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Sunrise Market Commentary

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Treasuries cautiously higher on global uncertaint

Mon, Jun 23 2008, 07:22 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Friday, global bonds rallied higher on weaker equities that generated a safe haven bid and left yields substantially lower in a daily perspective. In the US, the belly of the curve outperformed, while in EMU, the curve steepened.

In a session devoid of US data and with only second tier EMU data on the calendar, attention went to other markets for guidance. Equities traded very weak on the back of a renewed rise in oil prices and on ongoing stress in the financials. This generated a safe haven bid for bonds. Flows were rather thin though and both US an EMU ended the session off their best levels. In fact, the longer end only reversed Thursday’s losses, while the short end was mixed. German 2-year bonds more than offset Thursday’s losses while the US 2-year Treasury couldn’t recoup all of Thursday’s losses.

Treasuries cautiously higher on global uncertaint

Previewing this week’s calendar, the focus is of course on the FOMC meeting that concludes with a statement on Wednesday. The Treasury will auction 2- and 5-year Notes on Tuesday and Thursday to the tune of 30 and 20 billion $ respectively. The eco calendar is busy as it contains today the Chicago Fed National activity Indicator, on Tuesday, the S&P house price index (April), consumer confidence (June) and Richmond Fed survey (June), on Wednesday the durable orders (May) and the New Home sales (May), on Thursday the final Q1 GDP, the weekly claims and the Existing Home sales (May), to conclude on Friday with the Personal Consumption Expenditures (May) and Michigan Consumer sentiment (June). Fed vice chairman Kohn and St-Louis Fed Bullard participate at the ECB forum on monetary policy. Given the proximity of the FOMC, we suspect both governors will refrain from giving market sensitive comments.

Regarding the data, the Chicago Fed National Activity Indicator may be close to -1 in May, following a -1.24 in April. These levels suggest a high chance that the economy is in recession, even if we belief that also in Q2, the economy will have grown, albeit anaemic. There should be little change in the housing sector, S&P house prices should have declined further in April, New Home Sales probably reversed April’s surprising rise, while Existing Home sales may have risen in May, following a decline in April, if the pending home sales that were up sharply are a good pointer. Consumer confidence and sentiment should have been soft in June, but Personal Consumption Expenditures (May) should have done well, as the retail sales suggest, helped temporarily by the tax rebates. However, we suspect the eco releases ahead of Wednesday’s FOMC statement to have little impact on trading.

Regarding trading, last week, yields fell (between 16 and 6 basis points) and the curve steepened, as the market reassessed the outlook for monetary policy. Early in the week, three main financial newspapers ran articles saying that various Fed members didn’t subscribe the market expectation for neither speedy Fed tightening, nor the number of Fed rate increases discounted in a one-year perspective. Early June, the Fed clearly signalled that inflation had moved up in its parade of concerns, while growth concerns abated. Indeed, already the previous FOMC Minutes revealed that the economic situation stabilized and also in the beige book, the number of Fed districts signalling no further economic deterioration rose. In this context, one should forgive the market from taking Fed inflation warnings serious and acting accordingly. However, renewed financial distress reminded the market that the Fed is in a very delicate and awkward position. Besides the inflation risks and notwithstanding the recent signs of some stability in growth, economic risks are still very real. The situation in the housing sector has not stabilized and the manufacturing sector is flirting with recession too. To make bad things worse for the Fed, renewed distress in the financial sector last week (Monoliners/ Citi/ Fifth Third bank/ ....) underlined that the system isn’t out of the woods yet. So, markets priced out some of the expected Fed tightening. As of Friday evening, the market prices in a 10% chance on a rate hike at this week’s meeting, a 33% chance for an August 5 rate increase and an almost fully priced 25 basis points rate hike at the September 16 meeting. While these probabilities have been trimmed versus the start of last week, they are sharply up versus one month ago. For this week’s FOMC meeting, we expect unchanged rates and a statement that doesn’t contain too many changes and makes an August rate increase unlikely. It looks to us that the circumstances aren’t right for the Fed to prepare the markets for a turn in its rate cycle. The newspaper articles of last week, core CPI that was benign in April/May and inflation expectations (TIPS) that linger more sideways all suggest that the Fed needs to buy time and cannot afford to act now without strong evidence that it won’t be forced later on to reverse its decision. We don’t underestimate the inflation risks further out, but feel that for now the Fed won’t play that card in a tough way. Therefore, there is some room for a further downward correction of near term Fed rate hike expectations. In the same vein, it could push the shape of the curve a bit steeper.

