Monday, October 26, 2009

Financial Markets Review : Pound Tumbles on UK Q3 GDP Shock

Financial market review - foreign exchange

Sterling fell sharply on Friday following the much weaker than expected Q3 GDP data - GBP/USD and GBP/EUR closed the week at $1.6337 and €1.0887 respectively. Prior to the GDP release, sterling had been rallying all week as one of the top G-10 currencies. The large speculative short position (that had been built up over the past month) was being squeezed out, leaving GBP/ USD looking to test $1.67 on Friday morning. Then came the GDP shock, a fall of 0.4% in output over the third quarter. The UK remained in recession and correspondingly GBP/USD faced strong selling pressure, falling 1.7% throughout the day. This reinforces our view that the Bank of England will expand its quantitative easing programme in November. This expectation of further asset purchases left equity markets supported - the FTSE100 closed 0.7% higher on Friday.

The US dollar has had another poor week, with the USD index recording a (marginal) 14-month new low. Equity and commodity markets continue to provide a USD negative backdrop. Q3 earnings reports from US companies have continued to provide positive surprises, allowing the S&P500 to probe resistance at 1,100. US economic data have also generally been positive for equity markets - industrial production, capacity utilisation, leading indicators and existing home sales were all reported better than analyst expectations.

The Bank of Canada (BoC) left the overnight lending rate unchanged at 0.25%. However the BoC did note that the heightened volatility and persistent strength in the Canadian dollar were working to slow growth. Additionally, the current strength in the Canadian dollar is expected to fully offset the favourable developments since July. This triggered a reversal in the USD/ CAD downward trend this week, leaving the CAD as the weakest G-10 currency.

The Swedish krona was the strongest G-10 currency this week, rising 2.1% against the USD and 1.4% against the EUR. The Swedish central bank left the repo rate unchanged at 0.25% on Thursday. Additionally it announced that it expected the eventual phase-out of stimulus measures globally not to cause another dip in the world economy. Alongside strong corporate earnings, this left equity markets supported. This provided a positive environment for the growth sensitive krona.

Across emerging markets, USD performance has been mixed with the Chilean peso rising the most (3.3%) and the Colombian peso falling the most (4.2%) against the USD. Chinese economic data have, on balance, been close to market expectations, supporting current growth expectations and allowing Chinese equities continue in their upward trend. Chinese industrial production data was stronger than expected, providing support for commodity markets and commodity linked currencies.

Brazil announced the introduction of a 2% tax on foreign portfolio flows (excluding foreign direct investment). This is an important milestone, especially if this is followed by other emerging market nations (particularly those that are managing their currencies). A reduction in portfolio flows would remove some of the upward pressure on the currency, thereby reducing the FX reserve build up at the central bank. Additionally, a pass through to a reduction in reserve diversification would remove some of the demand for developed market currencies against the USD.

Interest rate market review - bonds, cash and swaps

Gilts sold off sharply but managed to recoup some losses late in the week after the ONS reported a shock 0.4% q/q contraction in UK Q3 GDP, against consensus estimate of a 0.2% rise. This caused gilts to reverse part of the heavy losses accumulated earlier in the week and pushed 5y swaps to a 3.30% close vs a 3.43% intra-week high. US Treasuries and euro zone bunds were also characterised by higher yields, with some benchmarks testing key resistance levels on better than expected economic survey data and higher equity markets.

Asset markets were characterised by high volatility, epecially in the UK where markets are on tenterhooks for what the BoE will announce on QE in November. A negative set-up for rates and swaps on Monday sparked a sharp rise in yields as equities extended gains and markets interpreted the October MPC minutes as less dovish than thought. Comments by BoE governor King and Paul Tucker failed to clarify the BoE's intentions with regard to QE and gave ammunition to the bearish backdrop (higher yields). The MPC minutes sparked a surge in swap rates and a stampede out of short-dated gilts. 5y swaps shot up 19bps to 3.40%, breaching key technical levels in the 3.30% to 3.37% area. UK 2y yields touched 1.0% and crossed over US 2y yields for the first time in two months. Weaker than expected UK September retail sales data brought some relief and caused rates to reverse off the highs. Sales were flat m/m for a second month running, and the deflator fell to -0.5% y/ y from -0.4% y/y. Dealers stepped up the purchase of gilts and short sterling futures on Friday after the shock report of a 0.4% q/q contraction in the UK economy in Q3. This marked a 6th consecutive drop, the longest stretch of falling output since at least 1955. The consensus was for a 0.2% rise. The data instantly fuelled speculation that the BoE will announce additional asset purchases and a rise in QE from £175 at the November 5 MPC meeting.

On the issuance front, the DMO £7bn syndicated 2060 gilt auction was sold at 2bps below 2050 paper and orders totalled only £8bn. The 5%, 2014 auction was covered 1.56 times. The gilt is part of the Bank's APF so that explains the solid demand. We also noticed a pick-up in corporate supply. Scotland Gas Networks sold £125mn of 2039 paper at 175bps over gilts. NRW Bank of Germany sold £300mn of 2012 paper at 95bps over. Three-month libor for a third successive week, finishing up 3bps at 0.60%.

A surprise drop in US September PPI initially sparked a rally in Treasuries early in the week, with 10y yields slipping to a 3.31% low and the 2y/10y curve bull flattening in the process to 242bps. Better than expected company results added fuel to the rally in equities and led dealers to shift out of fixed income securities ahead of the Treasury's supply announcement for next week. Stronger than forecast outcomes for the September leading indicators and existing home sales (inventories at an eight-month low) boosted yields to the intra-week high on Friday, with 10y rates touching 3.47%. 5y swaps touched a 2.81% high and, ahead of supply and Q3 GDP data next week, look in danger of reaching the August high at 2.88%. Biggest dollar issuers this week included Fannie Mae ($3.5bn, 2014 issue) and Boeing ($1bn, 2014 and 2019 paper). Three-month libor was flat at 0.28%.

Stronger October PMI data and a seventh successive rise in the German IFO survey supported optimism that recovery in the euro zone economy is becoming more established, even as EUR/USD strengthened above 1.50. This pushed 5y swaps up to a 2.87% high on Friday. Bunds outperformed Treasuries and gilts, especially in the front dates where 2y yields fell 2bps. Morgan Stanley (€1.5bn), Bancaja (€1.5bn) and Caixa Cataluna (€1.5bn) were among the top issuers in euro paper. Three-month libor was unchanged at 0.80%. Average overnight daily deposits with the ECB were fairly stable around €75bn.

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