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Sunrise Market Commentary

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US Treasuries go through the roof in frenetic trading. Correction ahead?

Fri, Nov 21 2008, 08:44 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Thursday, global bonds rallied hugely, as a sense of end of capitalism, as we know it now, kept markets in their grip and investors scrambled for safe haven government bonds. The economy falling of a cliff is of course feeding back into the already heavily battered financial sector, while the re-orientation of TARP, away from buying toxic assets, is deteriorating the situation in the credit markets. Movements in bonds were extreme and resulted in the US in yield declines of 8 basis points in the 2-year, 13 bps in the 5-year, but even 30 and 42 basis points in the 10 and 30-year sector. In EMU, the curve flattening was more modest, yields down between 12.6 and 15 basis points.

Equity markets had a hard time and selling pressures continued unabated. US indices held up initially, but in volatile trading, before crumbling later in the session, driving the indices another 5-to-7% lower. Interestingly, the S&P closed, near the intraday lows, below the 2002 lows, which is from a technical point of view a major negative (double top). Tentatively though, the recent move may be qualified as an exhaustion. It was a fast move down, that ended (at least temporarily) with a big loss session in high volume. The jury is still out whether it indeed concluded this bear market down-leg, but there are legitimate reasons to consider that scenario. The price action is the next days may tell us whether this is the case.

The US eco data were once more ugly: initial claims climbed sharply, suggesting that payrolls losses may exceed 300 000 a month, the leading indicators plunged and the Philly Fed survey was horrendous.

Central Bankers were active too. The surprise rate cut of the SNB by 100 bps raised rate cut expectations for the ECB too, but after official closing ECB’s Mersch suggested the ECB will continue with cutting rates by 50 basis points. Overnight, St- Louis Fed governor Bullard spoke about quantitative easing in the US.

The message China has stopped buying Agencies and switching to Treasuries might have been an additional positive factor for bonds.

US Treasuries go through the roof in frenetic trading. Correction ahead?

Today, the eco calendar is empty, but the regional Fed governors Lacker, Plosser and Evans speak for a different audience. Lacker spoke already earlier this week and thus shouldn’t have much impact on trading.

Yesterday, the Fed announced that the December FOMC meeting will take two days instead of the previously planned one day. This is unusual, but it happened before. They didn’t give a specific reason for the extension, but it is obvious that the Fed has a lot to discuss. The financial markets are malfunctioning, to say it even under cooled, and the Fed is running out of ammunition with regard to basis points as its FF rate stands at 1% and may be lowered again in December. So nearing the zero bound constraint, the Fed is considering what it can do next (if needed). Currently, by pumping money in the market, the Fed has already left its strict FF rate targeting. Indeed the effective FF rate trades way below the 1% target, notably at 0.40%. This is already a “quantitative” easing in place, but the Fed might make it official and describing the exact way it will use it going forward. Renewed strains in the credit markets following the latest re-orientation of TARP, no buying of toxic assets, has again increased the stress in credit markets to very high levels. So, also on this point the Fed may discuss new measures to relief the stress. Will it lower the quality of the accepted collateral further? Whatever it will be, the markets will have thought for speculating on the outcome of the two-day FOMC meeting.

St-Louis Fed Bullard said that deflation would be very damaging to the US economy and with nominal interest rates already very low, quantitative easing may be needed to keep it at bay. A signal that Fed is gradually preparing the markets and citizens for “official” quantitative easing. This needs to be well prepared as such an announcement may lead to some panic, as it may be immediately associated with the Japanese lost decade, who used quantitative easing, but only with mixed success. Bullard however said the Fed would succeed in its attempts to prevent deflation from getting ingrained. He played down deflation by noting that core inflation is now above 2%. He downplayed also whether the Fed would bring rates still further down. It is not the most critical issue. It is by announcing and maintaining targets for monetary quantities that the Fed may be able to keep inflation and inflation expectations near target and ward off a drift towards deflation or excessively high inflation.

Regarding trading, yesterday’s markets movements were exceptional, even if we have become familiar to quite some wild moves recently. Indeed, the longer end went through the roof, yields plunging 30 to 42 basis points, flattening the curve massively. The 30-year yield broke decisively below all-time lows, suggesting that the multidecade downtrend continues. The 10-year yield plunged through the cycle low of about 3.25% and even tested 3.07% (2.98% touched), before moving up to 3.12% currently. Above, we elaborated on events, but summarising deflation fears, distressed credit markets and plunging equities were main drivers, but internal market technicals were an important item too. LT (30-year) swap spreads crashed to – 60 sparked buying in the longer end. The shorter end of the curve reaching 1 and 2% for the 2- and 5-year yields made good but no exceptional gains. The absolute low levels are acting as a constraint. Looking forward, the eco calendar is empty and the Fed governors on duty while important shouldn’t be a main driver. It will all be about equities and risk appetite/aversion. Overnight in Asia equities are moderately higher and while that isn’t always a good precursor for trading later today, we think that market technicals point in the direction of exhaustion and thus some correction is likely. Both in equity and Treasury markets, it was a high volume day, in which extreme price movements occurred. Equities closed near the lows, the VIX set a new closing high and tested the eye-popping 2002 lows. They closed marginally below, but we don’t consider it as a confirmed break. Next days trading will be extremely important, but even if circumstances are exceptional, we might see bottom fishing around current levels. The opposite seems likely for Treasuries. A very vigorous downtrend in yields accelerated yesterday with frenetic panic buying (especially at the longer end). 2-, 5- and 10-year Treasury yields tested very major levels (1%, 2%, 3%) and the 30-year set a new all-time low with a large margin. Our ambitious targets for 2- and 5-year have been reached, and while we were, in retrospect, too conservative further out of the curve, we think that also here obvious targets have been met. Therefore, we would consider profit taking on long positions.

