More volatility in nervous markets push bonds higher

Rates

Yesterday, trading was very volatile in major markets with 1 pm CET the turning point. As the dust settled in the US session, global core bonds ended with juicy gains, especially in the Treasury market. US yields ended 5-6 bps lower, with the 2-yr underperforming (-2.4 bps). German yields ended the session slightly lower at the 2-5-yr and 1.7 and 4 bps at the 10-30-yr.

Weakness in oil, rouble and other EM currencies were bond supportive in the morning, but oil and the rouble turned cautiously north again in the afternoon, apparently on a short squeeze after a main FX broker said it would close any open rouble positions. European equities traded in the morning volatile, but without much direction. Stronger EMU PMI figures for December and a stronger German ZEW-indicator only temporary halted the bull run of core bonds. German yields again reached new all-time lows with the 5-yr yield temporary fell below 5 bps, the 10-yr yield below 0.60% and the 30-yr yield below 1.4%. Following the “turnaround” of oil and the rouble around noon the Bund run eased somewhat, but recouped part of it in later US session, when US equities lost ground again. Initially there were rumours that the influential Fed watcher (WSJ) Hilsenrath would write that the Fed could issue a more dovish statement. This might have helped the risk-on rally (that only modestly affected core bonds). Hilsenrath however stated that there is a strong possibility the Fed could drop its “considerable time” language, sending equities and US Treasuries sharply lower from initial strong gains. Concluding, it will be today’s FOMC decision that dominates trading.

The eco calendar remains interesting today with inflation data in the euro zone and US. According to the preliminary estimate, euro zone HICP inflation slowed to 0.3% Y/Y in November, down from 0.4% Y/Y in October and again at its multi-year low. The final reading is expected to confirm this outcome. We believe however that the risks remain for a downward revision. Core inflation stabilized at 0.7% Y/Y as downward price pressures were mainly based in energy. In the US, CPI inflation is forecast to have dropped by 0.1% M/M in November, mainly due to the sharp drop in energy prices. The annual rate is however forecast to ease substantially from 1.7% Y/Y to 1.4% Y/Y. Despite discounts at the start of the Christmas shopping season, prices in the services sector are expected to have increased by 0.1% M/M. Core inflation, excluding food & energy, is forecast to have stabilized at 1.8% Y/Y.

Last week PM Samaras called snap presidential elections after the Eurogroup delayed the final payment under the European part of the EU/IMF bailout package. Today, it’s the first out of three voting rounds in parliament. Today, a supermajority is needed (200/300) for Samaras’ candidate to get elected, which is highly unlikely given the 155-seat coalition. The supermajority needed drops respectively to 190 votes and 180 votes at the second and third voting rounds. The number of votes will be interesting. If they fall well below 180, it could spur more stress on Greek markets because if Samaras’ candidate doesn’t get elected, snap parliamentary elections will be called. Currently, anti-bailout party Syriza leads by a comfortable margin in the opinion polls. They threaten to tear up the reform and austerity programme and favour debt restructuring.

Overnight, Asian equities trade mixed to slightly higher which is all in all rather good given late night Wall Street weakness. The S&P 500 lost more than 2% in the final trading hours (after gaining around 2% earlier).
Nevertheless, we still expect weakness in the European stock opening. The US Note future trades stable overnight, but the Bund could thus still open slightly higher.

Today, the EMU eco calendar is empty apart from the Greek election (see above) and final figures for EMU inflation (downside risks). In the US, CPI data will be released but their market impact will be tiny given the main event later on the day: the verdict of the FOMC meeting. We thought the Fed could drop the “considerable time” phrase (keeping the door for a Summer rate hike open), while leaving the “dots” roughly unchanged.
Recent market stress raised doubts around this scenario. Has the Fed the determination to change its forward guidance in thin end-of-year markets given already high volatility? Finally, we stick to our opinion that the Fed will change its guidance (hawkish). In such a case, that’s a long term negative for US treasuries with underperformance of the front end (2-5yr) of the curve expected. However, whatever they decide, short-term safe haven flows might still dominate in case the crash in EM FX/oil/equities continues. For German rates, we expect only small spill-over effects from eventual higher US rates. At least until the day that the ECB effectively walks the QE talk, we think there is very little upward potential. For intra-EMU bond markets, contagion risks (Greek political gamble, higher volatility) increased which could lead to some spread widening (PIIGS).