The eco data ahead of the FOMC looks to be soft and while equities eventually might pause early in the week, following steep losses last week, the picture has turned definitely bearish and a re-test of the 2008 lows (1256/70 for the S&P) may be in the cards. So the context should be good for Treasuries at the start of the week, even if the market may trade quiet ahead of the FOMC. Despite last week’s gains, the technical pictures are still bearish though. However, we see opportunities that Treasuries can correct higher, following the brutal sell-off that started in April.

European business confidence surveys in the focus

Today, the euro zone calendar is well-filled with the PMI surveys, the German IFO indicator and the Belgian business confidence survey. These should give us a timely indication of the growth outlook in the euro zone. Over the past months, economic growth, especially in Germany, has been quite resilient in the face of the financial turmoil, record high energy and food prices and the strength in the euro. As such, the gradual slowing in economic growth wasn’t enough to ease concerns about the upside risks to inflation, as inflation expectations continued to rise in tandem with the surge in the oil price. This brought the ECB in a state of ‘heightened alertness’, which is likely to result in an interest rate hike at the July meeting.

Over the weekend, the meeting of oil producers and consumers in Saudi Arabia failed to alleviate concerns about the oil price, as the production increase by Saudi Arabia risks to be offset by the sharp drop in output caused by attacks on production facilities in Nigeria. This morning, the oil price is again up by around 1 USD/barrel. The sustained elevated levels in the oil price risks to raise the headline inflation rate towards the 4% level in the months to come. At the end of the week, the German inflation data for the month of June are again expected to rise from 3.1% Y/Y to 3.3% Y/Y. The ongoing rise in the headline inflation rate will keep the threat of higher interest rates alive in the euro zone, unless the ECB would signal that the economic outlook has deteriorated enough so that inflationary pressures won’t erupt and that inflation would fall back towards below the 2% level in the medium term.

Historically, a fall below the 50 level in the manufacturing PMI has been consistent with an easing bias at the ECB. Such an outcome would suggest that current interest rate hike expectations for three rate hikes have gone far enough in the euro zone. At the same time, European equities are testing the March lows and a sustained break lower would heavily deteriorate the technical outlook and (if also confirmed in the US S&P) would lead to new safe haven flows into the European bond market. This would, like on Friday, mainly support the short end of the curve. But also at the longer end of the curve, the cycle highs may prove a hurdle too high for now, as 10-year yields failed to break above the 4.70% level on Friday and fell back afterwards. So, while sentiment is still very bearish on the European bond market, there are some signs available that may point towards some consolidation or even some correction lower in yields. Although, we wouldn’t front-run on a fall below the 50-mark or a break lower in the equity markets, some profit-taking on recent short positions can be considered.

In the UK, the Rightmove house price index dropped the most this year in June, as prices declined by 1.2% M/M according to Britain’s most-used property web site. The index isn’t however based on real transactions but on average asking prices for homes. Therefore the indicator isn’t most reliable and influential in the market, but it nevertheless suggests that house prices continued their fall in June. This is likely to be reflected in the Nationwide house price index later on this week.

Currencies: dollar in the defensive, but is there room for euro strength?

On Friday, the eco calendar was empty, but this didn’t prevent EUR/USD from moving higher throughout the session. At least for now, the global uncertainty due ongoing high oil prices and renewed credit woes was seen as (slightly) dollar negative even if the losses on European stock markets recently were even more pronounced than for most US indices. In the current environment of low economic and financial visibility the interest rate support is apparently also a supportive factor for the single currency. So, EUR/USD moved higher throughout most of Friday’s trading session and closed the day at 1.5606, compared to 1.5505 on Thursday. The uncertainty going into this weekend’s oil meeting in Saudi Arabia was an additional negative factor for the dollar.

