The Italian spread dropped 8 bps

Markets: Rates

On Tuesday, most investors stayed put ahead of the Fed. US bonds outperformed German bonds in a thin trading session. Markets seem to be positioned for a rather dovish outcome. US equities eked out some gains, with the S&P within striking distance of the all-time high. USD was put further in the defensive.

Intraday, there was little news to guide trading. Trading ranges on global core bond markets were narrow and traded volumes low. Investors of course stayed sidelined ahead of the outcome of the FOMC meeting. During European trading, the German ZEW printed stronger (see news). The Bund ticked lower but there was no follow-through action. In the US session, the headline inflation number was slightly lower than expected. Core bonds now ticked higher, but again without follow-up action. At the end of the day, the German yield curve shifted 0.5 bps (2-yr) to 2.6 bps (10-yr) higher. In the US; yields dropped 1.6 bps (2-yr) to 3.5 bps (30-yr).

On intra-EMU bond markets, 10-yr yield spreads versus Germany shed 1 bp to 13 bps. The Italian spread dropped 8 bps. Italian media reported that Berlusconi would launch a video message today after a Senate Committee vote (a motion to halt expulsion proceedings against Berlusconi). In the video message, the ex-PM is expected to launch a new political party “Forza Italia” and to give his support to the current government. This should (temporary) take pressure of Italian bonds, also because there are quite some MP’s from Berlusconi’s current party who won’t follow him should he pull the plug out of the government.

Today, the focus will be on the outcome of the key FOMC meeting. Ahead of the announcements, US housing starts and building permits will be released and Germany (Schatz) and Portugal (T-Bills) will tap the market. All attention will go to the FOMC meeting though.

After increasing housing starts and permits in July, more mixed figures are forecast for August. Housing starts are forecast to have increased further in August, by 2.3% M/M to an annual level of 917 000. After a strong start of the year, housing starts fell back over the previous months partly due to poor weather conditions, while higher mortgage rates might have played maybe some role too. Nevertheless, construction activity should be supported by limited inventories of homes for sale, suggesting that the recovery will continue in the months to come. Recently however, permits have increased only slightly and therefore we believe that the risks for starts might be on the downside this month. Permits are forecast to have dropped slightly in August following a 3.9% M/M increase in July. The consensus is looking for a decline by 0.4% M/M to a total level of 950 000. We believe that the risks for permits might be on the upside, although higher mortgage rates could start to have an impact.

Today, the German Finanzagentur kicks off this week’s EMU bond supply by tapping the on the run 2-yr Schatz (€5B 0.25% Sep2015). It’s the first tap since the €5B launch at the end of August. This week, the Schatz cheapened around 1.5 bps in ASW spread terms and slightly outperformed versus surrounding bonds. At this year’s previous 8 Schatz auctions, total bids averaged €7.88B. The Bundesbank on average retained €0.82B (16.4%) of the total volume on offer. This week’s auctions won’t be supported by bond redemptions. In general, Schatz auctions meet with good demand and we don’t expect difficulties today.

We elaborated in length on the upcoming FOMC meeting in our previous reports. We summarize the main points. First, the Fed most likely will start tapering its bond purchases. We think the Fed will reduce the monthly amount by $15B ($10B Treasuries, $5B MBS). The latest Bloomberg survey showed a (median) consensus for a $5B cut in Treasury purchases and unchanged MBS purchases. US primary dealers consensus is for a $15B cut in the monthly purchases. While we don’t think that the amount of tapering is very key for the market reaction, unless it deviates substantially from consensus, the market is more neutral positioned than two weeks ago. 5-year T-yields are down 25 bps, 10-yr-yields 17 bps. This means that some reaction is still likely on the decision.
Postponement of the tapering should support Treasuries (and MBS), but longer term bonds could react negatively, as it would be considered confusing (higher term premium? Vague inflation concerns? ). Second item will be the forward guidance. We think the FOMC will keep it unchanged for now, but after the publication of the previous Minutes, it is obvious that the debate on this point is lively inside the FOMC. If they would lower the unemployment threshold, Treasuries would rally, the shorter end of the curve outperforming as it would shift the expectations about the timing of the first rate hike backwards. Longer term, it looks a risky strategy for the Fed, as its credibility would be questioned in case future eco releases would improve sharply. Introducing a bottom for the inflation threshold below which the Fed would not raise rates, even if unemployment rate would drop below the unemployment rate threshold is probably less important and thus should have less impact on markets. Third item is the eco and rate projections. These will also be important, especially as we get for the first time forecasts for 2016. A downward revision of the unemployment rate projections for 2013-2015 would be negative for Treasuries, especially as it would result in a new projection for 2016 at about 5.6% (the Fed’s long run projection). This of course needs to be interpreted in conjunction to the decision about (lowering) the unemployment rate threshold. The projections for GDP and inflation are probably less important, unless of course an unexpected sharp downward revision of the eco outlook. The end-of-year rate projections for 2015 and 2016 are very important.

In June, the mean rate for end 2015 stood at 1%, while the Fed funds futures are at an implied 1.25%. For the end of 2016, there are not yet FF futures, but if we look at the 3 month Eurodollar futures, we deduct that markets expect the FF to be in the vicinity of 2.40%. Taking a similar spread as for end-of 2015, if the Fed end-of-2016 projection would be higher than 2.25%, it might surprise markets and cause a sell-off of bonds. Above, two graphs show that based on the FOMC forecasts for 2015 and making conservative assumptions for 2016, the Taylor rule suggests higher rates. Fourth, Mr. Bernanke’s press conference might be important too. He is generally expected to be dovish and we have no reasons to doubt he will.

So, it is obvious that the combinations of the various decisions will determine the market reaction. As said above, the market is more neutral positioned than 2 weeks ago. If our calls are correct, the market may react negatively, or at least the gains should be limited. For the 10-year yield, we watch closely the 2.70% level. It should hold in our scenario, keeping the longer term technical picture bearish. Should we nevertheless drop below 2.70%, it would be a signal that the sell-off phase that started early May is over and a more pronounced consolidation/correction is in place. (For the German 10-year yield, we look for the 1.80% as a similar key level, which if broken (not our scenario) would suggest a more pronounced consolidation/correction phase might have started). Current range boundaries are at 124-24 and 122-07 for the T-Note future and at 138.99 and 136.42 for the Bund.