Sunday, December 20, 2009

Financial Markets Review : Dollar Extends Gains, Bond Yields Fall

Financial market review - foreign exchange
The US dollar was the star performer of the week once again as the DXY dollar index reached its highest level since September and registered its third consecutive weekly gain. Sterling outperformed against the G-10 currencies except the Canadian dollar and the US dollar despite a sharp sell-off towards the end of the week following poor retail sales data. EURGBP posted five consecutive increases to end the week at 0.88860. Commodity currencies were once again hit the hardest with the Australian dollar the worst performer.

Sterling experienced a fairly volatile week due to a raft of key economic releases. The CPI report released on Tuesday kept sterling supported earlier in the week, coming in a touch above consensus, rising 0.3% in November, taking the annual rate to 1.9%. It was the unexpected decline in the claimant count measure of unemployment on Wednesday that really gave sterling a push, however, sending GBPUSD to an intra-week high of 1.6411. Adding to the upside news was a downward revision of 7k to October's rise in benefit claims to 5.9k. While the fall is an encouraging sign, it is too early to call a sustained turnaround in unemployment data. Our cautious view on the UK economy was reflected in the retail sales report on Thursday. Volume retail sales unexpectedly contracted 0.3% in November. The annual rate slowed to 3.1% from 3.7%. The report was even more disappointing given the general expectation that consumers would bring forward expenditure ahead of the increase in VAT on 1 January. Sterling plunged on the report to a low of 1.6080 versus the US dollar - a fall of three cents in 24 hours, exacerbated by thin trading conditions. GBPUSD rebounded modestly to end the week at 1.6087. EURGBP drifted lower all week, driven by euro weakness.

The US dollar index continued its upward break this week and is now 5.1% above the recent lows. Commodity currencies have taken the brunt of the pain with AUD down 2.4%, NZD down 1.9% and the euro down 1.8% over the week. While some of the dollar strength can be attributed to a fall in risk appetite stemming from sovereign risk concerns on Greece's downgrade, interest rate differentials have begun to turn in favour of the US dollar and we are starting to see the dollar gain on positive data surprises. Producer prices surprised to the upside in November while industrial production also reported an encouraging rise of 0.8%. Wednesday's CPI report showed inflation remains subdued. Core CPI was unchanged at 1.7% in the year to November although the headline rate jumped to 1.8% from -0.2% on base effects but in line with expectations. Apart from a fall in the Empire manufacturing, survey evidence was positive with a stronger Philly Fed and an improvement in the leading indicators index. The FOMC meeting on Thursday did not deliver any surprises with no change to the Fed funds target rate. Minor changes in the Fed statement showed a slightly more positive outlook for the economy and confirmation that many of the liquidity schemes would not be renewed down in February as planned.

The eurozone was dominated by the downgrade of Greece this week. The action weighed on the euro which suffered losses this week against all the major G-20 currencies except for SEK, NZD and AUD. The technical break below the euro's upward trend line versus the US dollar continued and the currency pair looks set to revert back to its 200 day moving average (1.4180).

Interest rate market review - bonds, cash and swaps

Government bond yields in the US and the UK fell for the first time in three weeks after technically oversold conditions and a decline in equities triggered a sharp retreat in yields on Thursday and Friday. For gilts, disappointing November retail sales aided the cause for lower yields and this offset the upward pressure from stronger CPI and unemployment data. Strong demand for fixed income paper on Friday led yields to close the week at the lows with UK 10y yields settling below 3.80% and 5y swaps at 3.11%, with the yield curve a touch flatter. UK 3-month libor ended the week 0.5bp lower at 60bps.

UK and US yields extended last week's move to the upside over the early part of the week, with 10y gilt yields touching 3.92%, the highest level since late July. Stronger than forecast UK November CPI and US November PPI data were blamed for the move upwards in yields over the early part of the week. UK CPI rose to 1.9% y/y from 1.5% y/y in October, topping consensus forecast of 1.8%. RPI rose 0.3% y/y vs -0.8% y/y, turning positive for the fist time since January. We expect annual CPI to top 3% in Q1 and average 3.2% in the first half of 2010 before easing back in the latter part of the year. Stronger than expected unemployment data added to the case for higher yields on Wednesday when it emerged that employment rose in November for the first time since February 2008. The claimant count total fell by 6,300, bringing the two-month average to -200. The ILO unemployment rate rose to 7.9%. Average earnings picked up to 1.5% y/y from 1.2%. The data squeezed 5y swaps to an intra-week high of 3.21% and 10y yields to 3.92%.

The tide turned on Thursday when UK retail sales surprised with a 0.3% drop in November vs consensus of a 0.5% gain. Demand for short-dated gilts was also boosted when the FTSE-100 posted its biggest one-day drop in three weeks (-1.7%). Weak November M4 data on Friday cast doubts on the effectiveness of QE with regards to increasing nominal spending, and this should keep speculation of a further increase in QE in the new year alive. The £850mn 2027 index-linked gilt auction drew modest demand on Wednesday and was covered 1.59 times, below the 1.64 cover of the July auction. Corporate sterling issuance completely dried up this week and is not expected to resume until early in the new year.

US Treasury yields also rose for the best part of the week but reversed on Thursday and Friday from oversold levels and on flight from soft equity markets as the S&P-500 retreated below 1,100. The Fed kept rates on hold at 0-0.25% as expected on Wednesday and said it will let liquidity schemes expire in February as planned. The Fed sounded more upbeat on the economy and reiterated that inflation is likely to stay subdued. Strong November PPI data boosted yields but the rise in 10y yields above 3.60% was promptly reversed by a benign outcome for November core CPI (unchanged at 1.7% y/y). Corporate issuance was fairly light with JP Morgan ($1.5bn, 30y) Windstream ($1.1bn, 2017) and ANZ ($1.25bn) among the principal names coming to market. 5y swaps ended the week 2bps lower at 2.62%. The 2y/10y curve spread touched a 277bps high.

In the euro zone, the last ECB one-year tender attracted bids for 96.9bn euros, with just over 220 institutions bidding for funds at an indexed rate. The German IFO survey rose to 94.7 in November vs 93.4. Bunds attracted good support throughout the week as news from Greece emerged. Participants are not convinced of the country's debt reduction plan and switched out of peripheral paper into bunds. 5y swaps fell below 2.60% to 2.58%, the lowest for the year. 2y yields dropped below 1.15% to a 3-month low. Greece raised funds by selling 2bn euros of 2015 floating rate notes in a private placement at 250bps

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