Welcome to ECU's Market Commentary blog written by Neil MacKinnon, ECU's Chief Economist. This page will be updated from time to time to cover events impacting the global financial and currency markets.

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19th December 2008

Overnight, the Bank of Japan (BoJ) cut its key rate 0.20% to 0.10% and increased its monthly purchase of JGBs to ¥1.4 trillion from ¥1.2 trillion. It also announced that it would make outright purchases of commercial paper. The Japanese economy has been in recession for most of this year and the economy has found it difficult to escape from (minor) deflationary pressures for the last 10-15 years. That's why a stronger yen is hardly in Japan's best interests and why further yen appreciation is likely to be met by FX intervention.

Equities remain fragile with the Dow off over 200 points last night. Today's market focus will be on the plan to bail out US automakers which is expected to be unveiled today. Quadruple option expiries could make for a volatile trading day in the final week before Christmas. The oil price keeps slipping (as does coal and base metal prices) and bond yields edge lower as the world economy slips close to depressionary conditions.

Yesterday, the ECB widened its 'standing facilities corridor' and reduced the deposit rate 100bps as a way of reducing the attractiveness of holding deposits at the ECB. It also signals that the ECB will continue to cut its main refinancing rate in the New Year. The euro slipped from around 1.46 against the dollar and is around 1.42-1.43 this morning. Sterling contined to slip against the euro though (to 0.95). The slump in the pound this year is now sharper than all post-WW2 sterling devaluations and is the sharpest fall since 1931 when the UK came off the Gold Standard (click here to read the Telegraph's article).

This is my last blog for the year and I will resume in early January. Here are some charts to ponder which highlight the fall in sterling and the US dollar as well as the gains in the euro and yen.

MERRY CHRISTMAS AND GOOD LUCK FOR 2009!

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Click here to view the sterling trade weighted index (Bloomberg)

Click here to view the US trade weighted dollar index (Bloomberg)

Click here to view the euro trade wieghted exchange rate index (Bloomberg)

Click here to view the Japanese yen, trade weighted index (Bloomberg)

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18th December 2008

There have been some extraordinary moves in the FX market in the last few days. GBPCHF has fallen over ten big figures in 48 hours. Sterling makes a new low every day against the euro on what seems a relentless march towards parity. And since the beginning of the week, the US dollar has dropped 11 big figures against the euro. USDJPY is below 90 and the Japanese Finance Minister warns "we will take necessary steps if needed". FX intervention is a clear possibility (click here to see the Bloomberg chart).

The Fed's decision to move rates towards zero and expand its balance sheet (now $2.2 trillion) to continue purchasing agency- and mortgage-backed securities has dented the dollar though it is worth noting that Fed officials are making a distinction that what they are doing is distinct from the 'quantitative easing' implemented by the Japanese authorities during the 1990's (click here to read more). The Bank of England's (BoE) Charlie Bean in an interview in today's FT talks about how the BoE might consider quantitative easing especially as he thinks UK banks need more capital. Bean made no reference to the slide in sterling in his interview (click here to read the full article). Prof Buiter says that the BoE will adopt a zero rate policy by late winter/early spring with the ECB adopting a zero rate policy by mid-2009 (click here for more).

Is there anything else going on behind the fall in the dollar? Some think that European banks are repatriating euros to fill central/eastern european debt exposure on their balance sheets. In addition, Deutsche Bank announced yesterday that it would go against industry practice by passing up an oportunity to redeem €1 billion of callable bonds. Also, some say that it suits Chinese FX policy to see a stronger euro (against the yuan) as it offsets yuan strength against a weaker dollar. On a trade-weighted basis, the Chinese exchange rate has dropped nearly 6% in a month (click here to see the Bloomberg chart). The euro is ignoring a slew of bad news in the eurozone economy with this morning's German IFO index falling to a record low in November. It is also worth noting that the previous correlation between EURUSD and the oil price has broken down with the OPEC decision to cut output yesterday failing to lift the oil price. Demand destruction, a hard landing in China and storage of surplus oil could easily result in a much lower oil price. Are central banks diversifying away from the dollar?

