• Home ::
• Fundamental ::
• Analysis Reports ::
• Sunrise Market Commentary

• Send
• Print
• Add To
• Rss

Sunrise Market Commentary

2a487645-c5ae-4aee-8ee8-16af32f99e53

0

0

US Treasuries remain under pressure

Mon, Jun 16 2008, 09:45 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

Also on Friday, global bonds couldn’t find their composure, even if they tried to eke out some gains following the US eco data, but at the end of the day, yields were again higher, continuing the pattern that was witnessed every single day of the week.

The bond markets clearly continue to re-position on the emergence of inflation as the main trading theme and the likely Central Bank reactions to it. While in the US, the short end outperformed on Friday as the US inflation indications were not worse than expected (cf. below), in the EMU area, the short end underperformed as the German inflation data were revised up and EMU unit labour costs exceeded expectations. Earlier in the week, EMU short-dated bonds outperformed as ECB members, surprised by the sharp increased rate expectations, played down fears of a series of rate increases.

Intra-day, the EMU bonds started the session modestly positive, but the German inflation revision and the EMU unit labour costs statistics soured the fragile sentiment again. The short end led the decline. The US CPI report showed headline inflation (0.5% M/M) marginally above expectations while core CPI (0.2% M/M) was in line with consensus. After some initial hesitation and volatility, Treasuries rallied higher. It seems that markets with all the inflation talk earlier in the week were afraid of a still higher figure and thus the report was received with a sign of relief. The Michigan consumer sentiment was very weak (weakest since 1980) and below expectations, but importantly also consumer inflation expectations, while high, were not rising further. This gave the rally some more fuel. However, the rally petered out and gradually sellers re-appeared and Treasuries slid away, despite equities losing ground too. This was a very disappointing development and shows to what extent sentiment has become bearish. Treasuries revisited the intra-day lows reached ahead of the CPI release and closed only marginally higher, despite equities staging a late-session come-back.

US Treasuries remain under pressure

Previewing this week’s calendar, the focus is on the manufacturing and housing data, both two crucial sectors. Fed speakers are few and front-loaded, as the black out period surrounding the June 24-25 FOMC meeting kicks in.

Regarding the June NY Fed survey on manufacturing, (for release today) the market expects a slight improvement in the headline figure to -1.5 from -3.2 in May. It would keep the index marginally below the growth/contraction threshold. In March the index reached its all time low (-22), followed by a recovery in April (0.6) and a renewed weakening in May. This shows the huge volatility of the indicator, that is often surprising analysts. Overall, we would say that manufacturing is keeping up better than in previous recessionary periods, at least until now, maybe because firms are still in good shape (contrary to other recessionary periods) and exports are doing well. Without strong arguments, we put the risks on the downside. The Philly Fed survey will be released on Thursday. The housing data include the NAHB homebuilders’ survey (today) and the housing starts & permits (tomorrow). The headline NAHB survey has been in free-fall last year touching an all-time low in December at only 18 (50 divides good and bad climate) and has remained at these depressed levels (range 18-20) since. For June, a stabilization at 19 is expected. The market is looking for signs the situation in the housing market stabilizes and then improves. This would have an impact on markets. However, until now there are no signs that a bottom has been found and the first indications of the spring selling season weren’t confidence inspiring either. Inventories of unsold new and existing houses are still too high to incite homebuilders to start much new projects. However, some analysts are betting on increased apartment building (higher rental demand) as an offsetting force for declining single home construction. This was indeed the story of the “strength” in the May report. Other less important data for the market are the Q1 current account and the May industrial production (Tuesday) and the initial claims and leading indicators on Thursday.

Fed speakers include chairman Bernanke and Philly Fed governor Plosser today. The former speaks on health care, the latter on the eco outlook. The two other appearances, we are aware of, notably San Francisco Fed Yellen on Wednesday giving welcoming remarks on the Asian Financial crisis conference and Fed vice chairman Kohn on risk management and systemic risks. Giving the subjects of most speeches and the proximity of the FOMC meeting, we don’t expect the speeches to be influential for trading. However, if the Fed wants to massage expectations, it is their last chance. Currently, the market discounts a 20% chance on a 25 basis points rate hike (July FF future trades at 2.055%). A rate hike looks extremely unlikely to us, but the 20% chance is too low to expect the Fed to “rectify” it. The Beige Book showed still a grim picture of the economy and the latest inflation data haven’t been disastrous enough to warrant a sudden tightening, one meeting after the Fed still eased policy.

