November global currency and bond outlook

Comment

The G-7 conference in earlier October made most of the usual noises and pledged to make progress on debt relief for Iraq and poor African countries. Additionally, the Chinese finance minister, who was invited to attend this meeting, has commented that while China is moving towards a flexible currency there is no clear timetable for the Yuan to give up its peg to the US dollar. Other G-7 ministers did also express concern about China's appetite for raw materials including oil.

Volatility prior to the election on 3 November has kept the market busy, but within well-worn trading ranges. The dollar did come under downward pressure to 8-month lows but did not set new lows. Volatility is unlikely to let up, especially in the light of more terrorist threats and the increasing likelihood of a very close US election.

Growth in the US, through reported data and surveys showed that growth was not as strong as earlier in the year, but with oil over $50 a barrel this is hardly surprising - market rule of thumb is that a $5 increase in oil knocks 0.25% off GDP for 2 years - given that oil has doubled in the last year, growth is not doing too badly!

While the Homeland Investment Act might bring home $100-$120bn from overseas, which lent some initial support to the dollar, this was outweighed by the increase in the trade deficit to $54bn in August (worse than the $50.1 in July) and the share of it with China grew to $15.4bn. Another interesting component was the petroleum deficit of $14.1bn, when in August the average oil price was below $40 and is now over $50.

Elsewhere other surveys disappointed too. In the UK the purchasing managers' index fell to 54.7, the lowest level for over a year. With the prices charged component weak this should be ‘doveish' for inflation and again starts to suggest the MPC maybe near a peak in rates (although do not expect a cut for a while). Industrial Production fell 0.8% in August (consensus was for +0.3%, with other downward revisions), additionally manufacturing remains soft. With the consumer easing off and the general economy fairly soft the MPC again may think they have done enough.

UK Consumer Prices rose just 0.1% in September (below expectations of 0.4%). Headline CPI is now 1.1%, close to the bottom of the 1-3% range at which the Governor of the BoE would have to write to the Chancellor explaining. However, this is the new ‘harmonized' rate excluding cost of housing. The old RPI is closer to 3%. At the time of the release the Governor told the markets that rates may not have peaked. We believe that even if rates are at or close to a top that they will not start coming down for a while yet. UK 3Q GDP rose a mere 0.4%, although the 12 month rate was 3%. The CBI business trends survey was negative for manufacturing.

Despite the recent reduction in growth outlook for Japan their index of leading indicators rose to 72.2 in July from 60, providing support for the Yen. The Bank of Japan has started to project (at last!) higher consumer prices for the first time in eight years.

Euro-zone unemployment is still reluctant to fall, even though there has been modest economic growth, and remains at the 9% level. However, in Germany it is still much higher at and the August rate rose to 10.7%. The Euro-zone inflation rate ticked up in October to 2.5% (largely on oil).

China raised their interest rates by 0.27%, although a small move it is an encouraging sign that the authorities are moving from administrative measures to market based disciplines. Savings rates were raised by larger amounts suggesting the authorities are confident in their moves.

So, the ‘growth-phase' continues at its subdued pace and inflation remains modest with ‘real-yields' remaining close to all time lows. Therefore, on a global basis we continue to believe there is little room for lower nominal yields, while the risks and potential surprises point to higher nominal interest rates and yields, which is why we remain (overall) underweight duration.

Currency summary

• Undervalued: Australian Dollar, Norwegian Kr, Canadian Dollar, New Zealand Dollar, Danish Krona, Swiss Franc, Euro
• Neutral: Sterling (£), Japanese Yen, Swedish Kr
• Overvalued: US Dollar
• Attractive smaller currencies: Polish Zloty, South African Rand, Czech Koruna