Financial Markets Review

UK Base Rate Cut to 2%, £/€ Hits New Low

Financial market review - foreign exchange

Interest rates were cut this week in the UK, the euro zone, Sweden and New Zealand as central banks in the respective regions stepped up efforts to counter downward pressures in their economies. The BoE cut base rate by 100bps to 2% and in the accompanying press statement the Bank left the door open to further reductions in 2009. This pushed sterling to a new all-time low vs the euro of 1.1461. US data showed a decline of half a million jobs in November, the biggest drop since 1974. This did not stop the dollar from ending the week up as participants rushed into the safe haven of US treasuries. China and Russia decided to widen their currency bands in response to weakening activity in their economy. This effectively boils down to a devaluation of the renminbi and the rouble, designed to boost economic growth through exports. Both currencies lost ground against the dollar. $/yuan firmed to 6.89. The rouble extended its decline to 22% since August.

The steep fall in UK yields compared to the US and the euro zone weighed on sterling this week, leading £/$ and €/£ to reverse last week's gains. The 35bps drop in 2yr gilt yields to 1.86% characterised expectations of a sustained period of low UK interest rates and turned participants away from sterling. The BoE rate cut of 100bps was in line with consensus forecasts and therefore triggered only a muted response in the market. The important point for sterling is that the BoE kept its options open for a further reduction in interest rates in 2009. We forecast a bottom of 1% or below in February 2009 and therefore believe that sterling will stay weak near term against its major counterparts. The steep fall in the UK manufacturing and services PMI's in November point to a further contraction in gdp growth in Q4, whilst price cuts in the high street and the reduction in VAT mean that inflation will slow sharply in the months ahead, giving the BoE more ammunition to lower base rates.

The ECB cut interest rates by 75bps to 2.50% on Thursday in what marked the biggest reduction in the Bank's short 9-year history. Projections for inflation and gdp growth in 2009 were revised down and this led president Trichet to leave the door open to more rate cuts in 2009. On the week, the euro fell 0.2% against the dollar but rose 4.5% against sterling, hitting a new high of 0.8726.

The A$ and NZ$ held up quite well over the first part of the week but eventually settled at a lower rate vs the dollar as equities fell in response to the weak US jobs data. The RBNZ slashed interest rates by 150bp to 5.0%. The C$ was one of the worst performers this week as a result of political turmoil in Canada and the report of a 70,000 drop in Canadian employment in November. Canadian interest rates are forecast to fall below 2% next week Tuesday. $/C$ surged to a high of 1.3007 and could soon test 1.30. The worst performing currency in emerging markets this week was the Brazil real. $/real fell nearly 14% as participants scaled back expectations for Brazilian exports as commodity prices fell. The central bank of Brazil meets on interest rates next week.

Interest rate market review - bonds, cash and swaps

Both the Bank of England and ECB reduced interest rates this week by 100bps and 75bps, respectively, to 2% and 2.5%. Sweden's Riksbank also slashed rates by 175bps to 2%. The UK and eurozone data flow continued to worsen, indicating an even sharper economic downturn than anticipated, as oil prices fell below $40 a barrel. The risk of deflation has increased and, as interest rates approach very low levels, there are signs that central banks are starting to seriously consider 'quantitative easing', including the purchases of government and corporate debt. Indeed, Fed Chairman Bernanke suggested as much in a speech on Monday when he said that the Fed could buy longer-term treasuries, while the Bank of England and ECB also hinted at the possibility of quantitative easing.

In the US, the ISM surveys signalled a sharper than expected contraction in economic activity in November. The manufacturing ISM survey fell to 36.2, the lowest level since 1982, while the non-manufacturing ISM fell to 37.3 from 44.4. The employment component of those surveys also pointed to a very weak official employment report on Friday, which showed a massive drop in nonfarm payrolls of 533k in November, the biggest monthly fall since 1974, while September and October payrolls were revised down by a total of 199k. Thus, the US economy has lost 1.3m jobs in the last 3 months, about double the amount in the first 8 months of the year. The unemployment rate rose to 6.7% from 6.5%, slightly less than expected, but still a 15- year high. Financial market reaction to the US payrolls data saw 10yr bond yields slump to a low of 2.505% but then bounced off lows, suggesting that a bad number had already been anticipated. Bond yields had already fallen significantly during the week, in particular following Bernanke's comments about the possibility of the Fed buying government debt. At the close, US 2yr yields fell 15bps to 0.83%, but there were more sizeable declines in longer-dated yields, with 10yr yields down 41bps to 2.56%, while 30yr yields fell to a low of 3.005% and ended the week down 41bps at 3.03%.

UK PMI surveys for November fell to even weaker levels and by more than anticipated. The manufacturing PMI plummeted to an all-time low of 34.4 from 40.7, while the services PMI fell to 40.1 from 42.4. Housing activity remained in the doldrums, with mortgage approvals at only 32k in October, as HBOS reported a 2.6% drop in November house prices, down 14.9% on the year. Such figures raised expectations that the MPC may slash interest rates by as much as 150bps, the same amount as in November, but in the event rates were cut by 100bps to 2% (matching the all-time low), as originally forecast. Sterling 2yr bond yields hit a low of 1.565% just ahead of the interest rate announcement, but pared some of the declines to end the week down 35bps at 1.86%, while 10yr yields were 37bps to 3.40%. Swap rates continued to decline and long-dated swaps outperformed bonds. Five-year swaps closed down 28bps at 3.38%.

There was confirmation that eurozone economic growth fell 0.2% in Q3 and latest indicators suggest a sharper fall in the current quarter. EU-15 retail sales fell 0.8% in October, while German factory orders for the same month plunged 6.1% on the back of a 8.3% fall. Forward-looking PMI surveys deteriorated further, with the EU-15 manufacturing survey at 35.6 and services at 42.5, both deep in contraction territory. The ECB cut rates by 75bps to 2.5%, more than the original forecast of a 50bps reduction, but less than the 100bps that financial markets had priced in. The ECB's new staff economic projections showed significant downward revisions for growth and inflation next year. Growth for 2009 is now forecast in a range of -1.0% and 0.0% (previously 0.6% to 1.8%) and inflation between 1.1 and 1.7% (previously 2.3-2.9%), paving the way for further policy easing in the new year. ECB President Trichet also signalled that outright purchases of assets by the central bank were possible. Euro 2yr yields ended the week at 2.04%, having touched a low of 1.975%, while 10yr yields fell temporarily below 3%, ending the week down 24bps at 3.02%.

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