Sunday, December 13, 2009

Financial Markets Review : Fiscal Outlook Weighs on Sterling

Financial market review - foreign exchange

Sterling lost further ground this week, primarily against commodity currencies but also against the yen as concerns over the UK's triple-A status resurfaced and the Pre-Budget Report failed to clearly outline a credible plan how to cut the mediumterm budget deficit. The pound did, however, manage to eke out minor gains against the more defensive currencies (eur and Swiss franc) with GBP/EUR ending the week at 1.11.
Sterling sold off sharply at the start of the week following weaker than expected industrial and manufacturing data which came in flat on the month. In the three months to October, manufacturing output contracted 1.4%. Sterling declined from the high of the week of 1.6516 against the US dollar down to 1.6240. A report from Moody's suggested that the US and UK were most at risk of losing their triple-A credit rating, weighing heavily on sterling crosses. There was some support from other economic data during the week but the lower tier data was overshadowed by the Pre-Budget Report, which sent sterling to new lows for the week (1.6168 versus the USD and 0.9095 against the euro) as the market remained wary regarding the outlook for fiscal policy. The MPC decision resulted in no change to Bank rate or the APF as expected. Sterling recovered against the euro on Friday, however, as the euro bore the brunt of a sharp dollar rally.

After last week's poor performance, the Japanese yen was the outperformer in the G-10 space this week, rallying 1.4% versus the US dollar. The dollar had an encouraging week, posting gains against all the G-10 currencies except for the yen and New Zealand dollar. The euro, Swiss franc and Swedish koruna lost the most ground on the week.

The USD dollar index convincingly broke out above its downward trend line (March '09 high to Nov '09 low) and also crossed above its 50 day moving average this week. Whether this is the start of a major trend reversal remains to be seen but the reaction of the dollar towards economic data appears to be shifting back towards fundamentals with the dollar rallying on the back of positive surprises. As well as the reaction to the US labour market data last week, positive surprises in Friday's retail sales report and the University of Michigan confidence survey led to a broad-based dollar rally. Retail sales posted a 1.3% rise in November following a 1.1% gain the previous month. Ex-autos, retail sales rebounded by 1.2%. Coming a day after the better-thanexpected US trade data for October, the numbers suggest annualised gdp growth could accelerate through 3% in the final quarter . The reports sent the dollar to fresh highs for the week on widening interest rate spreads.

There was little top tier economic data released this week in the eurozone. German factory orders contracted unexpectedly in October by 2.1% while industrial production also surprised to the downside, falling 1.8%. The euro fell 1.6% versus the dollar this week and 0.3% against the pound.

In the emerging market space, USD strength was also evident. Eastern European currencies suffered the most with the Polish zloty (3.9%), and Hungarian florint both declining against the dollar as concerns about Greece's downgrade weighed on the Eurozone peripherals.

Interest rate market review - bonds, cash and swaps

Government bond yields rose for a second consecutive week in the UK and the US following weak investor demand at US Treasury auctions and much stronger than expected US November retail sales data. Optimism surrounding US Q4 GDP growth squeezed yields higher along the curve, but selling was mostly concentrated at the longer end. UK 10y yields surged over 3.85%, with pessimism about UK public finances stoking concerns about a futures ratings downgrade. In the US, 30y yields cleared 4.50% and caused the 2y/30y spread to hit a 29year-high above 370bps. Euro zone bunds outperformed gilts and treasuries, with yields closing lower pretty much across the curve.

It was a one-sided story for longer term yields this week in the US and the UK. After a fairly good start on Tuesday at the US 3y note auction, demand weakened for 10y paper on Wednesday and 30y bonds on Thursday, forcing a considerable concession in yields from which gilts and Treasuries would not recover. Gloom spread and yields snowballed on Friday when US retail sales data for November topped forecasts and led participants to bump up their projection for real US Q4 GDP growth to 4% or more. The breach of technical resistance levels at 3.78% for UK 10y yields triggered selling up to 3.86% on Friday, a one-month high. The 2y/10y spread widened to 276bps, the highest since mid-November.

The BoE decided on Thursday to leave Bank rate on hold at 0.50% and also reaffirmed the target for asset purchases at £200bn. Data wise, UK manufacturing output disappointed with a flat m/m outcome for October. A stronger CBI industrial trends survey for November projects stronger output levels in the months ahead so manufacturing should catch up. The NIESR reported a 0.2% GDP increase in the three months to November. This marks the first rise since May 2008 and fuels hopes that the official ONS estimate will also show GDP growth in Q4. Finally, on Friday the ONS also reported a 0.1% m/m increase in input prices, but a surprise 0.1% drop in core output prices assuaged concerns about factories passing on higher prices to retail. Separately, the £3.75bn 2019 gilt auction drew solid demand and was covered 1.81 times. A busy week in corporate deals saw the following names come to market: Infinis for £275mn at 647bps over gilts, Genfinances issued £250mn at 170bps over, Aegon launched £400mn at 235bps over, Stagecoach tapped investors for £400mn at 255bps over. Coventry launched £500mn at 69.1bps over. 5y swaps ended the week virtually unchanged at 3.12%. 3-month libor was unchanged at 0.61%, but 12-month libor edged up 1bp to 1.24%.

US Treasury yields spiked after disappointing 10y and 30y auctions, with sellers of fixed income paper rushing unwinding holdings after the strong November retail sales data bolstered optimism for a solid Q4 GDP outturn. Yields moved through key technical levels at 3.50% in 10y and 4.47% in 30y. The 2y held up around 0.80%, causing 2y/10y and 2y/30y spreads to widen to 274bps and 371bps, respectively. Westpac ($3bn), Time Warner ($2bn), Blackrock ($2.5bn) and Boston Scientific ($2bn) were among the biggest USD corporate issuers. 5y swaps closed the week 1bps higher at 2.64%.

A strong relative performance for euro zone bunds saw yields end the week lower vs gilts and Treasuries, despite fears of sovereign default in Greece and wider peripheral spreads. The flight-to-quality from countries with high public deficits paper and unexpected declines in German October industry orders and output helped bund yields to decouple from Treasuries and drift to a lower weekly close. The German Finance Ministry will release its 2010 borrowing calendar next week. The ECB will hold its last one-year tender next week Wednesday, marking a step towards the unwinding of unconventional credit measures. SocGen and BBVA were the principal euro issuers in an otherwise fairly quiet week for corporates. 5y swaps dropped 5bps to 2.68%.

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