Global Markets Weekly 16 August 2010

• Positive earnings figures give way to disappointing economic news
  Following a generally good earnings season, markets refocused upon slowing macro-economic momentum. Weaker-than-expected economic data and fears of deflation in advanced economies drove equities and other riskier assets lower. Government bonds continued to outperform, with US 10-year Treasury yields falling below 2.7%.
• Fed maintains policy stance for now but hints at further QE, undermining the dollar
  The Fed’s decision to invest the proceeds from maturing MBS into long-term (2 to 10-year) Treasuries supported the rally in US government debt. The Fed is maintaining the size of its balance sheet, but is shifting its composition towards Treasuries. While not easing monetary policy, the move prevents a passive tightening (caused by maturing MBS). But given continuing housing market weakness, the Fed may resume MBS purchases. The FOMC statement, which discussed the need to fight deflationary pressures, also raises the potential for a second round of QE, a possibility that has weakened the dollar.
• New QE measures also possible in the UK, following central bank report
  Similarly, the Bank of England’s Inflation Report said that “persistent spare capacity is weighing on companies’ costs and prices,” hinting at a new round of QE. Inflation expectations for the next two years were revised upwards (reflecting increases in VAT and other indirect taxes), but the inflation forecast remains below the 2% target. GDP projections were also trimmed to reflect the impact of fiscal tightening. Thus, further unconventional monetary measures to support the recovery are very likely.
• Healthy growth reported in France and Germany but other data points to underlying euro-zone weakness
  By contrast, euro-zone GDP was stronger than expected, rising 1.7% yoy, led by robust French and German growth. Germany grew at a spectacular 2.2% in the second quarter, driven by a pick-up in exports and construction. However, the impact of fiscal austerity measures is already apparent in Greece, where GDP contracted at 3.5% yoy, and unemployment reached 12%. Furthermore, core CPI in France fell from 1.4% to 0.8%, further highlighting the strength of deflationary pressures among developed economies.
• Slowdown suggests monetary policy will also ease in China
  Chinese data continued to signal an economic slowdown - industrial output rose by 13.4% yoy in July, down from 16.5% as recently as May. Consumer demand growth appears to be waning – the expansion of retail sales fell to a below consensus 17.9%. Consumer inflation accelerated to 3.3% in July. However, flood-related food price hikes drove this increase and PPI has registered sharp declines (mom) since May. We continue to believe that the slowdown is gathering pace, and that monetary policy should loosen in late-2010 or early-2011.
• Deflation will place further downward pressure on Treasury yields
  The weak economic recovery and the uncertainty arising from deflation has raised investors' sensitivity to macro news. In the US, jobless claims increased over the past month, a worrying development for equity markets. US CPI rose for the first time in four months, mostly driven by increases in energy prices. Core CPI remained at 0.9% yoy, but we expect core inflation to fall into negative territory next year, possibly driving Treasury yields down further. Our analysis indicates that if core inflation turns significantly negative, 10-year Treasury yields could fall to between 1.2% and 2.0%. Rapidly declining prices would lead to a second round of QE in developed economies, benefiting currencies where central banks have already started tightening policy (AUD, CAD, NOK, SEK, NZD).

Indices, Interest rates and Inflation

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