Market Outlook

Mon, Feb 1 2010, 12:11 GMT
by Lloyds TSB Financial Markets Economic Research Team

A retreat in global equity markets to one-month lows and widening sovereign debt and credit spreads have raised the alert level among international investors, prompting outflows from commodities and emerging market currencies into safe havens of government bonds and the USD. With key technical levels giving way in major equity indices and G10 crosses, disappointing US non-farm payrolls data next week would be a setback for global recovery optimists, resulting in a further increase in volatility and aversion through demand for USD and JPY and selling of EUR.

In the UK, the BoE faces arguably one of its most daunting policy decisions in its recent history as it decides whether or not to extend asset purchases to steer the economy out of recession and back towards a sustainable growth path whilst keeping inflation under control. Credibility, transparency and risk management will all be tied up into the decision on February 4th under the watchful eye of sterling and gilts. Profit taking in GBP/USD on soft UK Q4 GDP and S&P’s negative assessment of the banking sector could transpire into a more aggressive unwinding of long GBP positions as investors face up to bearish consequences of an increase or pause in QE. The magnitude of GBP/G10 reaction could ultimately be dictated by how the MPC votes and the detail of the accompanying statement.

GBP faces a shake-up next week with regard to the drivers of near-term performance and perceptions of the currency’s valuation relative to other G10 currencies as the BoE decision on QE forces a reassessment in credit, liquidity and inflation premia embedded in the long end of the gilt curve. Substantially weaker than expected Q4 GDP data and flight-to-quality from equities pushed 10y gilt yields to 3.90%, a one-month low, though UK/EU and UK/US 2y benchmark spreads have held near 15bp and 40bp, respectively. Conventional wisdom has it that a pause in QE would be a bearish steepening event for the 2y/10y part of the curve. Indeed, the concentration of BoE holdings in the 2015 to 2022 maturity bracket (see chart p2) and the DMO’s focus on the 7y-15y area for new issuance in the latter part of fiscal 2009/10, though 16.7% of this will be through syndicated sales, leaves the 7y-15y area more exposed relative to the front and ultra long end to a sell-off in the event of a freeze of BoE purchases at £200bn.

Hawkish comments by MPC member Sentance, a reversal in negative correlation with equities and corporate dividend flows have been credited for sterling’s outperformance and resilience since the start of the year vs its G10 counterparts. The fall in EUR/GBP to a 5-month low is primarily a function of EUR weakness and wider UK/EU yield spreads as funding concerns in Greece and surging CDS spreads for peripheral euro zone members prompt participants to trim overweight EUR positions. This has been evident in the weekly IMM positions, with net reported speculative EUR positions vs the USD turning negative and exceeding GBP shorts (see chart).

S&P’s negative assessment of the UK banking sector and reports that the UK (together with Ireland) holds 23% of Greek sovereign debt have (temporarily?) capped bearish momentum in EUR/GBP for follow-through selling below 0.8650, putting in a base around 0.8630. A return of confidence over Greece’s funding position would arguably form a powerful argument for a bounce back in EUR/GBP over 0.88, whilst a rebound in equities and other pro-risk assets (commodities) would favour a rally in GBP/USD over 1.6250.

What the BoE has to weigh up:

1/ how soon will inflation return below 2% target?
2/ what are the risks of a relapse in GDP ahead/after the election?
3/ size of cutbacks in public spending by the next government?
4/ if £200bn of QE has failed to boost money supply, what are the chances of success by raising QE any further?
5/ implications for asset prices, credit spreads, cost and access to capital market funding
6/ is it comfortable with raising gilt holdings above 30% of outstanding supply (excluding index-linked)?
7/ can the long end of the gilt curve absorb new issuance without BoE buying, threatening a spike in yields/plunge in sterling?

The UK economy barely limped out of recession in Q4-09, causing concerns to flare up over a possible relapse or so-called double dip in activity ahead of the general election. Based on historical trends since 1966, the case to be long GBP ahead of the general election is not compelling. A comparison of swings in output between quarters ahead of a general election shows that the economy has a tendency to stall and contract more often than not (swing in output here is defined as the net change between GDP, t-1 and GDP, t in table on p1). Optimism at the MPC, not equivocally shared by the market, that CPI will slow from above 3% in the first half to below the 2% target by year-end in theory argues for the Bank to take out extra insurance against a decline in activity, though comments by MPC member Sentance suggest that, like at the FOMC earlier this week, there could be a split MPC vote.

Though GBP did well to initially shrug of concerns of a double-dip, the underperformance of the UK economy vs the US in Q4 has put GBP/USD on track for a return below 1.60. Failure to rebound over the 100d MA at 1.6348 and subsequent reversal below 1.6078 support is reminiscent of the price action four weeks ago, and threatens to push GBP/USD back towards the lower end of the range at 1.5833 (December 30 low). A speedier decline towards 1.5708, the October 13 low cannot be ruled out in the event of a positive surprise for the US January non-far payrolls report on February 5, and pro-USD commentary at the G7 meeting in Canada on February 5/6.

Though the 36bp spread between UK/US 2y yields and 80bp spread in implied Dec-10 short sterling/FF futures should theoretically underpin GBP/ USD, the market is currently conditioned by safe haven aspect of the USD and downside risks to the UK economy going into the most uncertain of periods characterized by record public borrowing and gilt issuance, a general election, and the lingering threat of a downgrade to the UK’s AAA sovereign credit rating. It is unclear how these pieces will fit together in the MPC’s policy deliberations next week which will take place against the backdrop of up-to-date two-year projections for the economy In the Quarterly Inflation Report. Recent rhetoric from a number of MPC members does not indicate that major revisions are planned vs the November report.

Last but certainly not least, the Bank must wonder whether more gilt purchases are the answer to kick starting M4 lending growth. Though the success of QE can partly be measured by the compression in corporate spreads and re-opening of capital markets, optimism that inflation will return to target by year-end may sway the MPC to increase its £200bn limit (as governor King said last week, inflation subsiding is conditional on monetary growth staying under control). What is certain is that the direction of the economy and GBP is set to remain highly volatile with a deviation of macro forecasts creating ample scope for policy surprises and errors.

Key Levels

• Download Full FX Technical Strategy