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Global Markets Weekly - 15 June 2009

• Markets made continued gains as confidence in economic recovery grew.
  The mood of recovery continued last week, with equity markets making modest gains across the board. More cyclical and emerging markets were the pick of the bunch, as investors gained confidence. That was also true of commodity markets, where oil hit a new high for the year of $72 a barrel but gold fell back slightly, perhaps reflecting the reduction in investors' nervousness or the more attractive potential returns from economically cyclical investments as the recovery gains ground. In such a positive week, it was little surprise that bonds - particularly in the US and the UK - fell back, driving up yields.
• Despite earlier nerves, bond markets rallied after a new issue of US Treasuries was snapped up.
  The US bond market struggled in the face of massive new issuance, with investors demanding higher yields. This prompted stories of a buyers’ strike and pressure for higher interest rates to curb the inflationary risk from the Federal Reserve’s programme of quantitative easing. However, a less pessimistic view of the market would suggest that bond yields are rising as a natural response to an economic recovery that has probably already begun, while - with $65 billion of new issuance to absorb - we are seeing an auction discount, as the market demands a higher yield ahead of a new issue. This view was supported by the yield on 10-year Treasuries, which rose from 3.7% to nearly 4% before the auction but subsequently fell back to 3.8%. Interestingly, these apparent concerns about the outlook for the US – and indeed the UK, which has similarly huge funding requirements – did not prevent the dollar and sterling both rallying this week.
• Positive economic surprises continue, even in the UK... The economic news should continue to improve over the coming months, according to our work on forecasting monthly data. This positive view is confirmed by the UK’s National Institute of Economic and Social Research, whose monthly estimates indicate that UK output grew in both April and May. We now expect UK GDP to bounce back in the second half of this year - rather than at the start of 2010, as we had previously forecast.
• ...but a housing rally is likely to fade, amid difficult conditions for consumers.
  Although this good news has coincided with reports of a rise in UK house prices, we do not think that the housing market has bottomed. A sharp cut in mortgage costs has boosted affordability and encouraged buyers to go house-hunting during the good weather in a market with few sellers. Nevertheless, the level of buyers and credit available is not sufficient to drive a sustainable improvement in house prices, and we expect further price falls as pent-up selling is released into the market. Similarly, in the US, the troughing of the number of new unemployment claims is welcome and a positive sign of recovery. Yet unemployment is set to keep rising this year, leaving consumers under pressure even as the economy returns to growth.
• Economies continue to face headwinds, with financial systems still on life-support.
  That US banks are already repaying the capital injected under the Troubled Asset Relief Programme is a positive sign and an indication of investors' renewed confidence. However, this new money is being used to pay back the government, not to support new lending. Credit conditions remain tight, and governments and central banks are still actively intervening to inject liquidity into markets and the economy. Indeed, the Bank of England is proposing to extend its Asset Purchase Facility to buying commercial paper. That reinforces our belief that markets are premature in starting to worry about a rise in official interest rates.
• ...so the next two weeks should signal whether this rally can become more sustainable.
  The past month’s equity advance shows many hallmarks of a bear-market rally, and we on balance expect a corresponding period of weakness. There are risks to this view, especially the trend of less-bad economic data. Indeed, the arguments of both bulls and bears are likely to be rigorously tested over the coming fortnight. The outcome will be a clearer answer to the question of whether the rally of March 2009 was indeed just another false dawn or the start of something more significant.

Indices, Interest rates and Inflation

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