Markets: Fixed income

On Thursday, global core bonds only half-hearted profited from the disappointingly weak business confidence indicators in Asia and the EMU.
While the Bund eked out some daily gains and yields fell 2.5 to 6 bps, US bonds turned around during the US session and ended little changed.
US equities shrugged off early risk off sentiment and again closed little changed. The euro on the other hand did lose ground. Commodities were mixed. The CRB lost some ground, but oil rebounded. The usual correlations between markets were once more feeble. This strengthens our conviction that the price changes this week were largely technical in nature and linked to the big directional moves in the previous week.

Intra-day, weak Chinese and Japanese business sentiment put markets in a risk-off mode at the start of European trading. The Bund opened higher and got some additional gains when equities opened weak. However, there was no follow through buying and sideways trading kicked in. The European PMI’s were disappointing, but not too far from consensus. However, the sharp differences between manufacturing (up) and services (down) and between Germany (up) and France (down) are potentially sources of market frictions later on. The Spanish bond auction went well, but couldn’t prevent that Spanish bonds lost ground in the afternoon trading. News about the “bad bank” having difficulties to get participation of the stronger Spanish Banks and a difficult meeting between PM Rajoy and the president of Catalonia might have played a role in the deteriorating sentiment in the Spanish (and Italian) bond market. However, we don’t consider the news as very important. Markets are nervous about the willingness of Spain to apply for EFSF support and this brought a lot of volatility in the peripheral markets this week. We think that Spain will ask for a rescue package and this fits in with an FT article today stating that EU authorities are working between the scenes to pave the way for a new Spanish rescue package. Whatever, the Spanish and Italian yield spreads widened by respectively 13 and 12 bps, following a 19 and 12 bps narrowing on Wednesday.

When US traders got involved, core bonds caught again a bid, which was sustained after the early morning initial claims report and lasted until 16h. At that time, the Philly Fed was reported somewhat stronger than expected and equities turned up again. This was enough to erase all US Treasuries’ gains. The US 10-year TIPS auction was awful and led to more selling in the overall market. The Bund held up quite well until after the official close, but eased later on, dropping 20 ticks from the official close and leaving the Bund with only modest gains on the day.

Today, the eco calendar is very thin with only some second-tier economic data as Belgian business confidence and the UK public finance data. Fed’s Lockhart and ECB’s Liikanen are scheduled to speak.

Minneapolis Fed Kocherlakota, previously in the hawkish camp and forecasting higher official rates in 2013, surprisingly said that he would have voted in favour of QE-3 if he had voting rights in FOMC meetings this year. He added that the Fed should vow to maintain low rates until unemployment is below 5.5%, as long as inflation is below 2.25% (he favours more numerical targets).
He didn’t say what that would mean for QE-3, continuing till these “targets” would be reached? We don’t think Kocherlakota would go so far. Chicago Fed Evans earlier spoke about unemployment below 7% and inflation below 3%. We deduct from these comments that indeed the Fed thinks rates will stay low for very long, but also that the Fed starts preparing markets for accepting (temporarily?) somewhat higher inflation. Also in the FOMC statement and the press conference afterwards, there were some hints in that direction. This is a very interesting debate. St-Louis Fed Bullard, a moderate hawk, said he would have voted against QE-3. He hopes on 3% growth next year and warns that the unemployment rate may fall for the wrong reasons, notably because of reduced participation (people leave the workforce and thus lower the unemployment rate without having a job). Bullard also saw the sharp increase of inflation expectations after the QE-3 decision (see graph higher), which bears close watching, even if he added that inflation is near target. He wants the Fed to target inflation and not GDP, as the crisis has probably harmed the long term growth potential. Cleveland Fed Pianalto, a centrist, who supports the Bernanke majority, signalled her support for QE-3, but nevertheless added that the Fed should continue to monitor the cost and benefits of the programme.
Finally Boston Fed Rosengren, an arch-dove, said that 2% is the target, but no ceiling. While interesting, the Fed comments had no lasting impact on trading.

The Spanish bond auction fared well. The Treasury sold €4.8B of 3 and 10-year bonds, slightly above the pre-announced target range of €3.5-to-4.5B. It sold €3.9B of its new 3.75% October 2015 bond and an average yield of 3.845%. Bid totalled €6.132B giving a solid bid/cover of 1.6. Demand was maybe supported by the duration as the bond falls inside the scope of an eventual ECB bond buying programme. The Treasury also sold €0.859B of its Jan 2022 bond, the first longer-dated bond on tap this year. Bids amounted to €2.445B, resulting in a bid/cover of 2.8 (small size though). The French BTAN auction (€7.965B) on the contrary didn’t go very well, maybe also because of the disastrous French PMI data released shortly before the auction. It suggests the French government will have difficulties to reach the deficit targets in 2013, as growth risk disappointing. French shorter bonds underperformed a tad.

Regarding trading today, Asian equities are trading mixed, but are losing ground in the past hour. The Bund opened weak, but currently traded only 10 ticks below yesterday’s after-market levels (and about 35 ticks from official close). Overnight headline news is not exciting. The Spanish (officials working behind the scene) and the news on Greece is positive. BoE’s King was cautious on the recovery, but the Italian government sharply lowered 2012 growth forecast (-2.4%) and upped 2012 deficit forecast to 2.6%, a negative for Italian bonds. The eco calendar contains no market movers. This makes us think that we might close an uneventful trading week by an uneventful trading session.
The US Treasury “rally” apparently ran out of steam yesterday, but this was not yet clear for the Bund. All in all we expect sideways trading.