In this market environment, volatile moves are bad news for traders and challenge strategists over longer-term currency direction. While the dollar and sterling are weak (and very oversold at the moment) it would be dangerous to extrapolate current trends. All major central banks will end up copying the Fed. So don't write off the dollar (or sterling) just yet.

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17th December 2008

Well, the Federal Reserve did not mess about last night. A new fed funds target of zero to 0.25% prompted the Dow Jones to surge by 4.2%. The Fed highlighted in its statement (click here to see it in full) that it "will employ all available tools to promote the resumption of sustainable economic growth".

To some extent the rate cut last night simply re-affirmed the 'effective' fed funds rate which had been trading below 0.25% prior to the decision anyway. While the Fed did not directly refer to 'quantitative easing', it made it very clear that it will continue to use its balance sheet to purchase agency- and mortgage-backed securities. In a new development, the Fed said it would consider buying longer-dated Treasury securities. In other words, the Fed will act to ensure that bond yields will remain lower than otherwise would have been the case.

The Fed's statement was quite downbeat in its assessment of the economy ("the outlook for the economy has weakened further") and I think the Fed are clearly intent on avoiding economic depression which I believe is a clear possibility. The pressure is now on the other major central banks to follow the Fed, though recent comments from the ECB suggest little appetite to bring interest rates that much lower. However, Germany is being hit hard by the downturn in world trade and a stronger euro at this juncture will make the situation for German exporters much worse.

Here in the UK, I think there is more likelihood that the Bank of England (BoE) will cut interest rates again. Indeed, Prof Charles Goodhart (former chief economist at the BoE) is recommending 'aggressive' action on interest rates. Not that BoE Governor, Mervyn King, needs much persuading given that he is warning about the prospect of deflation next year and Prof Blanchflower is reported in the Guardian today that he expects unemployment in the UK to rise above 3 million (click here to read the article). Today's UK jobs data is likely to highlight the sharp deterioration in the labour market. Also released this morning are the latest BoE MPC minutes and they are likely to show official concern about the state of the economy. The FX market will also be looking at the minutes for any official concern about the slide in the pound.

In the FX market, the dollar took a tumble on the Fed's rate decision. EURUSD has made a 50% fibonacci retracement at 1.4182. The FX market is taking a simple view that quantitative easing equates with a weaker dollar. Going into year end, previous short positions in the dollar have been squeezed. If the market is right, the US authorities need to watch out that they don't end up with a dollar crisis which would be seen as a total loss of confidence in US economic policy. It is interesting that the FX market has virtually ignored all the bad economic and financial news coming out of the eurozone. At some stage, the ECB needs to cut rates sharply otherwise it will again end up with an overvalued exchange rate. As far as sterling is concerned, there is no good economic news at the momemt and sterling still remains vulnerable (see chart).

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16th December 2008

The past few days have seen weakness in the US dollar and a recovery in the euro and sterling. Dollar bears argue that zero interest rates in the US plus 'quantitative easing' by the Fed diminishes the value of the dollar. Some also argue that the US current account deficit will persist for longer than many think and that funding of the US budget deficit will be a problem especially as China accumulates less FX reserves thereby recycling less into US financial assets. Euro bears, on the other hand, argue that the ECB is 'behind the curve' and that its monetary policy guarantees a long recession in the eurozone. Already some influential forecasters see German economic growth slumping by 3-4% next year. Others question the longer-term viability of the euro and point to fiscal strains which are being reflected in rising bond spreads against German bunds (Greece and Italy in particular).

