US treasuries completely reversed the sell-off experienced last week. Markets absorbed the $75bn refunding quite comfortably considering the Fed decision to slow treasury purchases. The 3y and 30y auctions in particular went well in terms of overall bidding and overseas buying. Dealers snapped up more short-dated government paper following weaker than expected retail sales and confidence data. The key takeaway from the FOMC meeting is that the Fed will complete its $300bn treasury purchase programme by the end of October rather than late September or early October. The Fed will evaluate at the September 22 FOMC meeting whether further purchases are necessary or whether it sticks to the current planned purchases of mortgage and agency debt. US 5y swaps plunged 51bps 40bps to 2.83%.

Eurozone bunds followed gilts and treasuries higher (yields lower), despite the stronger Q2 GDP data from Germany and the eurozone. 5y swaps fell sharply below 3% and ended the week at 2.81%. The 3-month euribor rate fell 1bp to 0.87%.

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