Financial Markets Review

Sterling Approaches Parity vs the Euro

Financial market review - foreign exchange

The pound fell by 3.5% vs the euro as prospects for the UK economy deteriorated further and speculation rose that the BoE will cut interest rates to 1% in January. The sterling trade-weighted index hit a record low of 76.72. At the same time, the US dollar depreciated against almost all the major currencies on the Fed cut in its funding rate to a target range of 0%-0.25% and comments that it was evaluating stepping up purchases of US Treasuries and mortgage-backed securities. €/$ rose sharply to a weekly high of 1.4719. £/$ had a wide range of 1.4883-1.5724. The cut in Japanese interest rates to 0.1% from 0.3% was accompanied by a decision to increase monthly purchase of government debt and to buy commercial paper. This led to some strengthening in $/Y back towards 90 on Friday.

Weak UK economic data added to negative sentiment towards sterling. This was exacerbated by the dovish tone of the minutes of the 3/4 December MPC meeting, which showed a unanimous vote to cut rates by 100bp to 2%. There was also a discussion about a more sizeable rate cut. In addition, MPC member Bean said in an interview with the FT that UK interest rates may fall 'close to zero'. This added to the weight of opinion that the BoE will cut interest rates to at least 1% in January.

The UK claimant count unemployment figure of 75,700 in November was the biggest monthly rise since the last recession and took the number of unemployed to above one million. A fall in petrol prices helped CPI inflation to slow 4.1% in November from 4.5% in October. RPI inflation decelerated to 3% from 4.2%, helped by strong downward effects from lower mortgage payments. The open letter from the BoE governor to the Chancellor referred to a significant downward shift in MPC inflation expectations for 2009 due to an increased deterioration in economic activity, the impact of VAT cuts and lower energy costs.

Developments in the US were dominated by the Fed rate cut and the plight of the car industry. Chrysler, GM and Ford were offered a $13.4bn bridging finance facility on Friday, pending a longer-term solution once the new administration is in place. US data were also universally weak, including a 1.4% drop in manufacturing output in November, and a 18.9% plunge in November housing starts. There was also a report of aggressive liquidation of holdings of long-term US securities by private investors in October. The latter impacted negatively on the dollar on concern that overseas funding may be drying up.

The euro appreciated on a smaller than expected decline in the eurozone December manufacturing and services PMIs, although they still remain at very weak levels. Moreover, several ECB members raised speculation that the ECB may pause next month after cutting interest rates by 50bp in November and 75bp in December. But the result of the German IFO survey published on Thursday contradicted this view as the survey index fell to an all-time low of 82.6 in December. This, together with a 0.5 percentage point cut in the ECB deposit rate contributed to the dollar strengthening against the euro at end-week.

Interest rate market review - bonds, cash and swaps

Government bond yields and swaps fell sharply this week after the US cut the fed funds target rate close to zero and pledged to buy long-term fixed income securities. Speculation that UK interest rates may follow the US path and fall close to zero in the New Year sparked a buying frenzy in short and long dated gilts, with 2yr and 10yr yields plummeting by more than 40bps. UK 3-month Libor fell below 3% on Friday, reducing the spread over base rate to 98bps. Other measures of liquidity and risk appetite also improved. The UK Ois/3mth libor spread fell to 171bps and the TED spread narrowed to 150bps.

Speculation about lower UK interest rates and the decision by the Federal Reserve and Bank of Japan to cut interest rates close to zero played delivered most of the impetus for this week's rally in government bonds and corresponding decline in yields (and swaps). The fact that the Fed also pledged to expand its balance sheet to facilitate the distribution of credit to the real economy weighed on long dated yields. The Fed also hinted that interest rates would stay in a 0%-0.25% range for a 'long time', and said it will evaluate the purchase of longer-term government securities. In an environment of falling corporate earnings, decelerating inflation and fears that the recession in the US could be deeper, the case for holding government bonds, even at a hefty premium, is hard to dismiss. The depreciation in sterling and a looming flood of issuance next year hardly dented demand for UK gilts. Short-dated paper received a boost by the comments made by BoE MPC member Bean that interest rates could fall close to zero.

UK economic data this week brought confirmation of falling inflation but also fuelled fears about the rapid deterioration of the labour market. Data on Tuesday showed that annual CPI fell in November to 4.1% from 4.5% in October. Annual RPI slowed to 3% from 4.2%. On Wednesday it emerged that the claimant count rate rose by larger than forecast 75,700 in November. The ILO unemployment rate rose to 6.0%. The jobless level on this measure rose 137,000 in the latest quarter to 1.864mln. It also emerged on Wednesday that the MPC was unanimous in its vote for a 1% cut in base rate in December. The fact that the MPC had considered an even bigger reduction reinforced expectations that base rate will fall again in January, possibly to 1%. The report of a surprise 0.3% rise in retail sales in November - supported by early price discounts - is unlikely to stop the BoE from lowering rates next month. The fall in crude oil prices below $35pb this week implies that inflation may undershoot the BoE's forecast next year and gives the Bank more leeway to add monetary stimulus. Weak demand at the 2011 gilt auction on Thursday - the auction was covered just 1.58 times - underlined the challenges that the treasury may face next year as it tries to raise additional borrowing to fund the public deficit (data this week showed a record PSNCR deficit of £16bn in November). Closing levels for the week showed 2yr yields down 47bps at 1.25% and 10yr yields down 42bps at 3.18%. 5yr swaps dropped to 3.35%. The decline in 3-month Libor to 2.98% helped the 3- month Libor/5yr swap curve to steepen 5bps.

The bigger than expected rate cut by the Fed and its commitment to purchase large quantities of mortgage debt pushed US long-term yields down substantially, reducing 10yr paper to a low of just 2.05%. 30yr yields dropped to 2.52%. The fall was supported by the report earlier in the week of a 19% fall in housing starts in November, and a sharp decline in annual CPI in November to 1.1%. Core CPI slowed to 2%. 5yr swaps closed the week down 42bps at 2.11%, bouncing off a 1.99% low. US 3-month libor fell 42bps to 1.50%.

The decline to a new all-time low for German business confidence in December and a 3.96% appreciation in €/$ supported strong buying of bunds. 2yr yields plummeted below 2% to close at 1.80%, 70bps below the key ECB refi rate. 5yr swaps tumbled 20bps to 3.33%. Euro 3-month libor dropped 20bps to 3.08%.

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