The euro on a trade-weighted basis has shot up sharply since mid-October by some 9%. This represents an implicit tightening of monetary policy which offsets some of the interest rate cuts the ECB has made in recent weeks. Technically, EURUSD is hitting the 38.2% fibonacci retracement of the move since the summer at 1.3744. The 100-day moving average is at 1.3797. So, the euro either runs out of steam at these levels if the recent move in the dollar is nothing more than a year-end short squeeze (though note that both oil - OPEC set to cut production tomorrow -  and 2-year yield differentials have supported some of the euro move. Click here to see the Bloomberg chart). Should these levels be broken on the upside then the dollar's recent downmove has more traction and will put the euro bulls in the ascendancy as we go into 2009.

As far as the GBPUSD exchange rate is concerned, the economic newsflow for both the US and UK remains poor. In the UK, the Royal Mail is said to be getting rid of up to 50,000 jobs (watch Wednesday's UK jobs data for a further rise in the unemployment rate with 2 million expected to be out of work by next Spring). The US/UK 2-year yield differential which tracks the GBPUSD rate reasonably well is actually moving against sterling. Likewise, the share prices of UK bank stocks are failing to move higher and measures of credit market distress are widening, all of which are not helpful for sterling in the very near term. As a result, extrapolating currency trends in the run-up to Christmas can be a dangerous game. We are still waiting for the UK Government and the Bank of England to recognise that telling the world that you think a weaker pound is good for exporters cuts no ice when world trade is falling (click here for IMF forecasts).

The main focus is this evening's FOMC decision (7.15pm London time). The market expects the fed funds rate to be cut to 50bps. A zero interest rate policy (ZIRP) would be the next step. The effective (rather than the targeted fed funds rate) is virtually near zero anyway and 1-month and 3-month US Treasury bill yields are virtually zero too.

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15th December 2008

Not much in the way of good news on the UK housing market with Rightmove reporting that house prices dropped 2.3% in December. John Varley, Group Chief Executive at Barclays looks for house prices to drop another 10-15% between now and the end of next year. Likewise, the banking sector is still struggling to come to grips with the fall-out from the credit crunch with many banks facing rising corporate debt defaults and, thus, ongoing need for capital as they restructure. Mr Andrew Tyrie in the Letters section of today's FT highlights the onerous conditions of the government's bank bail-ourt which are hurting bank customers. He also (rightly in my view) urges an expansion on the UK Treasury Bill market as a way of helping to fund the budget deficit. A liquid Treasury Bill market would also be attractive for foreign investors. However, I'm not sure the Debt Management Office understands this. Anatole Kaletsky in today's Times says that the Government needs a Plan C ("it appears unlikely that financial conditions will return to normal in the near future").

Otherwise, the main focus this week is the Federal Reserve's interest rate decision and the market expects a cut of 50bps which would take the fed funds rate to 50bps. By January, I think there is a good chance the Fed Funds rate will be at zero. You can also expect the Fed to clarify its stance on 'quantitative easing' which I think has already been happening anyway. The financial and economic crisis is so severe that the Fed won't be the only ones adopting such policies.

In the FX markets, the US dollar is on the defensive and Goldman in its latest forecasts is expecting a weaker dollar (and a stronger pound) in 2009. FX volumes are low at the moment and nobody is really making any big bets on the direction of the dollar just yet. We might get a clearer picture early in the new year. As far as sterling is concerned, Yvette Cooper at HM Treasury says that their policy is not to target the exchange rate. But a weaker pound is starting to become more of a problem. Wednesday's BoE MPC minutes might highlight some of these worries. For sure they cannot raise interest rates to defend the pound but verbal intervention could at least start to stabilise the pound. David Smith's column in the Sunday Times highlighted a number of things covered in my blog in recent days. It is worth a read (click this link) ... he thinks sterling will bounce back and claims that the pound is 15% below fair value against the Euro.

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12th December 2008

The US auto bail-out talks in Congress collapsed last night and triggered a sharp fall in Asian stockmarkets with the Nikkei dropping around 5%. A procedural vote in Congress is expected this evening so some sort of compromise cannot be ruled out. Either way, it looks like being another of those "full moon" moments today with equity markets set to be volatile.

