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Sunrise Market Commentary

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US Treasuries rally and curve steepens on flight to quality

Fri, Jun 27 2008, 07:11 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Thursday, global bonds surged higher, the short end leading the way, as equities crashed on more bad news in the financial sector and a concomitant rally in crude. The safe-haven bid was clearly the driving force.

Intra-day, trading was more or less range-bound in the European morning session, as eco data like the EMU M3 failed to impact the market and weaker equities were largely ignored. That all changed in the US on more bad news on financials and the rallying oil price. The claims were a bit higher-than-expected and New Home sales a bit stronger-than-expected, but none got much attention. A safety bid for Treasuries/ Bunds drove the price action and steepened the curve, the usual reaction if fear affects emotions. A strong US 5-year auction gave the rally some extra fuel.

US Treasuries rally and curve steepens on flight to quality

Today, the market will be dominated by developments in the equity markets, that after yesterday’s horrible decline are now threatening key support levels (cf. graph S&P below). The Dow even broke below the neckline of a massive head & shoulder configuration. However, a small glimmer of hope. The close occurred near the lows possibly qualifying the move as an exhaustion/capitulation one (Marabodzu), which technical means that at least for the short term “all” investors that wanted to sell have sold, giving the market some respite. The oil market will also keep all attention, as yesterday the WTI future broke above 140 $/barrel for the first time ever. The break should still be confirmed, but if that’s the case, the risk is for the uptrend to resume with 150 $/barrel playing as an attractive level to aim at.

The eco release includes the May personal income and spending and the Michigan consumer sentiment for June. The retail sales for June, released last week, were surprisingly strong, apparently due to the tax rebate checks that were distributed. As a result also the consumption spending, that includes retail sales, besides services, is expected to have risen, notably to 0.7% M/M from 0.2% M/M previously. So a strong figure shouldn’t surprise and would suggest that consumption is holding up in the second quarter, preventing the economy to slide into recession, at least for now. In the current climate, markets sometimes look to the core PCE deflator (expected 0.2% M/M), the Fed’s preferred inflation gauge. However, while there are a number of differences with the CPI, its month-on-month profile is most of the time identical. So all in all, the release shouldn’t have too much impact. The Michigan consumer sentiment index is expected little changed from its early June reading of 56.7. The Consumer confidence measure weakened more than the preliminary Michigan reading, suggesting some downside risks to the Michigan final figure. However, the ABC weekly consumer comfort index improved throughout the month

The 20 bn. $ 5-year Note auction was a success, as dealers bid aggressively, but also the buy-side was eager to get their bids rewarded. The auction stopped 2 basis points below the bid in the WI at the moment of the stop and the 2.48 bid/cover was strong given the size of the auction.

Yesterday, Treasuries profited from a flight to quality as equities looked into the abyss and oil prices set a (minor) new high. The curve understandably steepened. Interest rate expectations receded, as financial strains may prevent the Fed to tighten policy soon and/or do it in an aggressive way as markets had discounted. The chances for an August cut have diminished to about 20% while the Dec Fed future future trades at 2.39%, down 10 basis points from the previous session.

The technical pictures of the 2- and 5-year Note have improved, as both are now below the uptrend channel and below the previous high. For the 10-year Note the improvement is less outspoken, as the 10-year yield should drop below 3.95/4% before major improvement is made. As indicated above, the eco data shouldn’t be the major driver today. Regarding the equities and oil, they remain the key factor for Treasury trading. If oil rallies convincingly above 140 $/barrel or more bad news from the banking sector filters through, equities would get a difficult time (dropping below major support, cf. graph) and a such drop would stimulate thinking about a major extra down-leg, or at least the media would come up with Armageddon scenarios. In such a climate, Treasuries would thrive well and the curve could steepen further. A second scenario is possible though, notably that bottom fisher’s turn up, after the wash out of yesterday, giving equities some respite going into the weekend. We turned more positive on Treasuries recently and would stick with that attitude for now.