Regarding trading, last week, yields were sharply higher and the curve dramatically flatter, as Bernanke and colleagues warned the markets that inflation was a threat that would be taken very serious by the Fed. Stronger data (retail sales) were an element too. The G-8 over the weekend (without central bankers) confirmed that inflation is now the top priority replacing the credit crisis. While before, an easier policy was the prescription (for easing the credit crisis and downside growth risks), the new top priority asks for a tighter policy. Of course, the Fed (and other central banks) are in an extremely difficult situation. The situation in the financial markets remains fragile and higher rates/yields and a flatter curve are certainly not the kind of help the sector is waiting for. Downside risks to growth are very real with the housing market frozen, house price declines accelerating and foreclosures rising. So, it is the question what kind of tightening, if any, the economy can withstand without sliding into a recession. This complex situation will ask outstanding stewardship of the Fed. Rate hike expectations can easily spiral out of control. Last week, the ECB had to ease market rate expectations as its warnings for a July rate hike caused panic, pushing rates and yields sharply up. Once the ghost of rate hikes is out of the bottle, it is difficult to get it back in. The US 2-year yield is now 65 basis points higher than last week and about 180 basis points above the trough in mid-March, while the 2-to- 10-year yield spread narrowed 86 basis points from the highs. The FF futures discount one 25 basis points rate increase for the August meeting, see the Fed funds at 2.75% at the end of the year and at 3.25% in April 2009.

The Fed has clearly made a point with its inflation warnings and got (rate) reactions that may even be a bit excessive for their liking. The big question is whether the Fed’s intention is to affect inflation expectations by talking tough or whether it is the first step in preparing the markets for effective tightening. Above, we described the difficulties the Fed is encountering. Others are the upcoming presidential elections and the origin of inflation, mostly food and energy, something they cannot easily influence by the rate weapon, unless it would strengthen the dollar considerably. However, is that a viable option, as exports are currently the only engine of growth that is functioning properly. In this context of uncertainty, the recent sharp market moves, while understandable, are vulnerable to further wild movements in both directions. Should the inflation expectations go up further, because oil prices increase further or the dollar declines again, the Fed might get in a situation it needs to hike rates to keep its inflation credibility intact, regardless the consequences on growth. On the other hand, if oil would fall back and inflation expectations too, the Fed may decide to give more weight again to downside eco and financial market risks and stay put for longer triggering another sharp reversal of the market. So fasten your seatbelts.

In a weekly perspective, should we get weaker manufacturing and housing data, a possibility, but no firm forecast, there may be a trigger available for a countertrend correction in the Treasury market that is by now very oversold. However, as the prevailing trend is very strong, as Friday’s price action showed, we keep a bearish stance at the onset of trading. Technical pictures are bearish and still more so after last week’s moves. The 5-year yield has retraced 50% of the previous downmove and the 10-year is close to that level (4.30%). The higher low, higher high configuration is intact as are the uptrend channels.

German 10-year yields approaching last year highs

Today’s euro zone inflation data for the month of May will be scrutinized to see whether second round effects from record high energy and food prices are materializing. Until now, core inflation has remained very subdued in comparison with the strong increase in the headline inflation rate. In May, the headline inflation rate is expected to rebound from 3.3% to 3.6% Y/Y and the core from 1.6% to 1.8% Y/Y. The upward revision of the German inflation data and the higher than expected French inflation data point to an upward risk for the headline inflation rate.

Lately, concerns about the inflation outlook have increased, as was reflected in the upward revision of the June ECB staff inflation projections. The ECB is not only expected to miss its inflation objective this year (3.4% Y/Y) but also next (2.4%Y/Y). As a consequence, the ECB signalled that rates may have to rise by a small amount at the next meeting in July. We now expect the ECB to hike rates by 25 bps to 4.25% in July. The rise in oil prices however suggest that the headline inflation rate will rise further over the summer and this has increased the chances that the ECB will hike rates again in the second half of the year. Currently, markets discount at least one more ECB rate hike, although several ECB governing council members have signalled that the ECB is not talking about a series of rate hikes. These comments should cap the upside in 2-year yields although sentiment is still very bearish.

