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Sunrise Market Commentary

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US Treasuries modestly higher on eve of key payrolls report

Thu, Jul 3 2008, 07:27 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Wednesday, the performance of European bonds and US Treasuries once again diverged, as the record high PPI and a disappointing German Bund auction added to the bearish sentiment on the European bond market ahead of today’s ECB meeting. In the US, the weaker than expected ADP employment report on the other hand sparked a repositioning rally ahead of today’s Payrolls report. A very weak closing of the US equities, with the Dow now in bear territory, however failed to push Treasuries above first key resistance levels. In a daily perspective, there was a bull steepening of the US yield curve, compared to a bear flattening of the European yield curve. As a result, the spread between German and US 10-year yields reached new cycle highs at around 70 bps.

US Treasuries modestly higher on eve of key payrolls report

Today, all attention will go to the June payrolls, the most comprehensive and timely report on the economy. In this context, the weekly initial claims and to a lesser extent also the Non-manufacturing ISM won’t get the usual attention. Trading will be a bit special as the session will be shortened ahead of the market holiday tomorrow and as the ECB will decide on rates and president Trichet will hold its press conference at the same time as the release of the Payrolls. There may be spill over effects in the US Treasury market.

The payrolls is expected to have declined by 55 000, following a drop of 49 000 in May. We put the risks on the downside of consensus though, as partial indicators pointed to a deterioration of labour market conditions in recent weeks. Indeed the initial and especially continuing claims are rising and consumers’ and producers’ opinions of the labour market conditions deteriorated to levels even not seen in the 2001 recession (for consumers at least). The ADP report showed a below consensus fall of jobs (79 000) that may be an indication that the payrolls might disappoint too, especially as the ADP in the past year has been consistently better than the payrolls. A drop of payrolls by 100 000 of more, the first triple digit drop in this cycle, would bring more gloom and doom. Of course, payrolls do surprise regularly.

Regarding trading, Treasuries eked out some moderate to good gains, steepening the curve in a bullish way. A European-induced drop in late European morning trading was reversed when the ADP report printed weak. Later on, oil prices jumped higher and equities dropped sharply and while it underpinned Treasuries to some extent, it didn’t push Treasuries further up though.

Regarding the payrolls report, a weak report, let’s say -100 000 or more, should be Treasury friendly, especially if the S&P drops further, confirming the bearish double top formation. It might steepen the curve somewhat further. However, there may be offsetting unexpected forces at work, the dollar and oil. If the dollar would weaken and threaten the lows (EUR/USD 1.6020, Trade weighed dollar (DXY) key support at 71.82, now at 72.10) giving the oil rally more fuel, it might as a paradox bring a Fed rate hike closer. It might stop the adverse feedback loop that pushes oil ever higher, raises concerns on inflation and affects disposable income, slowing consumer spending. However, we think that this alternative way of thinking is still not in the market’s mind. So, Treasuries should gain on a weak report. In case of a stronger figure, there is quite some room for a negative reaction on Treasuries, especially should the dollar rally and oil prices decline. Also the oversold equities may in that case stage a short covering rally.

ECB to hike rates today, but what will happen next?

Today, the calendar looks very interesting both in the euro zone and the US. In the euro zone, major attention will go out to the ECB monetary policy rate decision and press conference, as the ECB is expected to raise rates for the first time since June last year to 4.25%. And in the US, the ISM non-manufacturing and the Payrolls report will spice up trading. Regarding the US data, we refer to the US part of this report.

At its early June press conference, ECB’s Trichet surprised friend and foe by openly hinting at a 25 bps increase at their next meeting in July. With inflation remaining high for a more protracted period than previously thought, rising inflation expectations and tentative signs of second round effects in the labour market and the services sector, the ECB said it had moved to ‘a state of heightened alertness’.

Since the previous press conference, inflation has risen further and hit the 4% in June according this week’s flash CPI. At the same time, the eco data weakened further with both the manufacturing and services PMI (to be confirmed today) falling below the 50 mark, which suggests that economic activity is contracting in the euro zone. Although these low levels of business confidence historically corresponded with an easing policy of the ECB, they haven’t yet softened the ECB concerns on inflation this time.

During his testimony before EU parliament last week, 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. He went on saying that the ‘risk of triggering such an inflationary wage-price spiral is particularly acute, especially in countries where nominal wage indexation schemes exist’. These phrases will probably be repeated in the introductory statement on Thursday and emphasize the risk that one small rate hike in July won’t be sufficient to bring inflation back below the 2% level.

So although the statement may be quite hawkish, Trichet may during the Q&A try to ease current heightened tensions in the financial markets by reiterating that this is not the beginning of a series of interest rate hikes, like he did in December 2005 at the start of the tightening cycle. This may just like then lead to some short covering in ‘a buy the rumour, sell the fact’ movement today (if the Payrolls disappoint too of course). However in a longer-term perspective, as long as there is no clear sign available that inflation has peaked in the euro zone, the threat of higher rates will remain a clear and present danger. This threat will keep yields under upward pressure over the coming months.