ECB’s Mersch suggests ECB will continue to cut rates by 50 bps

Today the economic calendar heats up with the euro zone flash PMI figures (November). Both in September and in October, the manufacturing PMI showed sharp plunges in response to the increased turmoil in financial markets and the global economic slowdown. The manufacturing PMI is now at its lowest level since series began 11 years ago. For this month, it is expected to show a more modest drop (to 40.5). Also, the services PMI dropped sharply in the past month (45.8 from 48.4) with business expectations falling to the lowest level since series began. In November, the consensus is looking for an outcome of 45.0. We put the risks on the downside of expectations after the euro zone economy fell into a technical recession in Q3. But this might have only a limited impact on the markets.

Following yesterday’s ECB’s non-monetary policy meeting, ECB’s Mersch gave some interesting comments which suggested that the ECB won’t follow the example of the Bank of England or the Swiss central bank and start cutting rates even more aggressively. Yesterday, the Swiss central bank surprised markets again with an inter-meeting rate cut by 100 bps to reduce its target range for the three-month Libor to 0.5% and 1.5%. ECB’s Mersch repeated that while it could best be possible that inflation rates will turn negative for one or two months, this would be temporary and not a harbinger of deflation. As such, he said that ‘we have to look beyond such short-term falls in prices, just as we looked beyond short-term increases when commodity prices spiked’. He also warned that ‘a large rate cut could be counterproductive and signal the opposite of what we wish to signal, namely certainty and confidence’ and added that ‘the central bank has to keep a steady hand on the tiller and provide certainty in a time when many have lost their bearings’. As such, he concluded that the ECB ‘must be cautious not to overreact, because this won’t necessarily produce better results’.

Mersch’s comments suggest that the ECB will stick to its 50 bps rate cut approach when it meets in December. Following yesterday’s surprise move by the SNB, financial markets have been pricing in a 75 bps rate cut in the ECB policy rate to 2.5%. This means that the risks for an upward correction at the short end of the curve have increased significantly. The technical picture of the 2-year yield supports some profit-taking, as our first target, the lows of 2005 at around 2%, have been reached. Today, ECB’s Nowotny, Weber, Gonzalez-Paramo and Trichet are scheduled to speak.

In a similar vein, ECB’s Mersch also suggested that the ECB won’t widen the band between the deposit rate and the policy rate to help kick-start lending. ‘We seek to keep the overnight rate close to the policy rate, so a cut in rates on the deposit facility would be counterproductive and increase confusion between policy actions and financial stability actions – from that point it’s not in line with what we want to do’, Mersch said. Hence, although the ECB is feeling uncomfortable with the large amounts deposited overnight, it appears that they won’t take more steps to change the bank’s behaviour. ‘Increasingly I feel that too many decisions on our part could also create problems of digestion within financial markets, increasing operational risk’, Mersch noted.

Regarding trading, following this week’s break higher in the Bund above the December 2005 highs, the technical picture is bullish at all maturities. This doesn’t however mean that yields have to move unidirectionally lower and the curve ever steeper. As stated above, the softening comments of ECB’s Mersch do make especially the short end of the curve vulnerable to some profit-taking and as such does point to some corrective flattening of the European yield curve. The rebound in the Asian equity markets this morning supports this view.

In the UK, yields plunged despite the better than expected retail sales. Today, the calendar is empty.

Currencies: Major cross rates react rather mute to elevated level of stress on other markets

On Thursday, EUR/USD after all experienced a rather calm session as trading developed more or less sideways in a 1-big figure trading range roughly between 1.2490 and 1.2590 for most of the day. Given the high volatility and stress in almost all other markets, this relative calm was a bit remarkable. Intraday, ‘usual’ factors still played some role. The pair tried to move higher early in US trading, but the global market reaction on very poor US initial claims (decline in the oil price and in the stock market) sent EUR/USD back to the 1.25 barrier. Later in the session, the gyrations in the stock markets continued to set the tone for trading. The late sell-off on the US stock markets hammered the pair through the intraday (Asian) bottom around 1.2475 and the pair closed the session at 1.2453 compared to 1.2489 on Wednesday. However, we continue to hold on to our view that the single currency is doing rather well in the current environment. This is also being illustrated this morning as pair has already regained the 1.25 barrier on the back of an, albeit fragile, stock market recovery in Asia.