Sterling made a new low against the euro (again) but the spat between the German Finance Minister and our Prime Minister over UK fiscal policy would appear to put a question mark over the thesis that there are plans for sterling to join the euro. At some stage though, the Bank of England needs to step in and say enough is enough as far as the pound's decline is concerned. When world trade is collapsing as it is, a weak currency does not do much to increase exports. For economies that have budget deficits, a weak currency does little to generate external finance. I think the Bank of England will wake up to this fact soon so sterling bears should watch out. The Bank has the best part of £150 billion of gilt-edged securities to sell next year and they will almost certainly need the help of foreign investors to do it. Fed Chairman Bernanke understood this earlier in the year when he made a U-turn on the dollar and realised that dollar weakness not only might upset foreign investors (and America is totally dependent on the kindness of strangers) but also that a weaker dollar pushed the oil price higher.

Overnight, USDJPY broke down through the 90 level. A stronger yen won't help the Japanese economy. I think it won't be long (80-85?) before the Bank of Japan intervenes. Next Monday's Tankan survey (a very important indicator of Japanese corporate health) is expected to be weak.

Next week sees the FOMC meeting. The Fed is expected to cut rates again and the fed futures market is giving an 86% probability of a 75bps cut in the fed funds rate to 25bps. A month ago, the probability was zero. It is also possible that the Fed clarifies its stance on 'quantitative easing'. You can expect most of the central banks to follow the Fed's line on this in the months ahead. The Swiss National Bank yesterday moved closer to a zero rate policy by lowering its target rate to 50 bps.

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11th December 2008

Sterling's collapse against the euro is making the front pages of the newspapers. The state of the UK economy and the escalation in government borrowing are largely to blame say the media. The talk is of sterling going to parity against the euro and conspiracy theorists say Lord Mandelson is plotting to abandon the pound and join the euro. The Prime Minister says he isn't and let's hope that is true.

Some say that if the UK had been part of the eurozone in the last few years then the UK's bubble would have been bigger and the subsequent downturn would have been sharper. The ECB pushed eurozone interest rates down to 2% over the 2003-2006 period whereas UK interest rates never dropped below 3.50%. Likewise over that period, the euro became the most overvalued G7 currency hurting export competitiveness. If the UK had been part of the eurozone this year, it would have suffered an interest rate hike in the summer. The ECB made a big mistake then for which the German economy is paying a price. So euro membership would not have been a good idea then and it is difficult to see how it could be a good idea now.

Back to sterling. Goldman Sachs in their latest top trades suggest buying cable for a move to 1.65. The pound's 25% drop on a trade-weighted basis in 18 months leaves it at a 5-15% discount to fair value on a purchasing power parity basis. Goldman see 1.65 as "fair value" and look for dollar weakness as a result of persistent current account deficits and a further move to "quantitative easing" by the Fed. Goldman think that a lot of the "bad news" on sterling is now priced.

There are other theories as to why sterling has been weak, some of which are related to the idea of the UK being a giant hedge fund which is experiencing deleveraging and investor redemptions. The UK's gross foreign liabilities are about 500% of GDP and the UK banking sector's foreign liabilities are large ... about three times GDP (compared to seven times for Iceland). The UK's overseas assets are biased towards equities and bonds but financial market weakness has turned the UK's NET asset position negative. Goldman reckons though that the pound has fallen more or less enough to balance the UK's net asset position.

In fact, the trade-weighted value of sterling this year has closely tracked developments in the credit markets (click here to see this chart - Source: Bloomberg LP) . At the moment, measures of credit risk remain elevated thus largely expaining why sterling is weak. The Wall Street Journal this morning notes that "sterling may be simply a barometer for global investor confidence". If credit conditions ease up and investor confidence returns, then Goldman could be right and sterling could then recover some lost ground.

