Financial Markets Review

Sterling Wilts as UK Recession is Confirmed

Financial market review - foreign exchange

A very difficult week for the pound ended with confirmation that the UK economy entered technical recession in the second half of last year, with output down a startling 1.5% in Q4 2008 – the most since Q2 1980. Reverberations from the ongoing crisis in the banking sector also kept downward pressure on the currency. At the close, £/$ was 7.4% lower at 1.3677, recovering from a 23-year low of 1.3506. £/Y ended at 121.25 after falling to a record low of 118.87. Speculation of parity against the euro resurfaced again as £/€ dropped though key technical levels to 1.0666 at the close. Heightened volatility saw the dollar and yen both gain on safe haven flows this week, as equity markets saw sharp declines and key measures of money market stress edged higher. $/Y finally closed the week at 89.25, recovering after falling abruptly to 87.13, the lowest level since July 1995. Fears about credit rating downgrades kept the euro under selling pressure, with €/$ closing 3.1% lower at 1.2823 and €/Y falling to a seven year low (112.10). In emerging markets, Eastern European currencies saw the sharpest declines this week, led by the Polish zloty and Czech koruna. The Russian ruble strengthened on news of a new trading basket arrangement. Chinese officials confirmed GDP growth slowed to 6.8% in Q4 2008, the weakest since Q4 2001.

In the UK, the announcement of a new set of government initiatives to stabilise the banking sector and improve corporate liquidity failed to restore confidence and weighed heavily on sterling this week. Weak economic data and speculation that the Bank of England will cut interest rates further next month also had an impact. As well as official data confirming the first recession since 1990, figures this week showed rising unemployment and a further deterioration of conditions in the manufacturing sector, suggesting another large contraction in GDP is likely this quarter. The news that the public sector deficit had widened to £71.2bn in fiscal year to December, up from £37bn a year earlier, raised concerns about the UK’s financing needs. Governor King also disclosed that the BoE is actively preparing to purchase a range of financial assets to boost money supply and credit. With momentum growing against sterling, its vulnerability to a further sharp fall has clearly risen, but there are also signs that its recent fall may have been too aggressive.

The main focus in the US this week was on the inauguration of President-elect Barack Obama. The extent of the challenge facing the new President was underlined by economc data this week showing conditions in the US housing market remained grim, with both housing starts and building permits at record lows in December, while initial jobless claims rose to match a 26-year of 589,000 the previous week. A significant fiscal stimulus plan is expected to be confirmed shortly, as well as further initiatives to stabilise the US banking system, both of which could provide support for the dollar.

Although data from the euro zone were better than expected this week, fears about the economic health of its members remained a key underlying theme. This may help explain why the euro weakened against its main counterparts, with the notable exception of sterling.

Interest rate market review - bonds, cash and swaps

Short-term gilt yields fell this week, as figures confirmed that the UK was officially in recession, with weaker equities also lending support to bonds. However, new measures by the UK government to support the financial sector and increasing concerns about the ballooning fiscal deficit led to a sharp rise in long-dated yields and a further steepening of the gilt yield curve. A further selloff in medium and long-dated bonds occurred in the latter part of the week, following comments by Treasury Secretary-designate Timothy Geithner that China may be 'manipulating' its currency. China is a major purchaser of US treasuries and such comments from such a highprofile member of the new Obama administration led to fears that China may be less willing to buy US government debt.

The UK economy contracted by 1.5% in Q4, the steepest quarterly decline since 1980. The outturn was in line with our forecast, but at the bottom end of market expectations. In year-on-year terms, growth fell 1.8%. The CBI industrial trends survey showed that business optimism fell to -64, the weakest level since 1980, indicating that the economy will probably contract at a similar pace in Q1. Hence, 2yr gilt yields continued to fall this week, declining to a low of 1.34%, before closing down 15bps on the week at 1.46%. There was modest support for yields earlier in the week when December CPI fell less than expected, though the fall to 3.1% from 4.1% was still significant, driven by the VAT reduction, discounting and lower petrol prices. Other data showed claimant count unemployment rising 77,900 in December, while minutes of the January MPC meeting, when the Bank rate was cut by 0.5% to 1.5%, showed Blanchflower dissented in favour of a larger reduction. Overall, the MPC is set to reduce rates a further 50bps in February.

The UK government expanded measures this week to support bank lending, including the creation of an asset protection scheme to guarantee future losses on some assets held by banks, while the Bank of England was given the go-ahead to purchase high quality corporate bonds and commercial paper. These measures increase further the government's potential liabilities. Already, public net borrowing has risen to a cumulative £71.2bn in the financial year to December, with the expected glut of government paper weighing on bond prices and push yields higher. 10yr gilt yields closed near the week's highs at 3.67%, while 30yr yields soared nearly 50bps in a week to 4.63%. 5yr swaps ended just above 3%. In the euro zone, 2yr yields continued to fall, hitting a low of 1.35%, in anticipation of further policy easing by the ECB and as equities extended declines. Although the euro zone PMI and German ZEW surveys came in better than expected, they remained at very weak levels. The German ZEW outlook index rose to -31.0 from -45.2, while the advance euro zone composite PMI rose to 38.5 from 38.2, though still well below the 50 growth/contraction level. Longer-dated bond yields were pulled higher by rising concerns about fiscal deficits and by Geithner's comments, with 10yr yields up 30bps at 3.23%. In terms of intra-euro bond spreads to the German 10yr benchmark, Greece widened to 297bps from 252bps, Portugal to 151bps from 127bps and Ireland to 275bps from 185bps.

Aside from the inauguration of President Obama, the US calendar was relatively quiet but, as noted above, unexpected comments from Geithner helped precipitate a sell-off in global bonds, despite weaker equities. US housing starts fell 16% to only 550,000 in December, an all-time low, while weekly jobless claims climbed to 589,000, suggesting another big fall in employment in January. Ahead of next week's FOMC meeting and first estimate of Q4 GDP, US 2yr bond yields rose to 8bps tp 0.80%, while 10yr yields increased 37bps to 2.66% and 30yr yields soared 50bps to 3.38%. Although interbank rates continued to fall in the euro zone and UK, dollar 3m libor actually rose to 1.17%, likely reflecting some return of risk aversion.

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