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Sunrise Market Commentary

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US Treasuries react moderately positive on FOMC decision and statement

Thu, Jun 26 2008, 07:10 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Wednesday, global bonds traded lower for most of the day, but recouped all the losses following the FOMC rate decision and statement. At its June meeting, the Fed as expected left rates unchanged for the first time in 10 months and while the statement puts more emphasis on risks to inflation and inflation expectations, it also keeps downside growth risks signalling that a near term rate hike is unlikely (for more details, we refer to our flash on the FOMC meeting). As markets were positioned for a more hawkish statement, yields fell, the short end outperforming and driving the curve steeper. In a daily perspective, US yields were lower at the short end, but still somewhat higher at the longer end of the curve. In the euro zone, the official closing ahead of the FOMC rate decision showed some losses for the European bond mar-ket, especially at the short end of the curve, as Trichet called the risk of triggering an inflationary wage price spiral acute during his testimony before EU Parliament. Inter-estingly, the drop in the oil price during the afternoon couldn’t support the bond mar-kets, although it should improve the inflation outlook.

US Treasuries react moderately positive on FOMC decision and statement

Today, the market will continue to chew on yesterday’s FOMC decision and state-ment that got a remarkable calm reception. The eco calendar is less exciting. The fi-nal Q1 GDP is outdated and won’t show considerable changes compared to the pre-liminary report. The initial claims are always a bit of a wild card, given its weekly wiggles. The markets count on a slight decrease to a trend-like 375 000. Also con-tinuing claims are expected a bit lower, following last week’s jump. The Existing Home sales for May are expected to reverse April’s decline and be up 1.2% M/M (to 4.95 million). The Pending Home sales that are a pointer to Existing Home sales re-bounded strongly in recent months and this puts the risks for the latter on the upside of expectations. Existing Home sales lag New Home sales (for technical reasons) and while the latter fell in May, they rose in April. However, while a rebound in Exist-ing Home sales would be positive news for the economy, we shouldn’t draw too many conclusions from it, as all other housing indicators like NAHB, New Home sales, S&P house prices and housing starts all showed that the housing market isn’t on the verge of a turnaround.

The 20 bn. $ 5-year Note auction will raise all new cash upon settlement (Monday). The size of the 5-year has been increased again by 1 Bn. $ and is now the largest since February 2003, which is of no help of course. In April and May, the 5-year Note auction went very poorly, as it stopped above the bid side in the WI trading at the moment of the stop and had a very light bid/cover. Buy-side showed little interest ei-ther. However, it may not be all negative for today’s auction. On Tuesday, the 2-year Note auction went well, which isn’t a guarantee for the 5-year as past statistics show, but might encourage some investors. The 5-year yield is a bit higher than in May and much higher than a few months ago. On top of that, yesterday’s FOMC decision might have eased market concerns that the Fed is on the verge of starting its tighten-ing cycle. Therefore, we might see the auction go better than in previous months.

Yesterday, Treasuries were under pressure ahead of the FOMC, after higher-than-expected oil inventories pushed oil prices lower. However, given the limited (positive) impact on equities, the reaction of Treasuries was a bit of a surprise. Following the FOMC statement that was close to recent comments of Bernanke and a touch more dovish than markets feared, the losses were erased at the longer end of the curve. The reduced chances on an early start of the tightening cycle benefited the short end of the curve that outperformed and thus steepened the curve. As ex-plained in a separate research note on the FOMC decision (FOMC) there are no clues about the timing of the start of the tightening cycle, but an August rate hike looks very unlikely to us. The future course of growth, inflation and the situation in the financial sector will guide the Fed and markets on official rates. Rate increase expec-tations diminished slightly, but the FF future still discounts a 30% chance on a rate hike in August, while a rate increase at the September meeting is fully priced in. Overall, while yesterday’s reaction on the FOMC decision was constructive for Treasuries, it didn’t turn the sentiment all of a sudden to bullish. Nevertheless, we have the feeling that there is more upside for Treasuries and the sell-off phase may be over for now. However, for the technical pictures to become less bear-ish and neutral, the 2- and 5-year yields should drop below 2.77% and 3.5% respec-tively on a sustained basis. Also for the 10-year yield, no clear technical sign of im-provement.