Today, US calendar is empty. In Europe, the preliminary PMI data for the month of November and the French consumer spending data are on agenda. Especially, the PMI figures will be closely monitored. It is of course very difficult to expect any goods news from these data. Nevertheless, it will be interesting to see whether or not the euro reacts to negative news from the euro-zone area. We will also keep an eye on the speeches from ECB members in the wake of yesterday’s non-monetary policy meeting. It is not our favorite scenario, but markets will look out whether they open the way for more bold action (possibility on more than 50 basis points rate cut in December). The speed of additional rate cuts is an ambiguous factor for any currency. However, at the current juncture we are seeing the gradual approach of the ECB a cautiously supportive factor for the single currency.

For quite some time, negative eco news and risk avers investor behavior have supported the dollar (and the yen) and have weighed on the single currency. This theme was an important factor behind the decline of EUR/USD from highs above 1.60 to the correction low in the 1.2330 area. We are going to hold onto our EUR/USD negative bias longer term. However, since end October the single currency has developed a short-term consolidation pattern. The correlation between EUR/USD and indicators of risk aversion and economic stress still exists, but the euro is gradually showing more resilience. The bottom of the consolidation pattern between 1.2330 and 1.3294 is still within striking distance, but despite the heavy global market stress (the S&P closed below the key 768 support) no real test has occurred yet. The jury is still out on this item, but price action during last week has shown that probably a high profile event will be needed for EUR/USD to clear the 1.2330 barrier. It is still early days, but we also stay open minded on the established trading theme that global bad new is also bad news for the single currency. This is also no low of mathematics.

From a technical point of view, since the last week of September EUR/USD has tumbled from the 1.4866 reaction high to 1.2330 on October 28. High profile intermediate supports have all been taken out with remarkable ease. Over the last three weeks the EUR/USD decline shifted into a lower gear but the pair failed to regain the first important resistance area (1.3259/94) in a sustainable way and has established a sideways trading pattern. Recently, we favoured a sell-on-upticks approach in case of return action higher in the above mentioned trading range. We are holding on to that tactics long term. However, over the past week; we also have been advocating not to front-run on a break below the range bottom and we were inclined to take partial profit in case return action towards to bottom of the range. In a day-to-day perspective, we have the impression that the chances are rising for a more pronounced rebound in EUR/USD. So, additional profit taking/protection on EUR/USD shorts could be warranted and we’re not in a hurry to reinstall EUR/USD shorts.

On Wednesday, USD/JPY continued to trade according to the usual logic (swings in risk aversion). The swings in the stock market and the (poor) US data (claims) set the tone for trading. The late stock market sell-off in the US caused USD/JPY to close the session at 93.69, compared to 95.73 on Wednesday. This is still a decent loss, but as we mentioned for EUR/USD, the damage for USD/JPY could have been even bigger. The year low hasn’t come in the picture yet.

This morning, the BoJ left its interest rate unchanged at 0.30 %. However, the bank suggested additional ‘technical’ measures to ease funding pressures for the corporate sector. Japanese finance Minister Nakagawa warned that authorities must be ready to deal with big swings in markets as they are undesirable. This statement of course also applied to the recent strength of the yen. Asian/Japanese stocks try to resist the sell-off in the US yesterday evening and this is helping USD/JPY to recoup some of yesterday’s losses.

Looking at the charts, global market stress hammered the USD/JPY cross rate through the key 103.50 range bottom early October and the pair set a new reaction low at 90.93 three weeks ago. A temporary easing of global market tensions sparked a USD/JPY rebound. The pair set a reaction high in the 100.55 on November 04, but the rebound ran into resistance. Longer-term, we are preferring a scenario of the yen remaining well supported as there is still very little prospect for a sustained improvement in the global economic picture anytime soon. Gains beyond the 100.55 reaction high wouldn’t be easy short-term. A sell-on-upticks approach remains favoured as long as the pair holds below this 100.55 mark. The ST technical picture is still yen positive, but in a day-to-day perspective we have the impression that downside in USD/JPY might become more difficult short-term. Partial profit taking on USD/JPY shorts might be considered.

Yesterday, EUR/GBP made a nice rebound after the correction that had occurred earlier this week. This might have been a bit of a surprise as the UK retail sales came out less negative than fear by the markets. This only illustrates that this is very much an order driven market, with the swings in cable and EUR/USD causing erratic price action in EUR/GBP. EUR/GBP closed the session at 0.8456 compared to 0.8355.

Today, the UK calendar is empty

The aggressive BoE rate cut two weeks ago and the negative assessment from the BoE on the UK economy after the publication of the inflation report pulled the trigger for an aggressive sterling selling wave last week. The quick loss of interest rate support and the very negative outlook for the UK economy going forward have caused sterling losing a lot, if not all, its attractiveness. The break above the high profile 0.8200 resistance area has made the technical picture outright negative for sterling/ positive for EUR/GBP. After the sterling crash of last week, some correction has kicked since Friday. Longer-term we continue to put the risk for additional sterling losses. The pair must return below the 0.8215/40 area (Break-up/uptrend line) to call off the red alert for the sterling. We still need confirmation, but yesterday’s EUR/GBP rebound might be a first indication that the recent (sterling positive) correction has run its course.

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Published on  Fri, Nov 21 2008, 08:44 GMT