Financial Markets Review

Equities Rebound Strongly and Bond Yields Fall

Financial market review - foreign exchange

Risk appetite improved this week, reflected in a strong rebound in global equities, helping to underpin sizeable gains in some higher-yielding currencies. Commodity prices also rose, led by precious metals and crude oil. However, benchmark bond yields extended their declines as prices rose, with US 10yr yields falling to a record low of 2.91%, after the announcement that the Fed will potentially purchase $600bn of mortgage securities and further weak economic data. The US$ was weaker against its main counterparts, with the dollar index falling through 85 for the first time in three weeks, from a 2 1/2 year high of 88.46 last Friday. Within the G10, the Australian dollar saw the strongest gain against the US$, up by 3.8%, while the yen ended the week relatively unchanged. The pound also fared particularly well, £/$ rising 3.5% to 1.5295. Weak euro zone data saw £/€ briefly rally through 1.21 on Friday, though closing up 2.2% at 1.2070. Emerging market currencies saw the biggest gains this week, led by the Turkish lira and Brazilian real, as confidence improved but they still remained well off recent highs. The Indian rupee ended the week slightly weaker against the US$ following the terrorist attacks in Mumbai, while the Thai baht weakened on continuing political unrest in Bangkok. The Chinese yuan was steady, in spite of the surprisingly sharp 1.08% cut in the official lending rate this week.

In the UK, the focus was on the Pre-Budget Report and what new measures were introduced to mitigate the ensuing economic slowdown. In the event, there were few surprises, with a stimulus package equivalent to around 1% of gdp - headed by a 2 1/2% cut in VAT and support for small business and households - as largely anticipated. However, the government's medium-term borrowing plans looked aggressive, with a shortfall equivalent to 8% of gdp projected in 2009/10, from just 2.6% in 2007/8. Outstanding net debt was projected to rise to 57.1% of gdp in 2012/13, from 36.3% in 2007/8. The figures were based on Treasury economic projections, which were generally more optimistic than those of independent forecasters and the Bank of England. Following the chancellor's statement, sterling extended earlier gains against the US$ but closed the day slightly lower against the euro. Data this week confirmed the UK economy shrank 0.5% in Q3 2008, the first contraction since 1992. The detail showed consumer spending fell by 0.2%, while fixed investment spending dropped by 2.4%. Testimony by key BoE MPC members also the possibility of further aggressive interest rate cuts.

US data this week were weak, raising the risk of a sharp contraction in output in Q4. The fall in Q3 was also revised to -0.5%, from -0.3% previously. It raised the probability that the Fed will cut interest rates to 0.5% at its next meeting on 15/16 December. However, it continued to use other measures to help provide market liquidity this week, pledging a further $800bn to aid households and small businesses. The Treasury also announced a bailout package for Citigroup. Comments from and details of president- elect Obama's executive team also buoyed equities, keeping downward pressure on the US$.

Weak activity data and sharply lower inflation raised the risk of a sharp cut in euro zone interest rates next week. This saw the € pare earlier gains against the £ and $.

Interest rate market review - bonds, cash and swaps

Confidence that central bank rate cuts are fully discounted in the US, the UK and the euro zone, and reports of falling inflation in the US and the euro zone led to considerable flattening in government yield curves this week. The rise in short dated yield vs long dated yields was also attributed to gains in equity markets and the launch of a new initiative by the Fed to bring down mortgage rates. UK 3-month Libor fell to 3.91%, causing the spread over base rate to narrow to 91bps. Investor worries about the deterioration in the UK's fiscal position left the DMO with no other option but to offer a 10bps premium at the £3.75bn sale of conventional 2012 gilts.

Short dated gilts under performed their US and euro zone counterparts, ending several weeks of out performance. UK 2yr yields shot up on Friday to an intra-day high 2.39% as participants switched back in to equities. The FTSE-100 rebounded 13% to close the week above 4,000. Government plans to boost public spending were laid out in the Pre-Budget Report on Monday. The measures, like the temporary cut in VAT to 15% to boost household spending and a plan to offer help to large and small business, were well received. This also weighed on short dated gilts. Long dated gilts were unfazed by the Chancellor's plan to boost government borrowing to £78bn in 2008/09 and to £118bn in 2009/10, but this could in our view lead to a substantial rise in long term yields and a steeper yield curve if efforts to reflate the economy succeed. The spending will in part be funded by a rise in gilt issuance this year to £146.4bn. This marks a whopping 83% increase from the figures announced in the Budget last spring. Signs that the government could struggle to find enough support to fund the expansion of its balance sheet materialised on Thursday when the DMO was forced to pay a 10bps premium to attract buyers at the £3.75bn auction of 2012 government paper. The Pre-Budget Report did not materially change expectations for UK base rate. Forward sonias are now pricing in a 125bps cut in Bank rate to 1.75% on December 4th, and a further reduction to 1.5% by February.

The broader context participants focussed on was the announcement of sharp falls in inflation in the US and the euro zone, and the latest initiative by the Fed to try and revive mortgage lending. Inflation in the euro zone fell in November to 2.1% from 3.2% in October, marking the lowest level since February. This means that CPI will in all likelihood hit the ECB target of 'close but below 2%' much sooner than previously thought. This will enter the ECB's deliberation on interest rates next week. Given the grim outlook for economic growth next year, this should convince the ECB to make a sharp cut in interest rates on December 4th. We forecast a 0.50% reduction to 2.75%. US core inflation slowed to 2.1% in October from 2.4% in September, approaching the Fed's implicit upper target ceiling. However, the report of a sharp 1% fall in real personal spending in October and a 17.4% annual drop in US house prices compounded worries about the US economy. Weekly claims dropped marginally to 529,000 but did little to lift pessimism ahead of next week's employment report where a rise in the unemployment rate above 6.5% looks inevitable.

The Fed took a potential important step forward in its bid to revive mortgage lending. The $100bn buy back of direct obligations from mortgage entities Freddie Mac and Fannie Mare and the $500bn purchase of mortgage backed securities helped mortgage spreads over treasuries to narrow 29bps. The Fed also announced the creation of a Term Asset-Backed Securities Loan Facility (TALF) that will lend $200bn to facilitate the provision of consumer and small business loans. The measures helped to restore some risk appetite and caused a sharp narrowing in swap spreads in the US, the UK and the euro zone. US 3-month libor rose 5bps to 2.21%. Euro zone 3-month libor fell 7bps to 3.96%, reducing the spread over the ECB refi rate to 71bps.

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