The German yield curve bull flattened

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Panic in markets pushes core bond yields sharply lower

Wednesday’s trading had something surreal. We’ll start with the daily changes. Hold on tight. The German yield curve bull flattened. The 2-yr yield lost 1 bp, the 5-yr yield shed 4.5 bps (< 0.10%), the 10-yr yield dipped by 8.3 bps (<0.75%) and the 30-yr yield fell by 10.4 bps. Yields fell even lower during the session. Yields till the 4-yr sector are now negative and yields from 3-yr to the very long end of the curve recorded new all-time lows. In the US, the damage was intraday even bigger. By the end, bonds were well off their best levels, but gains were still juicy. The US 2-yr, 5-yr, 10-yr and 30-yr yields closed respectively 6, 9.7, 6.1 and 3.5 bps lower. The US 30-yr yield at some point completely retraced last year’s up-leg on the back of the tapering tantrum. The US 10-yr yield dropped below the 2%-mark, but closed at 2.13%.

What happened today and in past days cannot be simply explained by a couple of bad US eco data. It seems that markets are embracing a very bearish view in which growth missing and inflation downwardly oriented. Is the market losing its confidence in monetary/fiscal policymakers to turn the tide? Of course, special elements might have exacerbated the intraday volatility. There was talk of a liquidation of big positions by some hedge funds, also in the oil sector. This unsettles normal market functioning, also due to the decline of the capacity of market makers to hold securities on their books (as recently highlighted by the IMF).

For the first time in a long while, PIIGS spreads versus Germany suffered from risk-off sentiment and widened significantly: Ireland (+11 bps), Spain (+15 bps), Italy (+21 bps), Portugal (+24 bps) and Greece (+108 bps). The correction of Italy and Spain, while rather substantial isn’t source of concern for now, but that’s different for Greece, where 10-yr yields are now approaching 8% on ongoing political uncertainty and the government’s plan to exit its bailout plan (which might now be off the table).

Today, the eco calendar remains enticing. Euro zone HICP inflation for September will most likely be confirmed at 0.3% Y/Y, down from 0.4% Y/Y in August. Core inflation is forecast to be confirmed at 0.7% Y/Y, down from 0.9% Y/Y in August. We have no reasons to distance ourselves from the consensus, although the risks, if there are any, remain on the downside. In the US, industrial production is forecast to have rebounded by 0.4% M/M in September, following a 0.1% M/M drop in August. Hours worked in the sector picked up, which bodes well for activity. We believe that also a rebound in vehicle production might support the headline reading and see therefore risks for an upward surprise. The Philly Fed index is forecast to have weakened slightly further in October, from 22.5 to 19.7, but will probably remain at relatively robust levels. We believe that the risks might be for a somewhat weaker outcome following the drop in the ISM reading. Also the NAHB housing market index will be interesting. The market is looking for a stabilization at the post-crisis high of 59, following four consecutive monthly gains. We believe that the risks might be for even a slight pay-back.

Overnight, most Asian equity markets trade slightly lower. Losses remain contained in line with WS’s comeback yesterday. Japan is the big underperformer (more than 2% losses) on the back of a stronger yen. The US Note future trades with an upward bias.

Today, the eco calendar includes final EMU CPI data and multiple US figures. Overall, we believe they will be mixed giving no strong indication for trading though we wouldn’t be surprised that in current sentiment negative surprises will easier make the headlines. Apart from the data, several ECB and Fed speakers are scheduled. These are wildcards. Especially Fed speakers could be interesting following SF Fed Williams earlier this week (dovish) and the big disconnection between Fed dots (1.375% policy rate end of 2015) and market expectations (1st rate hike February 2016) regarding the Fed funds rate. Who will shift to who in the following weeks? Finally, equity market sentiment remains key. Dark expectations about the global economy/inflation and fears that monetary policy reached its limits take investors hostage. European/US equities crashed yesterday though WS’s late comeback could be an indication of short term consolidation to come (US Note future also returned large part of intraday gains). Nevertheless, we remain firmly below key support (respectively 1904 S&P & 8900/9000 Dax) which means that the technical picture of equities is still bearish. Any slowdown/consolidation in the downward correction of equities, could be a signal for bonds to shrug off some of the heavily overbought conditions. In that respect, yesterday’s trading session could be something of an exhaustion move. If the sell-off continues though, we will likely revisit yesterday’s highs/gradually move to the intraday lows in yield terms (see above). The technical picture is bullish for bonds.