During the weekend, ECB’s vice-president Papademos referred to last Friday’s Q1 labour cost data to say that domestic inflationary pressures are intensifying. These showed an above consensus increase from 2.9% Y/Y to 3.3% Y/Y. Today, ECB’s Liebscher will speak in Vienna. Liebscher will however leave the ECB in the near future when his term ends Aug 31. Over the weekend, Garganas, the governor of the Bank of Greece, has already left the ECB and is replaced by Provopoulos. This will mean that the ECB is losing two of its main hawks in a rather short period of time.

Regarding trading, the sell-off continued unabatedly on Friday. German yields are now close to or just above the cycle highs of mid-2007. In 10-year yields, these levels stand at 4.70% and this may be an important point of reflection for the market, whether the recent sell-off on the bond markets hasn’t gone too far. For now, sentiment is still very bearish and we see no reason to become more optimistic, although the market is heavily oversold.

In the UK, the calendar is empty today.

Currencies: G8 gives no signal on the FX market

On Friday, EUR/USD at first continued its downtrend. Once again there was no obvious link with the eco data. The (expected) negative outcome of the Irish referendum on the Lisbon treaty for sure was no positive for the single currency and markets also kept a dollar positive bias going into the G8 meeting. However, the US data (inflation more or less in line with expectations and a weak Michigan consumer confidence) slowed the ascent of the dollar and EUR/USD even recouped an important part of the early losses late in the session. EUR/USD closed the week at 1.5381, compared to 1.5777 at the end of last week.

Over the weekend, the G8 statement didn’t bring any message on the currency markets and this is of course a disappointment for those who expected the recent U-turn in the US approach on the dollar to filter through into the G8 debate. Paulson again repeated its recent preference for a strong dollar but this was not picked up in the official G8 communication. While we don’t see any reason for other G8 members to be against a stronger dollar, the G8 silence at least suggests that coordinated interventions are not around the corner. The dollar lost some ground this morning, but at 1.5400 EUR/USD is still within striking distance of the range bottom and of the key 1.5285 area.

Today, US calendar contains the Empire state manufacturing survey, the TIC data and the NAHB housing data. In Europe, the final May CPI figure will get most attention. The speech of Mr. Bernanke (on health care reform) shouldn’t bring much news for the markets. The European inflation data might come out above the Flash estimate, but we don’t expect this to be a major support for the single currency. We more look out for the US data to be published today and later this week. If they don’t yield big negative surprises and if they keep the way open for the Fed taking back some of the monetary easing, this might still be a support for the dollar.

In a medium term perspective, we have a neutral bias on EUR/USD as we assumed 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. A sustained break outside these ranges is needed for a directional move in one way or anther. The G8 didn’t provide the trigger for such a move, but on the other hand the dollar losses this morning are also very limited, suggesting that the ST environment remains dollar constructive. We still don’t want to front-run on a high profile break (lower) in EUR/USD. However, the US indicating that a weaker dollar is no longer in the advantage of the US should continue to give the topside in the EUR/USD pair decent protection. We hold on to our sell-on-up-ticks approach as long as the pair stays below the recent highs in the 1.5840/1.5820 area.

The absence of any clear signal on the dollar from the G8 meeting also caused USD/JPY to start this week’s trading slightly lower. However, the correction was very limited and a strong stock market performance in Japan helped USD/JPY to regain 108.00 barrier.

Last week, USD/JPY broke above the 102.55/105.75 trading range, as 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. The 14 February high at 108.68 now becomes the next target on the upside in this pair. Reaching this area might become a short-term point of reflection/ consolidation in this pair. A drop below the MTMA (106.30 today) would suggest that the uptrend is losing momentum.

On Friday, EUR/GBP moved cautiously lower and this mostly should be seen a euro correction rather than a sterling rebound, with also the Irish rejection of the Lisbon treaty as the most evident reason behind this euro weakness. There were no important UK data on the agenda on Friday. EUR/GBP closed the day at 0.7898 (compared to 0.7932 on Thursday and 0.8005 at the end of last week).

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 skeptical 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 0.7831 reaction low is the first hurdle on the downside in this pair. 0.7766 remains the key range bottom. We continue to see this area a strong support, also in a medium term perspective.

• Download Full Sunrise Market Commentary

Published on  Mon, Jun 16 2008, 09:55 GMT