For today, the eco data are less important, but we will be scrutinize how the markets react to eventual surprises in the eco reports, post FOMC, to get a sense whether something has changed in the underlying sentiment. The 5-year Note auction might also be a test of investors’ post-FOMC appetite for Treasuries.

Trichet sees ‘acute’ risks for an inflationary wage-price spiral

Today, the euro zone M3 money supply and credit growth data will be closely monitored, as recent ECB speeches stressed the crucial role these data play in their monetary policy decisions. According to these comments, the money supply and credit growth data have enabled the ECB to keep a medium term perspective and prevented them from pursuing a too activist monetary policy during the recent fi-nancial crisis. Indeed, despite the financial turmoil money supply and credit growth to non-financial corporations has remained surprisingly buoyant giving credence to the ECB’s view that monetary policy isn’t restrictive and that there is no credit crunch in the euro zone. On the contrary, the ECB still thinks that current high growth in money supply and credit point to upside risks in the medium term outlook for inflation.

Regarding the short-term outlook for inflation, Belgium and a few German States will publish their inflation figures for the month of June. These are likely to show a further rise in the headline inflation rate, which will raise the inflation concerns at the ECB.

Yesterday, comments from Trichet and Weber cemented market expectations towards a rate hike at the July meeting. In his testimony before EU Parliament, Trichet sounded increasingly concerned about the risk that current elevated inflation rates will become entrenched in private inflation expectations and lead to second-round effects in price and wage setting behaviour. In this context, Trichet called the ‘risk of triggering such an inflationary wage-price spiral particularly acute, especially in countries where nominal wage indexation schemes exist’. These are the strongest wordings we have heard from the ECB until now and increase the risk that one small rate hike in July won’t be sufficient to bring inflation back below the 2% level, although Trichet repeated that the ‘ECB did not envisage a series of rate increases’. As such, recent weak eco data didn’t appear to have softened the ECB’s concerns on inflation. On the contrary, Trichet continued to sound optimistic on the growth outlook and repeated that the economy is expected to reach a trough already in mid-2008, before gradually recovering thereafter. This ap-pears overly optimistic in our view, as recent business sentiment data came out very weak, there is no sign yet of a material improvement in important export mar-kets, like the US and the UK and the recent policy tightening in Asia suggest that growth will also weaken over there, while the credit tightening and the surge in the euro probably will still have to filter through into the real economy.

Yesterday, the ECB also confirmed that they will hold a press conference fol-lowing the August meeting. This will be third year in a row, that the ECB has scrapped its traditional telephone conference in favour of a physical meeting in Frankfurt. The ECB spokeswoman however noted that this decision was taken al-ready last year and that from now on this will remain the case also for the coming years. As such, we wouldn’t draw many conclusions out of this.

Regarding trading, European bonds have bottomed out over the previous days, as the weak eco data have capped the upside in yields. Nevertheless, it appears that some positive news on the inflation front will be needed before a further im-provement on the bond market will happen. In this context, the June inflation data may be interesting. For now, some further consolidation is the most likely sce-nario. A sustained break below the March lows in the equity indices would also be a positive for the bond markets.

In the UK, the testimony of the MPC to Parliament’s Treasury Committee may be interesting following the record strong retail sales numbers last week. These may have tilted the balance for some members in favour of a rate hike, as the weak-ness in activity may be insufficient to bring inflation back to the 2% target.

Currencies: Balanced Fed approach sends dollar (moder-ately) lower

On Tuesday, EUR/USD trading was in a wait-and-see mode ahead the Fed interest rate decision. The euro opened weak in the mid 1.55 area in Europe, but EUR/USD moved gradually higher to the 1.56 area as investors turned more USD cautious go-ing into the Fed decision. ECB’s Noyer made some interesting comments as he said that ‘we are experiencing a period characterized by large and disorderly fluctuations in the main currencies of developed countries and by insufficient flexibility in numer-ous currencies of emerging markets, which unquestionably calls for resolute and co-ordinated action by the big countries’. These remarks suggest that the current euro level is a factor of unease for the ECB even if it currently helps to address the infla-tion threat. However, the impact on EUR/USD was very limited. The US eco data (Durables and new home sales) hardly had any impact. Lower oil prices gave the dollar some support at the end of the European trading.

