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Sunrise Market Commentary

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US Treasuries sell−off continues unabated

Fri, Jun 13 2008, 07:22 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Thursday, global bonds resumed their sell-off, as a strong US retail sales report along with very hawkish comments of Fed’s Plosser pushed US rate hike expectations forward in time. Plosser said the Fed needs ‘to act pre-emptively’ to keep inflation expectations anchored and that it is ‘certainly clear that rates will have to rise’. As a result, it was again the short end of the curve that underperformed the longer end leaving the yield curve flatter. US 2-year yields surged around 20 bps higher and managed to break above the 3% level for the first time since January. Markets now discount an 80% probability towards an August rate hike. A poor US 10- year Note auction contributed to the overall bearish sentiment on the bond markets. In the eurozone, the yield curve flattened too (2-year yields were down, but this was due to a benchmark change), although ECB’s Bini Smaghi repeated that Trichet’s remarks ‘only sent indications for July, not beyond’. Yesterday’s rebound in the equity markets had no major impact on trading.

US Treasuries sell-off continues unabated

Today, the eco calendar contains only two eco releases, but important ones, notably the May CPI and the early June Michigan consumer sentiment survey. There are no appearances of Fed governors of which we are aware, but former Fed chairman Greenspan will speak in Mexico.

Philly Fed president Plosser spoke very hawkish yesterday, saying that Fed needs to act pre-emptively to quell rise in price expectations and that it is certainly clear that rates have to rise, with the question being when. He called current headline and core inflation not consistent with price stability and added that the dollar gives a signal on stance of monetary policy and prospect for inflation. In other comments he said that monetary policy is very accommodative and Fed need to take action that backs up anti-inflation language. On the timing of these steps he remained understandable vague.

The re-opening of the 10-year Note for an amount of 11 bn. $ was no real success. The bid/cover of 2.33 was not too far from the 2.4 average in the prior re-openings, but the auction stopped (4.225%) well above the 4.216% bid in the market at the moment of the stop. The buy-side was active with the bid the strongest since September 2007, but still amounted to only 6.6% of total bids. Also the takedown was the largest since September 2007, but at 13.9% still very low. The 25 bn. $ TSLF auction (Term Securities Lending Facility) generated a bid/cover of 1.09, the first auction that covered the offered amount since the April 17 auction. All bids were accorded at the minimum price of 10 basis points. The previous three auctions suggested that financial strains had eased and/or cheaper financing was available. We wouldn’t go as far to state that strains have increased again, but if demand increases in subsequent auctions and the price rises, such a conclusion may be warranted.

Regarding trading, the comments of Philly Fed governor Plossers, admittedly a hawkish regional governor and not a board governor, coupled with upbeat retail sales that suggest the economy is doing better than expected, even if it may be a temporary fiscal induced boost, does give the Fed some more leeway to act on inflation. We still think that the August meeting is too early, but given the upcoming president elections make the October 28-29 FOMC meeting not the best choice to change eventually the monetary policy stance, there remains the September 16 meeting, if the Fed wants to move pre-emptively or the December 16 FOMC meeting. The Fed funds futures trade now at an implied 2.19% in August, 2.34% in September and 2.72% in November. This means that markets now think there is about a 80% chance on a 25 basis points rate hike in August, while 50 basis points rate increase is almost discounted for the September meeting. The 2-year Note increased another 23 basis points yesterday, bringing its increase to about 70 basis points since the start of the week, which should be one of the biggest weekly increases in the last decades.

The curve re-flattened yesterday, following a one-day respite, but this shouldn’t hide that also the longer end is on the rise and at 4.21% the 10-year yield is at its highest for the year. We are witnessing a real crash in the bond market that starts to taste like the 1994 bond market crash that started when markets were unprepared for a change in monetary policy. Then, monetary policy was very accommodative, after the Fed had lowered its FF rate to 3% (inflation was also about 3%) in the wake of a….credit crunch (Savings & Loan crisis). In 1994, Fed increased the Fed funds rate to 6% (early 1995), because of inflation risks. The bonds crashed until the end of October, when the market considered the Fed was again ahead of the curve. Looking back to inflation, it was 2.5% in January 1994 and ended the year at 2.7%, after having touched briefly 3% in September, hardly an inflationary period. Core inflation started 1994 at 2.9% and ended the year at 2.6%. 2008 doesn’t need to be similar, and even inflation doesn’t need to flare up further to stop the market from pushing yields higher, or to keep the Fed sidelined. So, there is no need to think too rapidly the market is exaggerating.

Today, the CPI is another hurdle for the bond markets. It is expected to have been up 0.4% M/M and 3.9% Y/Y in May (and 0.2% M/M and 2.3% Y/Y for the core), once more on the back of higher energy and food prices. Given the focus on inflation, a deviation from consensus might lead to a sharp reaction. Michigan consumer sentiment for early June is expected marginally lower at 59 (from 59.8, the lowest since June 1980). The ABC weekly consumer comfort index jumped higher in the most recent week, suggesting an upward surprise is possible, but the 0.5%-point jump in unemployment rate could have depressed household morale. The IBD economic sentiment index dropped a few points further in June, contradicting the ABC results. Given these contradictory signals, we see little ground to distance us from consensus.

German 5-year yields close in to the cycle highs

Today, the euro zone data calendar contains the labour costs and employment data for the first quarter. Over the past months, the ECB has been very concerned that the tightening of the labour market along with current elevated inflation levels would cause a wage price spiral, which would drive inflation ever higher. In the yesterday released June monthly bulletin, the ECB already pointed to some signs of increasing labour cost growth, notably in the services sector. This may explain why the ECB explicitly referred to ‘increasingly inflationary pressures in the services sector’ in last Thursday’s introductory statement to clarify the upward revision of the ECB staff inflation projections for both 2008 and 2009. Looking ahead, the ECB is likely to remain concerned about the upcoming wage negotiations, as it stated that its indicator of negotiated wages shows signs of a marked acceleration in 2008. Compared with an average of 2.2% in 2007, the annual growth rate of negotiated wages stood at 2.7% in the first quarter of 2008, the article in the ECB monthly bulletin noted.

