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US Treasuries cannot find their composure

Wed, Jun 11 2008, 07:06 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Tuesday, global bonds were hammered in response to the hawkish speech of Fed’s Bernanke who suggested that the Fed may raise rates sooner rather than later to anchor inflation expectations. The tough stance among central bankers was again underscored in the afternoon when the Bank of Canada surprised markets by leaving interest rates unchanged. This strengthens the view that central bankers around the world are taking the inflation threat serious and may soon act accordingly. This sudden change in Central Bank posture surprised markets inciting quite some re-positioning and causing extreme volatility. In response, US 2-year yields are now around 50 bps higher compared to the post-Payrolls levels and eurozone 2-year yields are up around 30 bps compared to Thursday when the ECB first hinted at a rate increase, even taking into account a slight downward correction in 2- year German yields yesterday. At the longer end of the curve, yields continued their uptrend. Curve-wise, the massive flattening of the US yield curve continued, while in the euro zone the rise in longer-term yields led to a slight correction on the recent sharp flattening of the European yield curve.

US Treasuries cannot find their composure

Today, the eco calendar is uneventful as it includes only the weekly mortgagee applications and the May budget statement. These are no market movers. The Beige Book, a preparatory document of the June 24-25 FOMC meeting, is more important. We expect the book to lay the groundwork for an unchanged decision. Markets will scrutinize the book for signs about inflation. We don’t expect the Book to ease the current fear about inflation, as it is living in the markets. On activity, we will see whether the message of the book is a stabilization in economic conditions as Bernanke suggested some days ago.

Fed speakers on duty are Vice chairman Kohn on inflation and implications for monetary policy, Fed Kroszner and Pianalto on consumer credit markets and Fed Bullard about macro-economics. Following the upped attention of the Fed for inflation and Bernanke’s comments, it is obvious that Fed talk is potentially influential for markets. We suspect the message of Bernanke to be echoed in other speeches, keepingg the theme hot, especially as some inflation data are on the agenda for release in the next few days.

Yesterday, Fed Fisher defended again his hawkish position inside the FOMC and feels vindicated by recent events and change in tone from other Fed members. He said the Fed is aware of his ideas about the adverse feedback loop, meaning that lower rates hinders a resumption of growth via the mechanism of weaker dollar, higher commodities/inflation, pressure on disposable income and ultimately lower consumption. He had preferred the Fed to stop cutting rates at 3.5%, but hoped he was wrong as the FOMC drew the line at 2%. He strongly advocated that no Central Bank should accommodate energy and food price rises. The downturn will be less severe as feared, he said on activity, but growth may remain subdued for a while. However, he would accept weaker growth if this would be the price to keep inflation in check. On inflation expectations, the recent news has not been positive, Fisher said, adding that future markets are imperfect indications about these expectations. Outgoing Fed governor Mishkin said that inflation expectations are key for the Fed, but added little new info to the debate.

Regarding trading, the sell-off continued unabated yesterday, as market participants mark to market their views on inflation and on the likely Central Bank reaction. Central Bankers were very blunt in their inflation-fighting rhetoric recently and markets did pick up the signal. It looks as simple as that. In markets, it may indeed be costly to fight Central Banks view. The sudden cancelling of the BoC signalled rate cut fits the picture. The re-positioning that takes place makes look recent price action extreme, but that is often the case when there is an abrupt change in sentiment. In such a context, one shouldn’t too fast enter the market thinking that the price action has gone too far.

In this respect, we keep a negative attitude towards US Treasuries, also today, even if the calendar does look a bit boring, but Crude oil (inventories), equities and Fed talk are potential movers.

German 10-year yields closing in on cycle highs

Today, the euro zone data calendar contains only the French inflation data. The outcome may decide whether the euro zone flash estimate will be upwardly revised from 3.6% to 3.7% Y/Y in May. Over the coming months, headline inflation may still rise further depending on the developments in the oil price. Regarding the ECB, several ECB governing council members signalled that it’s of the utmost importance that longer-term inflation expectations remain anchored during this period of high inflation. There is also a lot of attention on comments of ECB’s Trichet that he had "never said that there was a group on the Council in favour of a series of rate hikes". Some conclude that this signals that the ECB does want to downplay market expectations towards rate hikes beyond July. It’s too early to draw this conclusion, but nevertheless think that the deterioration in the growth outlook will keep the room for higher rates limited.

On the supply front, Germany will issue new Schatz Jun10 for an amount of EUR 8 B. Yesterday, the Netherlands only sold 2 B of its 10-year benchmark, which is at the lower end of the pre-announced range and suggests weak demand. Greece on the other hand sold the expected 1.6 B of its 5-year benchmark with a solid bid/cover ratio of 3.19, but this couldn’t halt the recent spread widening between German and Greek bonds and as such does not point increased demand for bonds, despite the recent sharp increase in yields.

Regarding trading, sentiment on the European bond market is still bearish. This morning, the Bund even set new lows. As a result, 10-year yields are coming closer to the mid-2007 cycle highs at around 4.70%. Yesterday, 2-year yields however corrected slightly lower, which may signal that the uptrend is running out of steam. But as illustrated on Monday in the Bund, trading is still very volatile and we see no reason to become more optimistic today.

In the UK, yields fell back following the surge higher on Monday.

Yesterday, BoE’s King didn’t speak out about monetary policy in his speech before the BBA, which was completely devoted to the credit crisis and the steps that has to be taken to prevent it from repeating. As such, he announced a new money-market system, which should cope with both normal and stressed conditions.

Today, the labour market data and trade balance will be released. Following the recent sharp increase in inflation expectations, it will be interesting to see whether this will also lead to higher wage demands.

