Financial Markets Review : Bond Yields Rise on Credit Ratings Fears

Financial market review - foreign exchange

Speculation that the Fed may boost its asset purchase programme to reinvigorate economic growth and rising concerns about the credit standing of the US saw the dollar come under strong selling pressure this week. The dollar index, which measures its performance against its key trading counterparts, fell to its lowest level so far in 2009, slipping below 80 on Friday, from a peak of 89.11 in March. Further signs that strains in credit markets may be easing, with 3-month US $ Libor recording its biggest weekly decline this year, may also have dulled the safe haven allure of US assets and the $ this week.
The greenback closed the week lower against all the G10 currencies, with the New Zealand leading the way with a gain of 5.9%. Boosted by rising commodity prices and higher interest rate yields, both the Australian and New Zealand dollars set seven-month highs against the US$. The pound extended its recent gains, despite a leading credit rating agency changing its outlook guidance on the UK from ‘stable’ to ‘negative’, although reaffirming its triple A status on long-term debt. £/$ closed the week up 4.1%, hitting a six-month high of 1.5943. €/$ finally broke through the psychologically important 1.40 level on Friday, closing the week 3% higher at 1.4016. $/Y closed the week lower at 94.40, after the BoJ left interest rates on hold at 0.1% but improved its economic assessment, while the finance minister also ruled out intervention to weaken the yen. However, data showed the Japanese economy shrank by a record annualised 15.2% in the first quarter of 2009, following on from a drop of 14.4% in the previous quarter.
In the emerging markets, a resounding victory for the ruling Congress party saw the Indian rupee briefly strengthen below 47 against the US$ this week for the first time in 2009. Chinese yuan 12 month non-deliverable forwards rose to a 9-month high of 6.67. The Russion ruble extended its gains to hit a 4-month high against the $, underpinned by higher crude oil prices. Eastern European currencies performed particularly well this week , led by the Hungarian forint. The South African rand also rallied sharply higher against the $, buoyed by metal prices and its high yield.
In the UK this week, there was confirmation that the economy contracted by 1.9% in the first quarter, led by a drop of 1.2% in consumer spending and 3.8% decline in investment. However, there were some hopeful signs that this could prove to be the low point in this recession, with rapid corporate de-stocking again contributing significantly to the fall. The latest data on retail sales were also stronger than expected, with a 0.9% rise in sales volumes in April. There was also a sharper than expected drop in inflation in April, with annual CPI inflation easing to 2.3%, from 2.9% in March. With inflation likely to continue to fall rapidly in the coming months, the minutes of the 6-7 May BoE MPC meeting highlighted that the final size of the asset purchase programme may exceed the initial £150bn already sanctioned, if economic conditions warranted it.
Although it was the UK that experienced negative watch to credit rating this week, speculation that the credit standing of the US could also come under pressure saw the dollar apparently come under more sustained selling pressure. This followed the release of the minutes of the FOMC 29 April meeting earlier in the week, which revealed that some members felt that asset purchases may need to be increased to boost the US economic recovery.

Interest rate market review - bonds, cash and swaps

Standard and Poors changed its UK AAA ratings outlook to 'negative' from 'stable', because the country's debt could reach 100% as a proportion of GDP. The announcement led to a sell-off in gilts, as benchmark 10-year yields hit a high of 4.75% and 30-year yields reached a 4-month high of 4.66%, though strong demand at the 5-year gilt auction helped limit the rise in yields. Five-year swaps rose 7bps to 3.22%. Yields at the short end of the curve were little changed, as inflation came in weaker than expected, while minutes of the May MPC meeting confirmed expectations that the vote to keep interest rates at 0.5% and to expand quantitative easing by a further £50bn to a total of £125bn was unanimous.
UK annual CPI inflation fell to 2.3% in April from 2.9%, a bigger drop than expected, while annual RPI inflation fell further into negative territory to -1.2%. Looking ahead, we expect annual inflation rates to fall significantly in the coming months, with the CPI measure likely to drop below the 2% target next month for the first time since September 2007. In fact, we see annual CPI around the zero mark by the year end. The Bank of England's own central projection is for annual CPI to fall to around 0.4% in the final quarter of this year.
With this scenario for UK inflation in mind, the MPC minutes revealed that the Committee may consider asking the Chancellor to expand the current limit of the quantitative easing programme, if conditions warranted it. In terms of the economic outlook, the MPC said that, although there were 'promising signs' that the pace of decline is moderating, the economic recovery is expected to be 'relatively slow'. The second estimate of Q1 GDP supported this view. Quarterly growth was unrevised at -1.9%, the steepest contracton for thirty years, but the expenditure breakdown showed that the sharp pace of negative inventory adjustments in response to falling demand was easing. However, the quarterly contraction in both consumer and investment spending intensified. Other data showed that retail sales rose more than expected in April, but the figures do not account for weaker spending on services and cars.
Euro zone bond yields also rose in the past week, with 10-year bund yields rising above 3.5% for the first time in 6 months, pulled higher stronger equities and improvements in the ZEW and PMI surveys. The German ZEW index of investor expectations rose to a 3-year high, while the euro zone composite PMI increased for the third consecutive month to 43.9, though this still remained far below the key 50 no-growth level.
The increased risk of a UK downgrade led to concerns about the implications of rising US debt. Ten-year treasury yields rose a 6-month high of 3.43%, as the supply of $162bn of notes and bonds loomed next week. US 5-year swaps rose 19bps to 2.66%. The Fed also purchased less goverment debt than expected, which put further upward pressure on bond yields. The minutes of the 29 April FOMC meeting indicated that the Fed may increase its purchases of government debt, but the downward impact on yields proved to be short-lived. The Fed's prognosis on economic prospects was more optimistic, as the inventory adjustment runs its course, but the recovery in demand was expected to be sluggish. US initial jobless claims remained above 600,000, consistent with a sharp rate of decline in employment, while the Philadephia Fed manufacturing survey indicated that the pace of contraction had eased in May.
US interbank rates continued to decline, as money market tensions fell further. Dollar 3m libor fell 17bps to 0.66%, while sterling 3m libor fell 7bps to 1.29%, though euro 3m libor was marginally higher at 1.26%. Elsewhere, the Bank of Japan left interest rates on hold at 0.5%, as Japanese Q1 GDP fell 4.0% on the quarter. Nevertheless, the BoJ upgraded its view on the economy, saying that exports and production were beginning to level out, though economic conditions were still deteriorating.

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