The Fed kept rates unchanged at 2 %. Inflation risks apparently have become slightly more important than growth risks, but the Fed stopped short of adopting a tightening bias. This is a fairly balanced approach, but the chances for a rate hike in the months to come have diminished and this weighed on the dollar, especially against the single currency. EUR/USD jumped almost one big figure to the 1.5680 area. EUR/USD closed the session at 1.5667 compared to 1.5568 on Tuesday.

Today, calendar contains the first regional CPI data in Europe. The latter are impor-tant input for next week’s ECB interest rate decision. In the US the final Q1 GDP data, the jobless claims and the existing home sales are on the agenda.

Already for quite some time we have a neutral bias on EUR/USD. The economic data both in the US and Europe point to ongoing slow/declining growth but the Fed and the ECB have not many options to address this problem. We assume EUR/USD to extend the sideways trading pattern between 1.6020 and 1.5285. Yesterday’s Fed interest rate decision was slightly less hawkish than the market had expected and this led to some dollar losses against the single currency. However, we don’t think this has really changed the broader picture. Visibility on the economy remains low and both the Fed and the ECB have hardly any room of maneuver. Short-term, EUR/USD now trades above the previous short-term highs in the 1.5655 area and this is a slightly positive in a day-to-day perspective. Medium term we still see the 1.5840 area as strong resistance and look to sell in case of return action toward that area.

On Wednesday, two events dominated the price action in USD/JPY. After trading sideways in Europe, USD/JPY spiked higher to the 108.40 area as higher than ex-pected US oil inventories triggered a decline in the oil price. However, these gains were undone after the Fed statement came out less hawkish than expected. So, USD/JPY proved again less sensitive to dollar negative news compared to other ma-jor dollar cross rates (like USD/EUR). At the end of the day, USD/JPY again closed the session unchanged at 107.81.

The combination of USD/JPY holding stable and EUR/USD gaining one big figure caused EUR/JPY to set a new life-time high above the 169 mark. We don’t see a fundamental reason for EUR/JPY to go aggressively higher, but recently rowing against the established trend in EUR/JPY seldom was a successful strategy. We wait for a clear technical sign before setting up EUR/JPY shorts.

Two weeks ago, USD/JPY broke above the 102.55/105.75 trading range and the pair tested the 108.62 Feb reaction high. The inability to build out gains above this tech-nical 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. However, the ‘correction’ only developed at a very slow/guarded pace.

Recently, we turned neutral on USD/JPY. The news flow wasn’t always dollar posi-tive (for example this week’s US eco data and the Fed statement), but this caused remarkably little damage on the USD/JPY chart. From technical point of view, the MTMA continues to play its role as support. 108.60 remains the first important barrier on the upside. A sustained break above would further improve the technical picture. For such a break to happen, we need a further improvement in the overall dollar sen-timent. After yesterday’s Fed communiqué, the trigger for this is not available yet. So, the current deadlock in USD/JPY might continue.

Wednesday brought again a very dull session for EUR/GBP trading. Going into the Fed meeting, markets mostly looked at the dollar and for most of the day cable and EUR/USD traded in close connection. The CBI distributive trades report gave some mixed signals, but obviously was less buoyant than last week’s retail sales report. However, the impact on sterling trading was again close to non-existent. The most significant intra-day price move came after the Fed interest rate decision as EUR/GBP partially tracked the rebound in EUR/USD at that time. EUR/GBP closed the session at 0.7932 compared to 0.7899 on Tuesday.

Today, UK calendar only contains the BBA loans for house purchases. This series shouldn’t move the market. So,t he price action again will again mostly at the mercy of the repositioning in the dollar cross rates.

Since mid April, EUR/GBP develops a very uninspiring consolidation pattern (0.7766/0.8098). We turned neutral on EUR/GBP recently as an attempt to move higher ran into resistance (0.7955 area) and as the pair shows no trading momentum at all. We hold on to our view that the room for a sustained comeback of the sterling is limited. In a day-to-day perspective, some follow-through gains in EUR/USD after yesterday’s Fed decision might cause EUR/GBP to test the 0.7955 resistance. A break above this level would open the way to the 0.8033/34 reaction highs. The 0.7831 reaction low remains the first support area on the downside in this pair. 0.7766 is the key range bottom. We continue to see this area as a strong sup-port.

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Published on  Thu, Jun 26 2008, 07:39 GMT