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10th December 2008

The latest news on the UK economy remains grim. Industrial production dropped 1.7% in October and the trade deficit widened to £7.7 billion in the same month. Previous declines in the pound are doing little to boost exports as gains in competitiveness are being eroded by the slump in the global economy and in world trade. The influential forecasters, NIESR, estimate that the UK economy is shrinking at a year-on-year rate of 1%. With the price of crude oil at US$43 this morning, inflation can start tumbling. Indeed, 2009 is likely to be Year Zero for the UK economy...zero growth, zero inflation and zero interest rates. Sterling hit a record low against the euro yesterday and a test of the 0.90 level (or even parity) looks undemanding. However, sterling is holding up against the US dollar (still tracking 2-year yield differentials) as well as the yen and swiss franc.

In the US, 1 month and 3 month Treasury bills are at zero (actually traded negative, i.e. they are paying the US Treasury to look after their cash) and the effective (rather than the targeted) fed funds rate is virtually zero too. In the run-up to end-year. investors and institutions want to protect cash and preserve capital, hardly surprising after this year's events in the financial markets. The Wall Street Journal reports this morning that the Fed is considering selling its own debt for the first time. The Fed's balance sheet (now more than US$2 trillion) has expanded rapidly in the last few months.

Equities still remain volatile. The Dow closed last night down 2.7% though overnight Asian markets (Nikkei, Hang Seng) were up 3-4% presumably helped by news that White House and Congress agree on a US$15 billion aid plan for the auto sector. Bank of Japan (BoJ) Governor Shirakawa broke radio silence on the yen this morning by warning that they could intervene to prevent "excessive moves" in the yen. However, there is a close correlation between credit risk (as measured by the US junk bond spread over US Treasuries) and USDJPY. The higher the risk (the wider the spread) pushes the yen higher. So some alleviation in credit risk is required to push the yen lower. The BoJ's warning has to be taken seriously so expect further verbal intervention. Actual intervention may only take place if USDJPY moves towards 80-85. The last thing the Japanese authorities want right now is a stronger yen. This is simply a recipe for deflation and depression.

Elsewhere, EURUSD is returning to the top of its trading range (approximately 1.3000). The demand for dollar liquidity is being sated by the provision of such liquidity by the Fed and ECB. At the end of the third quarter, there was a scramble for dollar liquidity which pushed USD higher. Now it seems unlikely that a squeeze in liquidity can do the same as year-end and quarter-end approaches. Cross currency basis swaps (an indicator of liquidity demand) have actually been narrowing and this explains why USD is a little softer against the major currencies at the moment (click here  for an explanation of how swaps work).

A larger-than-expected rate cut (75bps) by the Bank of Canada (BoC) yesterday, together with negative currency statements by the BoC has actually done little to weaken CAD. USDCAD finds tough resistance in breaking the 1.3000 level and USDCAD is a little softer this morning at below 1.2600. CAD though gets a double-whammy from a weak US economy (70% of Canadian exports go the the US) and from a weak global economy (falling commodity prices hurt Canada as a commodity producer). Disappointed CAD bears need to watch out for a technical move to 1.2000.

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9th December 2008

There is little sign of any let-up in the downturn facing the UK economy. The latest Royal Institution of Chartered Surveyors (RICS) survey continues to highlight a weak housing market and the latest BRC survey shows that retail spending is at its weakest since 1965. Don't expect much respite in the months ahead. Unemployment is rising as the fall-out from the credit crunch takes its toll. Much like last Friday's US jobs report where the loss of jobs is on par with the worst of the 1980s recession, the same can be expected in the UK across all sectors of the economy with financial services and real estate being hit the hardest.

Equity markets started the week in positive fashion reacting to news that President-elect Obama is considering a US$1 trillion fiscal stimulus plus aid for the struggling US auto sector. The S&P index has jumped to a high of 909 (as at the close yesterday, 8th December) from a low of 752 on 20th November. However, it is difficult to get too optimistic about equity market returns over the medium term as earnings will be adversely affected by a low growth/no growth environment.

