Moderate core bond weakness as risk-on rally continues

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Yesterday, global core bonds started the week on a stronger footing and climbed robustly in the morning session, to hit an air-pocket in the afternoon, erasing all previous gains. The US manufacturing ISM fell more than expected with new orders and production indices falling. Both remained though at solid levels, suggesting that the details mitigated the weaker headline figure. The markets reacted accordingly and shrugged off the weaker headline reading, also as the ISM prices paid index jumped much stronger than forecast. The T-Note figure was almost immediately hit by an additional selling wave, while equities went up and the dollar remained under pressure though. Core bonds tried to fight back, but couldn’t escape the laws of gravity when equities started another upleg and sank back to the intra-day bottom. The sudden drop lower in the morning session and the dismal reaction on the weaker headline ISM (due to the higher prices?) despite weaker oil prices shows a similar fragility of core bonds as we saw last week. It suggests more weakness ahead or, our favourite scenario, base formation, in which case the Bund support at 160.81 and T-Note support at 128-01+ should hold. In a daily perspective, the US yield curve bear steepened slightly with yields up 0.8 bp (2-yr) to 4.6 bps (30-yr). The German yield curve flattened with 2-yr yields up 0.7 bp and 30-yr yields down 3.1 bps. On intra-EMU bond markets, 10-yr yield spread changes versus Germany narrowed 1 to 2 bps.

Empty eco calendar, but EC Spring forecast eye-catcher

The eco calendar is empty today, both in the US and euro zone, but interesting might be the EC’s Spring economic forecasts. Both growth and inflation forecasts are still above the ECB’s most recent projections and therefore also in the Commission’s forecasts there is room for a downward adjustment. However, more attention may go to the fiscal situation of the peripheral countries. There seems to be substantial slippage in Spain and Portugal and maybe Italy. This sets the stage for some country specific recommendations from the EC later on. Portugal has a left government that is supported by an ultra-left party. Spain is still without government and is going again to the polls on June 26 without certainty that a workable government might come out of it. In Italy, PM Renzi has a hard time and pleads often for more fiscal leniency. So, Commission demands may clash with political interests. We don’t expect markets to be alarmed by the EC forecasts, but some unease may be visible in peripheral markets. ECB’s Coeuré and Fed’s Mester & Williams are scheduled to speak. Coeuré spoke recently, but so did Fed Williams (centrist leaning recently somewhat to the hawkish side) (see below). Fed Mester’s (moderate hawk) comments might be interesting, coming on the heels of last week’s FOMC.

Fed’s Williams said that equilibrium rates (neutral rates) are much lower today than 20 years ago and sees significant downside risks to these rates. The new normal may be 3%, lower than the 3.25% from the dot plot. Nevertheless, he thinks it makes sense to raise rates. He said the Fed is right to take into account global growth and still sees insatiable demand for safe assets. Other assets are fairly priced versus US Treasuries, but he calls Treasuries priced extraordinarily high. His comments are mixed for US Treasuries. On the one hand highly priced, but on the other hand lower neutral rate.

Important test of core bonds’ health continues

Overnight, the Australian central bank cut its cash rate target by 25 bps (to 1.75%) The Caixin China manufacturing PMI disappointed as it slid to 49.4 in April from 49.7 in March (consensus 49.8), mirroring a tepid “official” PMI released over the weekend. The Chinese manufacturing sector is not falling off a cliff, but neither accelerating. Asian equities are doing well with Chinese and Australian bourses outperforming, also helped by good run on WS yesterday. Commodities are mixed. US Treasury futures jumped (modestly) higher on the Australian rate cut. The dollar weakens slightly more versus yen and stabilizes versus the euro.

Today’s eco calendar is devoid of market moving issues. The EC Spring forecasts are interesting for the periphery, but probably not for core markets. So, the general sentiment on risk will be the driving force for markets. In this context we prefer a neutral bias on today’s trading. A new quarter started yesterday and so we were looking out for new directions in markets, more in particular whether the risk-on has further to go. Our basic view was “no”, but it didn’t turn out that way, even if nothing dramatically occurred in core bond markets. Riskier assets are richly priced and oil/commodities should be toppish. Major central banks are side-lined and so are no support for riskier assets. Markets have priced in only one Fed rate hike for March 2017. Unless recession risks would rise, there is little scope for a still more gradual rate path. If it’s because of higher recession risks, that shouldn’t help the risk-on rally either. Of course, in recent weeks, especially the Bund traded weak, also in circumstances that would have justified a more bullish run (yesterday too). For the Bund, we think that 160.81 is a strong support (0.33% in 10-year German yield). The downward correction of the Bund may have nearly run its course, unless these levels are broken (not our favourite scenario). We changed our view on the core bonds from bearish to neutral.

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