Currencies: Dollar still profits from Bernanke/Paulson comments

On Tuesday, the dollar was still supported by the high profile dollar supportive comments from the Fed (including from Bernanke on inflation) and from Treasury Secretary Paulson. Markets grow more convinced that the US authorities have concluded that a weaker dollar is bad for the US and that they are prepared to take action if the situation would deteriorate further. We are probably not at the eve of coordinated dollar interventions, but the risk to go dollar short has been raised and at least yesterday, markets picked up this message and EUR/USD fell back from the 1.56 area to the 1.54 big figure. In this respect, most of the EUR/USD rebound that followed the ECB press conference and the payrolls at the end of last week is undone. The US trade balance deficit came out higher than expected in April, but this was ignored, as was a weaker-than-expected IBD economic sentiment survey. Neither could better French and Italian production data support the euro. Mr. Paulson also repeated his statement not to rule out currency interventions, but without generating a reaction. EUR/USD closed the session near the intra-day lows at 1.5467, down 180 pips from the previous close of 1.5647.

Today, the eco calendar is thin, both in the US and in Europe. Central bankers’ speeches (ECB’s Noyer and Stark and Fed’s Kohn on inflation) still deserve some attention, but over the previous days central bankers already gave a clear sign on where they put policy priorities, notably INFLATION FIGHTING.

Until last week’s ECB press conference and US payrolls release, we thought that the topside in EUR/USD became better protected and last week’s warning from Mr. Bernanke on the weak dollar was an important factor to support this view. However, the combination of the ECB pre-announcing a July interest rate hike, a disappointing payrolls report and sharply higher oil prices were enough a reason for investors to turn again USD skeptical at the end of last week. Nevertheless, already at the end of last week we advocated that, at some point, rising interest rates in an environment of sharply slowing growth could ultimately turn out to be dollar supportive. In this respect, we are ‘happy’ that after the ECB rate hike threat, this has not become a oneway euro upside market.

In a medium term perspective, we have a neutral bias on EUR/USD and assume the pair to stay in the 1.5285/1.6020 range as long as visibility on the economic picture in the US and Europe remains low. We started the week with a neutral bias for EUR/USD after the sharp swings at the end of last week. We hold on to that view. From a technical point of view, EUR/USD trading is currently confined to the 1.5840/1.5285 range. A sustained break outside these ranges is needed for a directional move in one way or anther. In the current volatile market conditions, we don’t want to front-run on such a break. However, the strong US message that a weaker dollar is no longer in the advantage of the US should give topside in EUR/USD pair decent protection. So, in a day-to-day approach we still slightly favour a sell-on-up-ticks approach as long as the pair stays below the recent highs in the 1.5840/1.5820 area.

On Monday, USD/JPY build out its gains on the back of Bernanke’s remarks about inflation and the economy that implied the possibility of a faster than expected rate increase. Bernanke and Paulson clearly indicated that they don’t want to see a weaker dollar. A similar message was heard from President Bush who visits Europe. It is usually unwise to fight central bankers and investors are acting accordingly. Equities held up quite well, which takes away one reason to buy yen. The pair making a technical relevant move above resistance in previous days only added the dollar. USD/JPY got a first boost after Bernanke’s comments early Tuesday, but won further ground in a number of intra-day rallies. The pair closed at 107.43 from 106.31 on Monday.

Overnight, the dollar remained well bid and advanced slightly to 107.70 currently. The Japanese data had little impact. GDP was revised slightly up to a very respectful 1% Q/Q, but corporate prices set a new 27-year high in May (4.7% Y/Y) and the trade surplus was a bit wider than expected. Japanese rates are rising too, but the move of the 2-year from 0.5% to 1% in recent weeks is of course not enough to offset the impact of the increased discounted in the US markets, giving the dollar an advantage over the yen. The latter losses also because of the return of risk appetite.

After a rebound from mid March to early May, USD/JPY settled in a narrow 102.55/105.87 trading range throughout the month of May. The topside of this range was tested several times, but a sustained break proved difficult, at least until Monday when the dollar supportive talk from US officials also helped USD/JPY to step across this hurdle.

Recently we advocated that the downside in this pair was well protected. We hold on to that view. Also the technical picture in this pair improves as the break above the previous range top (105.75) is confirmed. The 14 February high at 108.68 now becomes the next target on the upside in this pair. A drop below the MTMA (105.04 today) would suggest that the uptrend is losing momentum.

On Tuesday, EUR/GBP trading entered calmer waters after the rather wild swings seen at the end of last week and early this week. The slightly better than expected UK production data had no lasting impact on trading and BOE’ King in his speech for the BBA addressed few items that were of immediate importance for sterling trading. So, EUR/GBP basically held a sideways trading pattern in the 0.7950/00 area, after having briefly traded below 0.79 when Bernanke’s comments hit the screens early Tuesday. The pair is still trading in that range.

Today, the UK calendar is well filled with the labour market data and the trade balance figures. However, these are not really high profile market movers. However, negative surprises still confirm the sterling negative sentiment and may be a reason for sterling not to follow eventual upside moves of the dollar.

Since mid April, EUR/GBP develops a consolidation pattern after the steep sterling losses of the previous months. We turned neutral on EUR/GBP recently as a new attempt to move higher ran into resistance, mostly due to a loss of momentum in the euro overall. However, also this euro correction was blocked after the hawkish ECB press conference last week. We are sterling negative longer term and hold on to that view. Short-term, the pair trades again in the middle of the 0.7766/0.8098 consolidation range. We still think that the room for a sustained comeback of the sterling is limited. The 0.7833 reaction low is the first hurdle on the downside in this pair.

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Published on  Wed, Jun 11 2008, 07:17 GMT