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Sunrise Market Commentary

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US Treasury curve steepens sharply on safe haven inflows as equities tank

Thu, Jun 12 2008, 07:31 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Wednesday, global bonds rebounded slightly following the sharp sell-off at the start of the week. The rebound was centred at the short end of the curve, which was hit the most on the back of the hawkish comments from ECB and Fed officials. As such, both the US and European yield curve reversed part of the recent massive flattening and steepened moderately yesterday. Weaker equities contributed to the rebound, but compared to the losses in the equity markets the gains on the bond markets remained limited, even if the outperformance of the short end points to safehaven inflows. This signals that the underlying sentiment has not yet improved much, which was also due to some hawkish comments of Fed’s Kohn and Bullard in the afternoon/ evening. In the euro zone, the ECB on the other hand sought to dampen interest rate hike expectations saying that they were not talking about a series of rate hikes.

US Treasury curve steepens sharply on safe haven inflows as equities tank

Today, the eco calendar contains the weekly initial claims, the May import prices and the retail sales, besides the less important business inventories for April. The Treasury will re-open its most recent 10-year Note for an amount of 11 Bn. $, while the Fed will hold a TSLF auction. The 10-year Note re-opening will raise as usual all new cash upon settlement. At 11 Bn. $ it is the largest re-opening since March 2004. Traditionally, re-openings are dealer-dominated and rather sloppy and this might be the case today too. The stop mostly is a tad above the bid in the market. The recent TSLF auctions showed modest demand that fell short of the amount offered, suggesting that financial market stress has eased.

The various eco data from May will be very much impacted by high energy prices. The import prices (consensus 2.5% M/M & 17.2% Y/Y) will have skyrocketed in May, because of the higher petroleum prices, but even core prices should have continued to rise. They rose by 1.1% M/M and 6.2% Y/Y in April. Retail sales (May) are expected up 0.5% M/M in May (0.7% M/M for sales excluding car sales), following a 0.2% M/M drop in April. Also here higher sales at gasoline stations should have been an important factor behind the expected increase, but it will be interesting to see whether tax rebates are starting to play some role. The unit car sales were reported slightly down (from already depressed levels) and this might also be translated into declining car sales figures. Concluding, most of the gains should be due to price effects (gasoline) and not to an increase of volumes. However, the tax rebates are a wild card, even if the weekly retail sales didn’t show much of an impact. Initial claims unexpectedly dropped in the previous week, causing a negative reaction in the Treasury market. However, the result was probably distorted because of a holiday. Therefore, claims should have rebounded to about 370 000 in the most recent survey week.

The Beige Book painted a weak picture of economic conditions, but at the margin a little bit less weak than the previous one Book did. Indeed, five districts now report stable economic conditions against three in the previous book. This corroborates with recent views of Fed chairman Bernanke. All districts also report tighter credit standards for consumer, residential and commercial loans. Regarding consumer spending, activity has slowed though due to higher food and energy prices and retailers complain about high inventories. On inflation, reports of higher input prices were widespread and some firms are able to pass through the cost increases, but this was not the case for retailers, while wage pressures were reported as moderate or limited. Concluding, the inflation news should be not too bad for the Fed, but neither reassuring. No noticeable improvement in the real estate markets. This book should allow the Fed to keep its policy unchanged when it meets later this month. Further out, it looks to us that rate hike expectations for the August meeting at least seem premature. The economic conditions don’t allow the Fed to signal the start of a tightening cycle. The August FF future still trades at an implied 2.12%

Regarding trading, the Treasury market got some respite yesterday, as pronounced equity weakness led to some safe haven buying of Treasuries. It shouldn’t surprise that in these circumstances, it was the short end that was favoured, reversing a part of recent huge losses and of the recent steepening. However, we consider the gains as being disappointingly small, even at the short end, if one considers the extent of the previous sell-off.

The eco data look to be mixed from a market perspective. Higher initial claims should be a positive, but sky-high import prices will keep inflation concerns more than alive, also ahead of tomorrow’s CPI release and even if consensus already discounts a steep rise. The retail sales are as usual a wild card. The headline figure might look fine, but rising gasoline price should be the main factor. Will markets look through the headline and react on sloppy real retail sales? The behaviour of equities and oil might be still more important though. Is the credit crisis again rearing its ugly head and becoming the dominant market theme or remains it a sector problem with relative modest overall consequences (systemic risk- credit crunch) as the market considers it since mid March when the Fed signalled via the rescue of Bear Stearns that it would not let a big investment bank go down. The technical pictures remain bearish and yesterday’s price action doesn’t convince us either that the market has taken a turn for the better. Therefore, we keep our negative stance.

ECB dampens expectations for a series of rate hikes

Today, the euro zone data calendar contains the industrial production data for April. These shouldn’t surprise anymore following the release of the national data from Germany, France and Italy and are probably too outdated to move the market.

