Sunday, October 18, 2009

Financial Markets Review : Pound Bounces Back as Market Perceives an End to QE

Financial market review - foreign exchange

Sterling bounced back sharply this week, crowning the week as the best performing G-10 currency over the last five days. GBP/USD closed the week at $1.6350. GBP/EUR rallied up towards €1.10, eventually closing at €1.0980. UK economic data were slightly upbeat, with the BRC (British Retail Consortium) indicating a rise in retail sales in September. Likewise, the RICS (Royal Institution of Chartered Surveyors) house price balance report showed another increase in the number of surveyors reporting increases in house prices. The sterling positive response to these reports was countered by the CPI report, when inflation fell by more than expected, to 1.1% in September. The trigger for the large sterling rally occurred in the form of speeches from Charlie Bean and Paul Fisher (members of the Bank of England's monetary policy committee). The market perceived their comments to suggest that the Bank's quantitative easing programme may be reduced or even paused in November - resulting in a rapid purchase of sterling against most currencies. Our opinion remains that the Bank will continue its quantitative easing programme next month.

The US dollar has been one of the weakest G-10 currencies this week - only the Japanese yen fared worse - resulting in the USD index recording a 14-month low, 75.2. Equity and commodity markets continue to provide a USD negative backdrop. Equities have been supported by a raft of companies reporting strong Q3 earnings - resulting in the S&P500 breaking to a 12-month high. Commodities have tracked equities higher, breaking up and out of their recent consolidation formation.

The Australian dollar has rallied further against the USD, closing the week only 7% below the high ($0.9850) recorded in July 2008. The AUD has been supported by commodity prices. Additionally, Reserve Bank of Australia's Governor Stevens, reiterated that interest rates need to move to more neutral levels and that the high level of the Australian dollar reflects strength in the economy. Short term interest rate futures contracts moved to discount further tightening in interest rates, providing a boost to the Australian dollar via cyclical support.

US economic data were mixed this week. Retail sales (ex autos) and empire manufacturing reports pushed higher. Consumer price inflation rose by more than expected in September. The report led to a widening in US/G-10 interest rate spreads, triggering a short term rally in the USD. Consumer confidence (University of Michigan survey) and business confidence (IBD/TIPP index of economic optimism) both pulled back, lower, in October. The softer consumer confidence report, on Friday afternoon, weighed on equities and gave the US dollar a small defensive boost, into the end of the week.

Across emerging markets, the USD has followed the theme of broad based weakness - falling against the majority of the highly traded emerging market currencies. The Brazilian real performed well, rallying 1.8% against the USD. As a large commodity exporter, Brazil's currency benefited from the move higher in commodity prices. The Hungarian forint and the Polish zloty were the best performing emerging market currencies, rising 2.3% against the USD. Improving Chinese trade data (showing an easing in export and import declines) also helped lift sentiment for emerging market currencies.

Interest rate market review - bonds, cash and swaps

Government bond prices and yields rose sharply this week following better than expected corporate earnings results from the financial sector and comments from central bankers. Goldman Sachs and JP Morgan's Q3 earnings reports both surprised to the upside providing a boost to equity markets with the major indices finishing higher for the second consecutive week. Comments from the Bank of England hinting at a possible pause in QE sent UK swap rates and gilt yields surging higher. 5yr swap rates had drifted lower at the start of the week down to 3.05% while 10y gilt yields reached 3.37% following softer UK CPI data before surging higher to close the week, at 3.27% and 3.60%, respectively. The encouraging corporate earnings and improving outlook for the economy kept equity markets well bid.

The early part of the week was dominated by the UK CPI and labour market data releases. Headline CPI surprised to the downside for the first time in months, slowing to 1.1% in the year to September. That said, it is likely that September will mark the trough in the inflation cycle. A more positive labour market report, however, showing a slowdown in the rate of unemployed helped stem the fall in gilt yields and swap rates. Comments from the Bank of England's markets director Paul Fisher, published on Wednesday, sparked a strong sell-off in gilts which continued into the close of the week. Fisher's comments that there were now signs that QE was working and that the forecast for the November Inflation Report (published on 11th November) were likely to be similar to August's were interpreted by the market that there may be a pause in the asset purchase programme next month. Fisher, did however, stress that no decision had as yet been made. The comments and market reaction highlight the importance of the November MPC meeting and Inflation Report. There was underperformance from the belly of the gilt curve with the 7-10yr segment ending the week up 24bps.

This week's gilt auction was reasonably received with the sixth sale of the 1.75% 2020 gilt auction achieving a bid cover ratio of 1.78. 5yr swaps ended the week up 14bps at 3.27%. The 2y/10y swaps curve steepened markedly, by 10bps to 204bps.

Corporate earnings from the financial sector took focus in the US this week sending Treasury yields and swap rates higher. Retail sales, despite falling 1.5% on the month following the end of the cash-forclunkers programme, were better than expected (consensus -2.1%) while ex-autos held up well rising 0.5%. The latest inflation data also showed a slowing in the rate of headline deflation while the core rate also ticked higher to 1.5%. Combined with better- than-expected industrial production, empire manufacturing and initial jobless claims data and the positive earnings surprises, US 10y yields rose from a low of 3.35% on Tuesday to end the week at 3.43%, up 8bps. 5yr swaps experienced a similar move, however the minutes of the FOMC meeting reiterated that rates would stay low for an extended period of time, despite the improving outlook for the economy leading to underperformance in US Treasury's and swap rates versus the eurozone and UK. The 2y/10y swap curve steepened sharply out to 230bps before flattening a touch on Friday following a disappointing University of Michigan confidence survey outturn.

The economic data calendar was fairly quiet in the eurozone this week. Apart from an in-line (with expectations) CPI outturn, the only other major data release this week was the German ZEW survey which registered a modest improvement in the current situation index. Economic sentiment, however, fell to 56.0 from 57.7, highlighting the slowdown in the rate of improvement in the economy. Eurozone swap rates followed UK and US swap rates higher across the curve although they were kept muted somewhat after comments from ECB President Trichet who reiterated that the time was not yet right to begin exit strategies from the various liquidity and credit easing measures currently in place.

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