Global Markets Weekly 11 October 2010

• QE2 expectations mean that everything goes up, except the US dollar

  Expectation of a further round of quantitative easing (QE2) drove most markets higher, but the US dollar down. With many members of the regional Federal Reserve (Fed) banks lining up to support the case for QE2, there is a clear market consensus that action is inevitable. The prospect of a further flood of US dollars to stimulate the economy and employment drove down the US currency, just as it drove up the dollar price of other assets. Hence bonds rose (and their yields fell) in anticipation of the Fed buying Treasuries, but equities and commodities were also bid up by the prospect of cheap money and economic stimulus.

• US economic data remains mixed – able to sustain growth, but weak enough to justify QE2

  After the weakness of the manufacturing survey last week, the September ISM survey for the non-manufacturing sector rallied to 53.8 from 51.5, implying continued growth. New weekly jobless claims also fell moderately to 445, 000, but news on employment remains mixed, with total September non-farm payrolls falling 95,000, and the private payrolls component up only a modest 64,000. Our central case remains a combination of continued sluggish growth in the US economy, which is not sufficient to generate appreciable jobs growth, prompting QE2 from the Fed.

• Japan halves its interest rates, from 0.1%

  Japan has already acted, spending ¥2 trillion ($24 bn) in currency markets, announcing a further ¥5 trillion ($61 bn) of quantitative easing and cutting its official interest rates from 0.1% to a stated range of 0-0.1%. But the yen is once again at 15-year highs against the dollar. This apparently perverse reaction reflects the relatively small scale of these policy moves. By contrast, the Fed’s last QE operation was larger by an order of magnitude, spending more than a trillion dollars. While this difference of scale is important for relative trades, as is the case in currency markets, the incremental additions of liquidity are still helpful in sustaining economic growth, supporting asset markets and alleviating the risks of deflation.

• ‘Currency wars’ have been broadly good for markets, but there is risk in increasingly disorderly FX markets

  Because it is restricted in the pace at which it can rise against a falling dollar, China’s renminbi has risen 2% against the dollar since June, but has fallen by as much as 10% against the euro and 7% against the yen. Chinese Premier Wen Jiabo warned at a summit with the EU that a sharper appreciation of the renminbi would threaten China’s economy and "would be a disaster for the world". While we see QE2 and associated stimulative measures as a positive, there is an increasing risk that such intervention leads to a ‘disorderly’ shift in currency markets , prompting trade restrictions that are damaging for overall growth. In this respect, the fact that this weekend's IMF meeting of finance ministers and central bankers broke up without clear agreement on a way forward over currencies was a concern.

• IMF warns that UK residential property is overvalued as Halifax house-price index sees record fall

  The IMF highlighted the lack of correction in UK house prices relative to other assets in the aftermath of the financial crisis, leaving it appearing overvalued,

  echoing our own forecasts. This was followed by the announcement of a record 3.6% monthly fall in the Halifax House Price Index. While the extent of this drop may reflect the index’s greater geographical spread, with a lower weighting to London markets that we expect to be more resilient and greater weighting to more vulnerable regional markets, we believe that further declines are in prospect.

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