Today, the US eco calendar is empty. However, the European calendar contains the advanced reading of the June PMI surveys and the German IFO release. We would be rather surprised to see these indicators bring much good news on the European economy. In this respect it would be interesting to see the market reaction in case of a steep fall in the Ifo or in case the European PMI would come out below the key 50 mark. Oil and the credit crisis might continue to be (slightly) negative for the dollar; however, the European data probably don’t warrant a euro bullish sentiment either. The Jeddah oil summit didn’t yield any perspective for a quick solution to the high oil prices, but at first sight the impact on markets in general and on the currency market in particular is rather limited this morning.

In medium term, we have a neutral bias on EUR/USD. The eco picture on both sides of the Atlantic is highly uncertain and both the Fed and the ECB have not many options to address the difficult economic context. In this context of low visibility on the economy, we assume EUR/USD to extend the medium term sideways trading pattern between 1.6020 and 1.5285.

After the Fed warning on the inflationary impact of the weak dollar, sentiment temporarily grew more dollar constructive, but it was also not enough for EUR/USD to clear the important technical barrier of 1.5285. The recent moderation in Fed rate hike expectations reduced the appetite to build up aggressive dollar long positions and this probably won’t change going into this week’s FOMC meeting. So, the current eco and monetary policy context remains highly indecisive for EUR/USD trading and there is no obviously trigger available to unlock this stalemate.

For today, the outcome of the European Business sentiment indicators will be important for trading. Later this week the Focus will shift to the Fed interest rate decision and communiqué on Wednesday. In the current uncertain environment, we take a close look at the technical picture and continue to see the 1.5840 area as a strong resistance for EUR/USD. We still look to sell on up-ticks in case of return action higher in the established 1.5285/1.5840 range.

On Friday, global dollar weakness also weighed on USD/JPY. Uncertainty on the outcome of the Jeddah oil meeting and a very negative stock market sentiment both in the US and in Europe kept the USD/JPY currency pair under pressure throughout the trading session on Friday. USD/JPY close the day at 107.33, compared to 108.01 on Thursday.

The oil summit didn’t yield much prospects for a quick improvement in the situation on the oil market, but the global market reaction this morning is very subdued. The losses on the Japanese/Asian stock markets should be considered as limited given the extremely negative sentiment in Europe and the US at the end of last week. This ‘moderate reaction’ this morning at least slows the decline in USD/JPY this morning with the pair still trading in the 107.50 area.

Two weeks ago, USD/JPY broke above the 102.55/105.75 trading range and the pair even reached the next high profile barrier on the graphs (108.60 Feb reaction high). The inability to build out gains above this technical level, resurfacing global economic and financial uncertainty and some cooling of the temporary ‘improvement’ in dollar sentiment, all caused the USD/JPY ascent to slow and since last week the pair even had to cede some ground. However, at least for now, the correction still develops at a very slow/guarded pace.

Recently we advocated that the downside in this pair was well protected and even if the context is far from optimal for USD/JPY (high oil prices and faltering stock market sentiment), this assumption remains valuable. However, after the ‘rejected’ test of the 108.60 resistance and with the fundamentals (stocks, oil and the US data) not that convincing, some further consolidation/profit taking may still occur short-term. The pair currently tests the MTMA (107.25 today) A drop below this area would suggest the risk of some additional loss of momentum in this pair. We wait for a signal that the correction has run its course before adding to USD/JPY long positions short-term.

On Friday, EUR/GBP trended higher in a move that was mostly driven by global euro strength. In this respect, the sterling again had to give back some of the gains recorded on Thursday after the stronger than expected UK retail sales. EUR/GBP closed the session at 0.7898 compared to 0.7860.

Overnight the Rightmove house prices again confirmed the difficult situation in the UK release estate market and this remains slightly negative for sterling at the start of this new trading week.

Today, the UK calendar is empty.

Since mid April, EUR/GBP develops a very uninspiring consolidation pattern (0.7766/0.8098) 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. Last week, the sterling tried to regain some ground on a strong retail sales figure, but we hold on to our view that the room for a sustained comeback of the sterling is limited. The recent deadlock in EUR/GBP remains in place. The 0.7831 reaction low is still the first hurdle on the downside in this pair. 0.7766 remains the key range bottom. We continue to see this area as a strong support, also in a medium term perspective. On the topside the 0.7955 area was tested several times last week but also this barrier was not broken.

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Published on  Mon, Jun 23 2008, 07:53 GMT