European bonds ignore higher inflation data

Today, the euro zone calendar is packed with EU Commission confidence indicators, the retail PMI and the German and Spanish inflation data. Regarding the latter, yesterday’s Belgian and first German Länder inflation data suggest that the euro zone headline inflation rate may come out as high as 4% in June. This will put the ECB in an awkward position, as at the same time the EU Commission Confidence indicators will indicate that the euro zone economy is rapidly losing momentum and may even have contracted in Q2 following the unexpectedly strong Q1. The retail PMI’ are notoriously volatile, but yesterday’s lending figures to households and plunging consumer confidence surveys throughout the euro zone suggest that no strong growth contribution from the consumer side has to be expected.

On the ECB front, ECB’s Gonzalez-Paramo and Trichet will speak today. Gonzalez- Paramo will speak on ’10 years of the euro’, while Trichet will participate at a conference between central banks in the East Asia-Pacific Region and the Euro Area. Although this probably won’t yield headlines directly related to the near term outlook for ECB monetary policy, the conference may be very interesting, as the current rise in energy and food prices is closely related to the strong growth performance in Asia. Yesterday, BoE governor King blamed Asian governments for fuelling inflation by linking their currencies to the dollar and urged policymakers worldwide to pay more attention to these global price pressures. Indeed, by linking their currency to the dollar, these Asian economies are importing the current very low US interest rates, which aren’t appropriate for their economies. In recent months, several Asian central banks have raised rates to counter the escalating inflation risks. Yesterday, Taiwan’s central bank increased rates to a 7-year high in a move that followed rate hikes in India, Indonesia and the Philippines earlier this month. A tightening of monetary policy in Asia should slow growth, ease demand for commodities and as such temper the current surge in commodity prices and inflation. It remains however very hard to predict from what point the slowdown of the world economy will start to affect commodity prices and consequently the inflation outlook. Yesterday’s sell-off on the equity markets failed to bring down commodities too, as the CRB index and the oil price set new highs. In an interview in Der Spiegel, ECB’s chief economist Stark said that ‘interest rates around the world have been too low for too long’ and that this is fuelling financial ‘bubbles moving from one sector to another’ and now ‘from the real estate sector to the commodities sector’.

On the supply front, Italy will tap its 3- and 10-year benchmarks for an amount of EUR 5.5 B, as well as its 7-year CCT for an amount of EUR 0.5 B. In comparison to recent German taps, where demand has been particularly weak, demand has held up quite well for Italian government bonds. It remains however to be seen whether yesterday’s heightened risk aversion will also damp today’s demand for the Italian bond issues or whether the spread between German and Italian yields will widen again.

Regarding trading, European bonds had a very strong run yesterday, as renewed banking woes dragged the equity markets down and overshadowed the higher inflation data from Belgium and Germany. From a technical point of view, 2- and 10-year yields are now below the neckline of a double top formation at respectively 4.50% and 4.55%. A confirmation of the break lower would improve the technical picture and support our view that the upside in yields is capped. The room for a further downward correction will however depend on the inflation outlook, which remains worrisome for now. At the same time, increasing concerns about the growth outlook reflected in the sell-off on the equity markets provides counterweight and may become the dominant factor if the sell-off continues. Following the break below the March lows in the Eurostoxx, the major US indices have now also approached these lows and a sustained break lower would heavily deteriorate the technical picture.

In the UK, Gilts even outperformed the European bond market, as the testimony of the MPC indicated that the Bank won’t overreact to the inflation data. Today, the final Q1 growth figures are expected to confirm the preliminary figures.

Currencies: Dollar extends correction

On Thursday, EUR/USD extended its gradual rebound of the previous sessions. The Fed indicating on Wednesday that rate increases are not around the corner caused investors to execute additional re-positioning away from the US dollar. On top of that, European inflation data only reinforced the case of the ECB to raise European interest rates. The US Q1 GDP revision was in line with expectations while the claims suggest a further weakening in US labour market conditions. The turmoil in the financial sector, which currently hits Europe at least as hard as the US, apparently is not really an issue for the currency markets at this stage and even tends to be slightly dollar negative/euro positive. Late in US trading, oil prices set new intraday highs above the high profile USD 140 mark and this put some additional pressure on the US currency. So, EUR/USD closed the session at 1.5756, compared to 1.5667 on Wednesday.

