Sunday, October 11, 2009

Financial Markets Review : Pound Falls again as UK Manufacturing Data Disappoint

Financial market review - foreign exchange

Sterling has had a poor trading week, resulting in it being the weakest G-10 currency this week. GBP/EUR has closed at €1.0793, a fall of 0.77%. UK economic data have been mixed - whilst the services PMI rose to 55.3, marking the 5th consecutive monthly expansion in the sector, the August industrial and manufacturing production data showed heavy falls in production (2.5% and 1.9%, respectively). The weaker data weighed heavily on sterling. Further, the sharp rise in PPI output prices (over September) in an environment of weak economic growth all added to the selling pressure on sterling.

The US dollar also fell this week as equity and commodity markets rallied, supported by a strong opening to the US Q3 earnings season. The rally in commodity prices (the broad based CRB commodity index is 4.4% higher) left commodity currencies (Australian dollar, Canadian dollar, Norwegian krone and the New Zealand dollar) as the major outperformers this week.

The Swedish krona has also been one of the weaker G-10 currencies. Concerns over Latvia's budget and government considerations to better protect consumers holding euro-denominated loans are having a negative effect on the krona (foreign lenders want to see radical cuts in government spending). In the event of a currency devaluation (of the lat), Nordic (with a heavy focus on Swedish) banks would be left nursing losses, which could be extremely negative for the krona. Weak economic data, Swedish industrial production and orders (fell by 2.9% and 4.2% in August, respectively) also weighed on the krona this week.

The Reserve Bank of Australia (RBA) became the first G-10 central bank to raise interest rates from the current emergency levels. The cash target was increased from 3% to 3.25% on Tuesday morning. The RBA believes that economic growth will be close to trend rate next year and that the risk of serious economic contraction in Australia has now eased. AUD/USD rallied sharply following the increase in interest rates. It has closed the week 4.5% higher at $0.9040, its highest since August 2008.

There have been limited US economic data this week. The most important release was the service sector ISM report, which increased to 50.9. The first above 50 reading since August 2008 finally marks a return to expansion of the sector. This was positive for equity markets and triggered a rally in the S&P500, which had been under pressure the previous week. The USD index remained under pressure as equities rallied, recording a new 2009 low during the week.

Across emerging markets the USD has generally fallen against most currencies. The sharp rise in global equity and commodity markets has supported emerging market currencies. The currencies of major emerging market nations (Brazil, India and Russia) are correlated to the economic growth cycle and therefore have a tendency to rally alongside equity and commodity markets. The Chinese yuan is the most significant exception as USD/CNY is held relatively stable by China. The South African rand is the best performing currency this week, rallying 3.8% against the USD.

Interest rate market review - bonds, cash and swaps

UK government bonds attracted good support and this kept yields near 5 1/2 month lows after a run of disappointing activity data cast doubts over the strength of economic recovery. 5y swap rates touched a low of 3.03% and 10y gilt yields reached 3.35%, before drifting upwards into the close on Friday on stronger UK PPI data and a sell-off in US and euro zone rates. The release of UK CPI and unemployment data next week could set rates and swaps up for a test of key support levels as markets try to square low yields with the rally in equities and credit spreads. UK 3-month libor rose 2bps to 0.56%, signalling that rates have potentially hit a floor. With financial institutions set to exercise caution over inter-bank liquidity in the final quarter, we could see libor rates edge up a bit further over the coming weeks, leading spreads over base rate to widen.

The strong reception of three US Treasury auctions along with much weaker than expected UK manufacturing output data and solid gilt auctions helped gilts to extend gains over the early part of the week. UK manufacturing output slumped by 1.9% m/m in August, marking the biggest drop since January. In addition, the NIESR reported that GDP in the three months to September was flat, whilst August was revised down to +0.1% from +0.2%. The two data points cast doubts over the widely anticipated bounce in Q3 GDP and stoked speculation that the BoE may again vote to increase QE next month. The BoE kept base rate on hold at 0.50% on Thursday and said it would keep its £175bn asset purchase programme under review. Yields and swap rates reversed sharply on Friday, led initially by stronger than expected UK PPI output data for September. The selling was concentrated at the front end, where 2y yields spiked 12bps to 0.83%, arguably led by selling in overseas rate markets on reports that the Fed is looking to drain liquidity via reverse repo agreements.

The two gilt auctions this week attracted strong demand. The 4.5%, 2013 sale, was covered 1.99 times. The 0.625%, 2042 auction, was covered 2.19 times. We took note of another very slow market for corporate sterling issuance, despite the decline in swaps. The Coventry Building Society said it plans to issue £350mn in 10y bonds at 265bps over gilts. 5y swaps ended the week up 2bps at 3.13%. The 2y/10y swaps curve flattened 6bps to 194bps. 5y break even rates surged to 2.16% on Friday, closing 27bps higher on the week.

US Treasury auctions generally drew strong demand. Especially the 10y TIPS, 3y and 10y note issues drew good coverage, with overseas investors showing good appetite. The 30y bond auction struggled (2.7bps tail) and follow through selling squeezed 30y yields above 4.10%. The idea that the Fed is testing measures to withdraw liquidity spooked the bond market on Friday and caused 2y yields to jump above 0.95%. 5y swaps finished the week up 17bps at 2.70%. The 2y/10y curve steepened to 238bps (+3bps). US 3-month libor closed flat at 0.28% for a second consecutive week. Chunky corporate dollar deals were launched by Commonwealth Bank of Australia ($4bn), the state of California ($2.8bn) and the Baltic state of Lithuania ($1.5bn).

Euro zone yields followed the same upward path despite fairly dovish interest rate comments by the ECB at the monthly press conference and a downward revision to EU-16 Q2 GDP to -0.2% q/q from -0.1% q/q. German industrial output and new orders data arguably came in above forecast for September, but this was offset by a larger than forecast drop in the German trade surplus through lower exports. 5y swaps closed the week up 7bps at 2.72%. 3-month libor stayed at 0.70% for a second successive week. Abbey (€1.75bn), the EIB (€1.5bn) and Caja Mediterrane (€1bn) were the principal corporate issuers in euros. On the sovereign side, Ireland successfully sold €7bn of 2025 bonds at 165bps over mid-swaps.

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