Financial Markets Review

Pound Soars Despite Historic Rate Cut

Financial market review - foreign exchange

After depreciating by almost 25% on a trade weighted basis in 2008, the UK pound started the new year on a strong footing.This was in spite of the Bank of England cutting official interest rates to the lowest level since its creation in 1694 and further weak economic data. The pound rose by 5% to 1.5278 against the US$, easily the most in the G10. Against the euro, where parity was threatened only a few weeks ago, the pound recorded its biggest gain on record this week. £/€ closed up 8.2% at 1.1308. The euro suffered as weak economic data from the euro zone raised pressure on the ECB to reduce interest rates, possibly as soon as next week. €/$ closed the week down 3% at 1.3508, recovering from an intraweek low of 1.3313. In large part mirroring the performance of equities, the yen had a volatile week,with $/Y closing on Friday at 90.20 after touching 94.62 on Tuesday. In the main emerging markets, the Chilean peso was the best performer against the US$ this week, following a larger than expected interest rate cut of 1% to 7.25%. At the other end, the Romanian leu, South African rand and Hungarian forint all saw falls of over 4% versus the US$.

In the UK, the main focus this week was Thursday's BoE interest rate decision, where a second successive cut of 1% was considered a real possibility. In the event, the BoE MPC chose to cut Bank rate by 0.5% to 1.5% - the lowest for over 300 years - and the pound rallied on the news of a smaller reduction. The press statement gave little clear indication of further easing in the months ahead and did not comment on more unconventional measures of easing monetary conditions.However, it highlighted that the availability of credit to both households and businesses had tightened further and that additional measures to ease strains were needed. This suggests that further rate cuts are likely with, in our view, at least another 0.5% in February. The prospect was enhanced by economic data on Friday showing UK manufacturing output contracted by a much larger than expected 2.9% in November, the most since 2002 and down for the 9th successive month. Survey data suggest a further fall is likely in December. However, the pound still closed the day higher against both the US $ and €, taking advantage of weak figures elsewhere.

The first US labour market report in 2009 was the main data highlight this week. Following some surprisingly weak outturns for employment surveys ahead of the report, the market was positioned for a dire outcome. In the event, reports of a massive 524,000 drop in non-farm payrolls and jump in the unemployment rate to 7.2% in December - the highest since 1993 - actually temporarily boosted the US $ on relief that the outcome was not worse. However, sentiment soon turned and gains were pared back at the close. The other main influence on the greenback this week was from more details of presidentelect Obama's plans for a massive fiscal stimulus package to help underpin the economy. These supported a growing view that the US may prove the first major economy to recover from the slowdown and underpinned the dollar.

Weak economic data from the euro zone this week raised speculation that the ECB may reduce interest rates next Thursday, putting downward pressure on the euro. EU- 16 business and consumer confidence indices saw sharp declines in December and industrial activity figures from Germany were very disappointing. In addition, the 'flash' estimate of euro zone CPI fell to just 1.6% in December, the lowest since 2000.

Interest rate market review - bonds, cash and swaps

The past week saw further steepening of yield curves in Europe, as short-dated bond yields were marked lower with economic prospects deteriorating. Swap rates also fell, with UK 5yr swaps declining below 3%, despite the Bank of England reducing interest rates by less than some had expected, though the fall partly reflected a sharp narrowing of swap spreads, likely related to further easing of money market tensions. But bond yields rose further out on the curve, pointing to concerns about whether investors are willing to digest the glut of paper set to be issued by governments to fund burgeoning fiscal deficits. Indeed, Germany this week sold only twothirds of the €6bn of 10yr bonds it offered. Moreover, in the US, the minutes of the Dec 16th FOMC meeting made no mention of purchasing longer-term treasuries, which may have disappointed some market participants.

On Thursday, the Bank of England cut the Bank rate by half a point to an all-time low of 1.5%, but the reduction was not as large as some had expected. The statement acknowledged that credit availability had tightened further and that additional measures may be needed to increase the flow of lending. It also noted that the recent fall in sterling is expected to support growth and increase import prices, and this may have been a key reason for not cutting interest rates by more. But given that the pound was a strong performer in the past week, the MPC may have missed the opportunity to reduce rates by a full 1%, especially after further dire economic numbers released this week. Official industrial production figures showed a sharp 2.3% fall in November on the back of a 1.6% decline in October, while Nationwide reported a 2.5% drop in house prices in December (- 15.9%y/y). Producer price data also confirmed that inflationary pressures are ebbing. Thus, we now expect the Bank will cut rates by a further 100bps to a low of 0.5% this quarter. Over the week, 5yr swaps fell to 2.97% from 3.15%, while 3m libor continued to decline, falling to 2.38% from 2.71%, with the spread between libor and expected interest rates (OIS) continuing to narrow, as money market tensions ease from 2008 highs.

German 2yr bonds outperformed their US and UK counterparts, following some dreadful economic data and concerns that the ECB's more cautious approach to monetary policy easing may deepen the economic downturn. German factory orders plummeted 6.0% in November (-27.2%y/y) and exports plunged 10.6% on the month. German unemployment started to rise in December for the first time in 3 years, while euro zone consumer and industrial confidence continued to deteriorate, boding ill for economic prospects. Moreover, preliminary euro zone December CPI was estimated at 1.6%, down from 2.1% in November and now below the ECB's definition of price stability. Thus, we expect the ECB will cut rates by 50bps next week to 2%, with further easing likely in the months ahead. As the week drew to a close, German 2yr bond yields fell more than 20bps to 1.51%, while 5yr swaps fell to 3.05% from 3.21% and 3m libor fell to 2.69% from 2.85%. In contrast, 30yr bond yields rose 24bps to 3.73%.

US bond yields ended the week slightly higher across the curve, though the significant narrowing of swap spreads, related to further easing of money market tensions and a steeper yield curve, meant that swap rates were lower. Markets focused on the key employment report on Friday, which showed that non-farm payrolls fell 524,000 in December, less than feared following a large fall in the unofficial ADP employment earlier in the week. In fact, the slight improvement in the ISM non-manufacturing report earlier in the week proved to be a more reliable guide to non-farm payrolls. Nevertheless, job losses totalled more than 1.5 million in Q4 and the unemployment rate climbed to a 15-year high of 7.2%, thus the outlook for the US economy remains challenging. Factory orders and pending home sales were also weak. Overall, US 10yr bond yields rose slightly this week to 2.40%, while 5yr swaps fell to 2.03% from 2.21%.

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