As far as the foreign exchange (FX) market is concerned, there was a classic short squeeze yesterday which saw the euro and sterling claw back some lost ground. However, most of the fundamental and market indicators did not suggest anything of significance was really going on despite some commentators starting to look for a bottom in the pound. UK fundamentals still remain poor and a low interest rate economy where the central bank seems indifferent to a lower exchange rate will make external financing of the deficit quite difficult. At some stage, the Bank of England will have to reconsider its attitude towards the pound, otherwise foreign investors will have little incentive to buy UK government debt.

Technically, most of the sterling crosses ran into trendline resistance yesterday and this morning, sterling started to roll back again. FX trading volumes are still below average and as the year-end approaches, there seems little enthusiasm amongst FX traders to take big bets on any of the major currencies. The euro is struggling to make any recovery and around 1.25 against USD is regarded as approximate "fair value" having been overvalued when the euro was trading in a 1.30-1.60 range. A return to trading below 1.25 cannot be ruled out. Sterling is undervalued though and there are few, if any, long positions. On a trade-weighted basis, sterling has had its sharpest decline since the 1970s. It is unlikely that we will see fresh declines of similar magnitude during 2009. If anything, investors and traders might start to see some value in the currency.

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4th December 2008

Bank of England cuts interest rates
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The Bank of England cut interest rates by 100bps to 2%. The markets had been prepared for a rate cut of up to 100bps. Certainly, the UK economic situation has deteriorated since the last rate cut in October. A variety of indicators show a slump in activity in the manufacturing and services sector, unemployment is moving higher and the housing market shows little sign of bottoming out. In addition, shop price inflation has declined for the third consecutive month according to the British Retail Consortium and highlights the need for aggressive price discounting, given that consumer confidence is so low at the moment. In the financial markets, equities remain jittery while the credit markets are actually deteriorating with credit default spreads rising sharply. The UK's sovereign credit default spread has exploded in the light of the government's recent forecasts of a massive increase in borrowing (8% of GDP). Against this background, the Monetary Policy Committee is right not to pussy-foot and they must be alert to do whatever is necessary to restore confidence and get the economy back on track.

Of course, the financial and economic crisis is global in nature and policymakers everywhere have implemented unprecedented monetary measures to combat the risk of deflation and economic depression. In the US, the Federal Reserve is expected to cut interest rates to 0.50% at their 15-16 December meeting and I think there is a good chance that the fed funds rate may go to zero at their policy meeting at the end of January. There is also growing evidence that the Fed is already adopting a policy of 'quantitative easing' given the rapid expansion in the Fed's balance sheet. Quantitative easing is economic jargon for 'printing money' and 'monetising debt'. There is every possibility that most, if not all, major central banks will adopt this policy including the Bank of England.

Hopefully, radical measures such as these in conjuction with further fiscal stimulus (especially in the US) will help stabilise both the financial system and the real economy. However, the overhang of the massive build-up in household debt both sides of the Atlantic will take time to unwind and suggests a period of prolonged sub-par growth. In spite of the massive monetary stimulus taking place, the velocity of circulation of money has declined sharply. Liquidity is being hoarded and "cash is king". Until velocity speeds up, inflation will not be a problem but it has to be remembered that history shows us time and time again that inflation is the tool governments use to get rid of debt but I think that is an issue for the financial markets further down the road.

What does this mean for sterling? Over the past 18 months or so, sterling has experienced its sharpest decline since the 1970's when Denis Healey went cap in hand to the International Monetary Fund (IMF). Sterling has fallen because of the role played by the housing market and financial sector in the UK economy. The fall in the UK housing market and the problems in the UK banking sector as a result of the credit crisis have dented sterling. Recent interest rate cuts, the process of deleveraging (Reykjavik on the Thames) and talk that Britain could join the euro have accelerated the decline in the pound in recent days. But it is worth noting that currency moves are rarely a 'one way bet' and what goes down does eventually go up. As debt managers, we are watching the situation closely because we think there will be an opportunity for sterling to recover from a situation where sentiment is overwhelmingly bearish and the market is short of the currency.
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