Yesterday, ECB’s Bini Smaghi reiterated earlier comments of ECB’s Trichet, Stark and Noyer that they ‘only sent indications for July, not beyond’. ECB’s Weber spoke too, but he refrained from giving similar comments. Today, he will speak again. Overall, recent comments of the ECB should put a cap on the rally in 2-year yields, although the expected further rise in inflation over the summer will keep the threat of more rate hikes alive. This morning’s upward revision of the May German inflation data does already suggest that the euro zone flash estimate will be upwardly revised from 3.6% to 3.7% Y/Y, which would be the highest number in 16 years.

Regarding trading, sentiment is still bearish and although a correction at the end of the week cannot be excluded, we see no reason to become more optimistic on the European bond market going forward. From a technical point of view, 5-year yields are now closing in to the cycle highs at 4.65%. In 10-year yields, similar levels stand at 4.70%. These may be points of reflection for the market, whether the recent sell-off on the bond markets hasn’t gone too far.

In the UK, the calendar is empty today.

Currencies: Dollar cautiously stronger ahead of G8

On Thursday, EUR/USD was again in the defensive. There was no obvious trigger to explain this move as was also the case for the rebound on Wednesday. The fact that most of the move took already place in Asia and very early in European trading suggests that it was technically inspired. The uncertainty on the outcome of the Irish EU referendum and the USD 46.3 bn ImBev bid for Anheuser-Busch might have played a role. So, EUR/USD already traded in the low 1.54 area at the start of trading in Europe. The EU production data were better than expected but hardly left any traces on the charts and markets looked forward for the US eco data. US import prices came out at a high 17.8 % Y/Y and also the US retail sales were much better than expected. At around the same time, Fed’s Plosser spook out very hawkish but was less straightforward on the impact of the dollar on inflation as did some of his colleagues recently. This altogether caused a brief spike below the 1.54 barrier, the dollar was not able to build out its gains. So, at least for now, any dollar gains against the single currency apparently still become more difficult as soon as the pair approaches the range bottom in the 1.54/1.53 area.

Today, the calendar contains the CPI and the consumer confidence of the University of Michigan. Headline inflation is expected at 3.9% Y/Y (same as in April) while the consumer confidence is expected to slide further to 59.0 from 59.8. The latter is a wild card (after yesterday’s retail sales it will be interesting to see whether sentiment bottoms out) while an upward surprise in the CPI could fuel market speculation on a Fed rate hike. The latter should be (slightly) dollar supportive. On top of that, markets also will take a close look at the G8 meeting this weekend. Traders will closely monitor whether the recent US ‘policy shift’ on the dollar will also leave its traces in the G8 statement. Inflation in general and oil and commodity prices in particular will be high on the G8 agenda and the dollar is often seen as a source of commodity price rises. However, we don’t expect that the ‘US U-turn’ will lead to some kind of pre-announcement of currency interventions to support the dollar. First, such interventions should be in line with other policy steps (interest rate moves/differentials) to yield optimal results and that is not yet the case, for example after last week’s ECB rate hike warning and a similar approach by a lot of other (major) central bankers. On top of that, any dollar rebound, from a US perspective, should still be ‘selective’. For example, one can not expect the US to plead for a stronger dollar against the likes of the yuan. In this respect, the degree of the US U-turn on the dollar is still far from clear. At this stage we assume that the US intends to slow the fall of the dollar, but with net exports becoming an important source of US growth, an aggressive and global dollar strengthening is probably not preferred by the US either. In this context, we still expect the G8 statement to give a balanced message on the developments on the currency markets.

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 the 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 the 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. Interesting to see whether the G8 meeting will deliver a trigger for EUR/USD to challenge the key support area.

On Thursday, USD/JPY extended its gradual rebound throughout the session. Ever more signs that the Fed will take action sooner rather than later continue to give the dollar interest rate support and also the US data (retail sales and import prices) came out dollar supportive. Early in US trading, also US stock markets could be seen as a supportive factor for USD/JPY and the pair briefly traded above the 108 big figure. However a loss of momentum on the US stock markets and oil prices returning to the intraday highs later slowed the ascent of USD/JPY. The pair closed the session at 107.96, still a gain of a full big figure compared to the close on Thursday.

This morning, the BOJ as expected left rates unchanged a 0.50%. Over time, inflation can also become a factor of importance for monetary policy in Japan. However, policy action in Japan, if any, will lag the action in most other major economies. So, at least short-term, interest rates will continue to move against the yen, even if they are not the only factor to set the tone for currency trading.

Since May, USD/JPY settled in a narrow 102.55/105.87 trading range. The topside of this range was tested several times, but a sustained break only occurred on 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 (106.01 today) would suggest that the uptrend is losing momentum.

On Thursday, EUR/GBP again held a sideways trading pattern and in this respect the pair didn’t join the correction lower in EUR/USD. There were no eco data in the UK but a BOE survey showed a sharp rise in Britons’ inflation perception/ expectations. However, in a context of sharply slower growth, signals that the BOE might be forced to raise rates remain a very ambiguous factor for sterling trading. EUR/GBP closed the day even slightly higher at 0.7932 (compared to 0.7922 on Wednesday).

Today, the UK calendar is again empty.

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. We are sterling negative longer term and hold on to that view. Shortterm, 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  Fri, Jun 13 2008, 07:40 GMT