Today, US personal income and spending data and the final Michigan consumer confidence are scheduled for release. Also the European calendar is very interesting with the EU Commission sentiment indicators and the second part of the German inflation data to be published.

Recently, we had 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.

Wednesday’s Fed communiqué was slightly less hawkish than the market had expected, but 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. The prospect that the ECB is more inclined to take bold interest rate action is a short-term positive for the single currency and at this stage apparently gives the euro the benefit of the doubt over the dollar. Technically, EUR/USD trading above the previous short-term highs in the 1.5655-area is a slightly positive in a dayto- day perspective and opens the way for a retest of the 1.5845 area. However, we don’t see many convincing fundamental arguments for EUR/USD to move aggressively higher over time. If the eco situation in Europe continues to deteriorate quickly (cf. today sentiment indicators), markets will start to question the adequacy/room for aggressive ECB interest rate hikes further out in time and if the ECB would stick to a tough anti-inflationary approach this for sure will be seen as killing European growth. So, 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 Thursday, the turmoil in the financial sector, the rebound in oil prices and uncertainty on the health of the US (and world) economy kept also kept USD/JPY under pressure. One can consider this as the yen again taking up some kind of safe haven function on global risk aversion and the correction in EUR/JPY later in the session supports this view. However, the safe haven attraction of the yen is not as convincing as was the case during the period of financial stress in the first quarter. USD/JPY closed the session at 106.82, compared to 107.81 on Wednesday.

This morning there was a heavy load of Japanese eco data. Labour market data were close to expectations; inflation (both in the June Tokyo data and the May national data) showed quite marked rise, but this was not really a surprise for markets. Also the Japanese and Asian stock markets recorded quite some losses this morning, but compared to what happened yesterday in the US and in Europe, the damage is not excessive. This slowed the decline in USD/JPY and the pair trades again above the 107 mark at the moment of writing.

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 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, however, until yesterday, the ‘correction’ developed at a very slow/guarded pace.

Recently, we turned neutral on USD/JPY. We put forward, the MTMA as a first point of reference to asses the short-term sentiment in this pair and this level (today at 107.67) was clearly broken yesterday, pointing to a loss of the ST momentum. As indicated several times before, we still consider the losses in this pair as well contained considering the negative global environment. However, after yesterdays break lower, the pair needs a cooling in global market stress and/or a stabilisation/decline in the oil price to resume the gradual uptrend of late. Those conditions clearly are not fulfilled. So, we continue to adapt a wait-and-see approach looking for signs of such an improvement in the market context to gradually buy back into this pair.

On Thursday, the sterling gained some ground in the first place against the dollar but to a lesser extent also against the single currency. However, the latter only is a retracement of the EUR/GBP rebound Wednesday evening after the Fed interest rate decision. So, in this respect one shouldn’t give too much weight to the early correction in EUR/GBP. Later in the session the appearance of the BOE policy makers before a parliamentary committee yielded a lot of headlines on the screens. However, the message from King and Co was more or less the same as given in the letter to the Chancellor of the Exchequer last week. UK inflation is high and might rise to 4%, but as the source of this inflation is mostly external, this shouldn’t be the signal for an aggressive rate hike campaign. So, the impact on EUR/GBP trading was gain very limited. So, after recording some early losses EUR/GBP throughout the session settled in a tight trading range in the 0.7930/10 area. The pair closed the session at 0.7922 compared to 0.7931 on Wednesday.

Today, UK calendar contains the final Q1 GDP release and the current account data. They might have a limited intraday impact on trading.

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, EUR/GBP maintained most of the post Fed gains, but still didn’t really challenge the 0.7955 resistance. So, at least for now, the stalemate continues. 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 support.

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Published on  Fri, Jun 27 2008, 07:22 GMT