German bonds crash as trading desk sell inventories

Rates

Yesterday, core bonds were under sharp downward pressure during the European session. A very weak US Q1 GDP release brought only temporary relief for US Treasuries. Eventually, a dovish Fed fend off the downside in US Treasuries together with strong US auctions. The Bund on the other hand, headed south into the close. There were a lot of potential drivers behind the move. Stronger EMU/German data, the sell-off of Swedish bonds despite more QE by the Riksbank, a failed German Bobl auction, huge supply and renewed hopes on a Greek deal. The German curve bear steepened with yields 3.5 bps (2-yr) to 15 bps (30-yr) higher. US yield changes varied between -0.4 bps (2-yr) and +4.9 bps at the 30-yr. According to trading desks, the absence of real money buyers, a result of stratospherically high prices driven by ECB activity, led to a violent selling from trading books.

FOMC: Soft patch, but greater uncertainty on outlook

In the April FOMC statement, the Fed fully recognized the Q1 soft patch, in line with yesterday’s Q1 GDP release. However, the FOMC still believes it is (partly) transitory, even if it raises uncertainty about the economic outlook. The FOMC now wants serious evidence that the economy is back on a stronger trajectory and inflation will move to its 2% target, before initiating the long-awaited lift-off. A June lift-off is off the table, with the September meeting the best contender for a first rate hike if the economy is much stronger than in Q1 (our guess). However, the hurdle is higher. The statement was nearly unchanged on inflation, even if the Fed could have been a bit more optimistic as inflation and market based-inflation expectations rose.

The Fed extensively explained economic softness. Growth in household spending is declining, business fixed investment weakened, housing remains soft and exports declined. They even pointed to a slower pace in job growth and little changes in the underutilization of labour resources. The latter is a bit strange as there was only one (weak) payrolls report since the previous meeting. However, as said, they still see the soft patch as partly transitory. Little changes in the outlook. The Fed sees progress towards reaching their dual mandate. They keep their reinvestment policy of maturing assets intact and when they decide to remove accommodation, they will take a balanced approach (inflation and labour market). The decision was unanimous (10-0).

EMU Inflation and US employment cost main drivers.

In the euro zone, HICP inflation is expected to jump out of negative territory. The consensus is looking for an increase from -0.1% Y/Y to 0.0% Y/Y. Yesterday, both Belgian (0.3% Y/Y from -0.4% M/M) and German (0.3% Y/Y from 0.1% Y/Y) inflation rose more than expected and therefore we see risks for an upward surprise in the euro area reading too. Core inflation, on the contrary, is expected to stay unchanged at 0.6% Y/Y, its record low level. Also here, we see risks for a higher outcome. The euro zone unemployment rate is expected to extend its downtrend in March. In the US, the Employment Cost Index, is expected to show a 0.6% Q/Q increase in the first quarter, slightly up from 0.5% Q/Q in the fourth quarter. After a slowdown in the fourth quarter, the risks might be for an upward surprise after signs of a cautious pick up in wages.. Initial jobless claims are forecast to have dropped slightly in the week ending the 25th of April, from 295 000 to 290 000.. We believe that distortions will fade and see therefore risks for a lower outcome.

Strong US auctions

The US concluded its end-of-month refinancing operation with strong $15B 2-yr FRN auction and $29B 7-yr Note auctions. The 7-yr stopped firmly through the 1:00 PM bid side with a close to average bid cover (2.44 vs 2.49 over the past year). Bidding details showed good demand with the indirect bid, reflection foreign investor demand, again standing out.

Today’s Strategy

Overnight, most Asian equity markets trade negative with China outperforming. Japan markets underperform, returning from holiday. Japanese eco data were somewhat stronger while the BoJ and the RBNZ kept policy unchanged (see currencies). The US Note future is marginally higher, well off yesterday’s intraday lows. The dovish FOMC statement (see above) fend off the downside in the US Note future (128-04+).

Today’s eco calendar remains well-filled. In EMU, risks for EMU (core) inflation are on the upside of expectations. Together with a strong Spanish GDP reading and improved sentiment on Greece (temporary deal hoped for by May 3, signed agreement by May 11 Eurogroup), this suggests that the downward correction in the Bund could go somewhat further though the violent pace of yesterday’s decline is unsustainable. We hold on to the view that any correction remains temporary in nature as long as the ECB mechanically pushes EMU yield curves down with its PSPP-programme. Nevertheless, if we remain below the uptrendline in the June Bund contract, the short term technical picture changes from bullish to neutral.

In the US, the employment cost index is the main release. Risks are for an upward surprise. That’s a negative for the US Treasuries, but the reasoning is similar than for the Bund. It could extend the down-move, but at a slower pace. 128-04+ should hold given the Fed’s stance and technical elements (end-of-month) extension buying.