Sunday, January 17, 2010

Financial Markets Review : Sterling Hits 4-Month High vs Euro

Financial market review - foreign exchange

Sterling ended among the best performers of G10 currencies this week, logging gains of 1.6% vs the Swiss franc, the Norwegian Krone and the euro. €/£ tumbled to a 4-month low of 0.8810 (£/€ 1.1350) after concerns flared up over the deterioration of public finances in Greece, and BoE MPC member Sentance hinted that he could vote for a pause in QE in February. The USD was under pressure for most of the week but managed to recoup some losses on Friday when a 1% drop in US equities triggered safe-haven flows and profit taking in high yield and commodity currencies. The Brazilian real dropped 2.6% vs the USD and 3.9% vs sterling. GBP/ZAR firmed 2.1% as gold retreated below $1,130.

A 5-day winning streak for GBP/USD pushed the cross to a 1.6355 high on Friday, before easing back on profit taking and a minor flight-to-quality bid on lower equities and weak US economic data. Doubts that the bounce in Q4 US GDP can be sustained into the early part of 2010 caused equity benchmarks to retreat off their highs and sparked a round of profit taking in the AUD, CAD and NZD which have all done very well since the start of the year. AUD/USD moved through 0.9300 this week, supported by strong Australian employment data and a widening in AU/US 2y rate differentials to 361bps. With a 25bps rate hike priced in for the RBA rate meeting in February, speculation could intensify of a larger 50bps hike if Q4 inflation data surprises to the upside next week.

GBP/EUR posted four successive days of gains, clearing key technical levels that could translate into further gains in the week ahead. MPC member Sentance set the ball rolling on Tuesday when he said that the time may have come for the BoE to adopt a wait-andsee approach in February. MPC colleague Barker sounded a less hawkish note on Wednesday and said that UK economic growth in the first half would be very patchy, but that conditions would improve in the second half of the year. The ECB decision to keep rates at 1.0% and put Greece on the spot with regard to its public finances put the euro under pressure and helped GBP/EUR to extend to 1.1350 on Friday, the highest since last September. EUR/JPY dropped back below 130.50 and could threaten to break below 130.0 if appetite for the euro continues to wane. GBP/ CHF also did well this week by firming to 1.6756.

The decision by China to increase commercial banks reserve requirements by 0.50% from January 18 caused only a minor blip on the radar, but could be a hint of more policy tightening ahead in the Chinese new year (starting February 14) as officials try to rein in speculative excesses and rapid credit growth. USD/CNY 12-month forwards strengthened a touch to below 6.60. The Brazilian real fell to a 3-week low on data showing foreign portfolio outflows and speculation that the Treasury will buy USD to curb real strength. GBP/BRL rose to 2.8963, a one-month high.

Interest rate market review - bonds, cash and swaps

Government bonds rose for a second successive week and yields fell back to late December 2009 levels, led by weaker economic data from the US and confidence that G7 central banks will keep interest rates low.

Strong demand at US Treasury auctions, declines below key technical levels and stagnating equity markets were credited for the follow-though drop in yields. The US outperformed the UK and the EU, with US 2y yields falling back below 0.90% and 5y swaps dropping below 2.75%, causing UK/US and EU/US basis spreads to widen. Greek 10y spreads over bunds resumed their widening trend on concerns over the country's deteriorating public finances.

UK data releases had no major impact on gilts this week as markets paid close scrutiny to comments by MPC members Sentance and Barker. Mr Sentance's comments were hawkish and hinted at his preference to pause asset purchases at the February MPC meeting. By contrast, Kate Barker sounded dovish and said that growth would be quite patchy in the first half of 2009, though would strengthen in the second half. The jury is out on what the MPC will do next, but the release of the January MPC minutes next week should give us a better understanding of the Bank's latest assessment. Data wise, the BRC reported an annual 4.2% rise in like-for-like sales in December, the strongest result since April. A decline in the RICS house price balance in December to 30% vs 35% and weak manufacturing output data weighed on yields and dragged 5y swaps below 3.20% for the first time since December 22. The NIESR reported on Wednesday that the UK economy grew by 0.3% q/q in Q4 2009. The first official ONS release is due at the end of the month. A big week lies ahead and will feature releases of December CPI and labour market data, and the January MPC minutes. 5y swaps ended the week down 13bps at 3.20%. 3-month libor was unchanged at 0.61%, causing a flattening in the spread with 5y swaps to 259bps.

The £2.25bn, 4.25%, 2049 gilt auction was covered 1.81 times, not a great participation rate considering the previous cover of 2.30 for this maturity. A very busy week for corporate sterling issuance resulted in nearly £4bn of capital raising. The biggest deals included Virigin Media (£875mn, 2018 paper, 325bps over gilts), Bank der Nederlandse Gemeenten (£700mn, 2013 paper, 70bps over gilts) and KFW (£600mn, 2014 paper, 34bps over gilts).

US government bonds had their best week since November, supported by a number of elements including dovish comments by Fed member Dudley (interest rates to stay low for 'at least 6 months'), weak December retail sales and softer than expected headline CPI inflation data. Treasury auctions including 3y, 10y, 30y paper were all very well supported, drawing strong participation and overseas bidding. The Fed's Beige Book reported further falls in lending and deteriorating credit quality. A fall in US equity indices on Friday helped 2y yields to extend below 0.90% and 10y yields below 3.70%, leaving the yield curve very steep around 280bps. 5y swaps ended the week down 16bps to 2.71%. Fannie Mae, Ford and Pepsico were among the biggest corporate USD issuers.

In the eurozone, the ECB kept interest rates on hold at 1% and refrained from making forward looking statements, sticking by its projection for growth and inflation published last month. The ECB intensified pressure on Greece to bring public finances in order, but this did not soothe interest rate markets as Greek 10y yields surged through 6.10%. Germany 2009 GDP data was a tad weaker than expected and tempered optimism for a stronger pick-up in 2010. 5y swaps closed the week down 10bps at 2.64%. Heavy sovereign supply from Germany was comfortably digested this week. France will sell as much as 12bn euros next week.

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