Yesterday, several ECB governing council members, like Stark and Noyer, sought to downplay market expectations towards rate hikes after the summer. Stark said that ‘markets have understood the governing council’s signal’ about raising borrowing costs next month, but added that ‘we are not talking about a series of rate increases’ echoing comments of ECB’s Trichet on Monday evening. Noyer on the other hand said that he ‘doesn’t see a clear link between’ what Trichet has said and market expectations for after summer. He also remained ‘confident that inflation should progressively slow in the second half of the year’. Although current elevated inflation levels will keep the threat of a further policy tightening alive in the second half of the year, these comments should put a cap on the rally in 2-year yields. Today, the ECB will also publish its monthly bulletin, which may include some interesting articles that give some background info on the current thinking of the ECB.

On the supply front, Italy will tap its 5- and 15-year BTP for a total amount of EUR 4.5 B. A large redemption of an Italian bond worth 17.5 B and the recent sharp increase in yields should support demand, but this however failed to support demand at yesterday’s issuance of the new German Schatz. The German auction went very poor, as the Bundesbank had to retain 40% of the total issuance. This signals that real demand for bonds is still very tepid.

Regarding trading, European bonds traded mixed yesterday, as the short end rebounded on the back of the soothing comments of several ECB officials, while the long end still suffered more losses. The weak closing in US Treasuries and further losses overnight, despite the weak performance of the equity markets, suggests that sentiment is still bearish. At the short end of the curve, the ECB has probably put a cap on the rally in 2-year yields.

In the UK, the yield curve re-steepened too. Today, the Bank of England will publish its quarterly inflation attitudes survey. In recent quarters, this has shown a dramatic rise in public inflation expectations.

Currencies: Dollar retreats slightly on equity weakness, but rebounds in overnight trading

On Wednesday, EUR/USD trading activity took a breather after the sharp swings seen over the previous sessions. The eco calendar on both sides of the Atlantic gave no impetus for trading. The most interesting news came again from the central bankers and more in particular from the ECB. The sharp rise in yields at the short end of the European yields curve apparently has gone far enough, even for the ECB. Some prominent ECB members indicated that it isn’t the Bank’s intention to trigger the start of a series of rate hikes after the (probable) hike in July. However, this loss of interest rate support had no negative impact on the single currency. On the contrary EUR/USD even regained slightly ground throughout yesterday’s trading session. We don’t draw conclusions from yesterday’s price action, but this more or less fits our view that a too aggressive ECB policy stance would no be euro supportive longer term. EUR/USD closed the session at 1.5550 compared to 1.5467 on Tuesday. Overnight, the greenback reversed yesterday’s losses and trades now again at 1.5465. There is no good trigger to explain the overnight dollar strength. The price may be an indication that investors and traders are afraid to short the dollar at this juncture and in the wake of the Fed signaling a change in attitude on the dollar and interest rates. The referendum in Ireland on the EU reform treaty today might be a source of uncertainty, convincing some to sell euros. A No vote would be a setback for the EU and might hamper decision making, a negative also for the euro.

Today, eco calendar is better filled. Especially the US data (import prices, retail sales and weekly jobless claims) have the potential to move the market. In the current environment of central bankers warning on inflation, the import prices probably will get more attention than usual. Especially a higher than expected figure would reinforce the recent warnings of the Fed on inflation and thertefore be (slightly) dollar supportive.

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 Wednesday, USD/JPY fell slightly lower, after having set a new reaction high at 107.76. The pair finally closed at 106.96, down from the previous close of 107.43. Equity weakness might have played a role, but the recent gains might also have convinced some traders to book profits. Overnight the dollar is again better supported and rose to 107.40 against the yen, despite equity weakness in Asia. So while equities might remain a theme for the USD/JPY trading it is clearly less influential than some weeks ago. Also here, investors are wary to take on dollar short positions ahead of the G-8 meeting, especially given the recent signs that the US view on the dollar may have changed.

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 (105.67 today) would suggest that the uptrend is losing momentum.

On Wednesday, EUR/GBP trading developed in a tight sideways trading range, with the UK eco data the only factor to disturb the calm. The labour market data (jobless claims and employment rate) came out weaker than expected and also the trade deficit was higher than expected. This triggered some intraday losses in the sterling and EUR/GBP spiked higher from the 0.7915 level to an intraday high at around 0.7940. However, as already seen a few times recently, domestic UK data had no long lasting impact on trading. To be honest, the deviation from consensus was also limited and not enough of a reason to cause a sharp market reaction. So EUR/GBP soon returned to the 0.7910 area and stayed there for the rest of the day.

Today, the UK calendar is empty, so the impetus for trading should come from the global market reaction to the US data, central bankers’ speeches in the US and Europe and the Irish referendum.

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  Thu, Jun 12 2008, 12:52 GMT

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