In the UK, the services PMI are expected to fall to 49.5 in June from 49.8 in the previous month, but following the plunge in the manufacturing and construction PMI the risks are clearly on the downside. Besides, the Bank of England will also release its Q2 credit conditions survey. Yesterday, BoE’s Bean said that the impact of the tightening in term of availability of credit could prove greater than is embodied in the central projection and may lead inflation to undershoot the target in the medium term. In the near-term, energy prices however remain particularly uncertain and risk to dislodge inflation expectations. Overall, his comments suggest he isn’t eager to hike rates, as this would increase the chances of a recession. Overnight, the Incomes Data Services indicated that salary negotiators in the UK fail to clinch bigger pay increases than a year earlier in the three months through May, despite accelerating inflation. This may ease concerns in the UK for a wage-price spiral.

Currencies: Dollar under pressure, as EUR/USD moves above key resistance opening way to highs

On Wednesday, EUR/USD made an important step higher, as it broke above key resistance of 1.5840. The break needs confirmation today, as the ECB meeting and the US payrolls will set the sentiment for longer.

Already in early European trade, the pair tested the resistance and the 1.5850 option barrier before receding. It looked a more technical driven move as the pair receded to opening levels, but that changed in the US session, as a weak ADP employment report pushed EUR/USD sustainable higher to a 1.588 intra-day high and a 1.5852 close, up from 1.5792 Tuesday’s close. It happened of course against the background of the ECB meeting that will decide to raise rates today. Equity weakness was a minor supportive factor. While the pair broke above the resistance, the movement didn’t accelerate something one might have expected. This might be due to cautiousness on the part of traders who want to wait for today’s payrolls report and the ECB decision before drawing conclusion. It might also that official sources are active in the market to try to avoid a further slide of the dollar, given its impact on the oil price and inflation.

The dollar is at crossroads. Should the payrolls be weak and the ECB hawkish, the dollar may come under further downward pressure. On the ECB we expect the statement to be hawkish, but Trichet might use the teleconference to soften the message, eventually by repeating that it isn’t the start of a series of rate hikes. However, how credible is this in the current context? Investors will remember that he said the same when he raised rates in December 2005, even if circumstances are different now. A weak payrolls report might still heighten the degree of bearishness in the US equity market, even if we might be close to the capitulation trade that concludes this downleg. Given recent upped concern of G-8 policymakers on the dollar, we cannot exclude some talk/action should the greenback threatens get caught again in a downward spiral.

We have a neutral bias on EUR/USD and assume the pair to extend its sideways trading in the wide 1.6020 to 1.5285 range. Visibility on the economy remains low on both sides of the Atlantic and the Fed and the ECB have very little room of maneuver, as inflation mounts. The ECB is more inclined to take bold interest rate action, which is a short-term positive for the single currency. Technically, EUR/USD trading above the previous short-term highs in the 1.5655-area and now 1.5840/45 is a euro positive and if confirmed today may open the way for a retest of the 1.6020 all-time high. However, we don’t see many convincing fundamental arguments for EUR/USD to move aggressively higher over time and suspect some official interest to prevent more dollar weakness. If the eco situation in Europe continues to deteriorate quickly, 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, it might push the economy over the cliff, killing growth and laying the groundwork for a euro decline. Yesterday’s move above 1.5840 puts our ST strategy of a sell-it into the 1.5840 area under pressure. However, it is today that we get the final say on the subject. In this respect, we will re-examine the situation after today.

On Tuesday, USD/JPY ended very modestly lower at 105.91 from a previous close at 106.13 and the pair still hovers around these levels in range-bound overnight trading. Equities traded positively during the European session, pushing the USD/JPY modestly higher to 106.77, but the tide turned during the US session. The greenback came under pressure following a weak ADP report. Sliding equities later on didn’t help the yen extending its gains While equities play a somewhat smaller role in yen trading than some time ago, we think that it remains a positive factor. So, today’s reaction on the labour market report will also depend on how US equities react. For more details on the payrolls, see above.

Recently, we turned neutral on USD/JPY. The break of the medium term moving average last Thursday convinced us that the upside is blocked for now. 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, convincing us to adapt a wait-and-see approach. A re-break above the MTMA (107.06 today) or even better above the 108.58 high is needed to become again more optimistic on the dollar.

After days of boring range bound trading, EUR/GBP yesterday rallied higher, breaking about the top of the sideways range (around 0.7955) to close at 0.7969, the high of the day.

Another batch of weak UK eco data, falling mortgage equity withdrawals and a plunging construction PMI set the tone, but maybe more important was more corporate gloom and doom. M&S reported very weak sales with consequences for profits and Taylor Whimpy, the biggest homebuilders, in serious existential financial difficulties, saw its share price drop more than 50%. Late in the evening new BoE vice governor Bean saw inflation dropping below target as the result of economic weakness. The result of this horrible news flow was a declining Sterling.

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 and now even broke above the 0.7955 resistance. This opens the way to the 0.8033/34 reaction highs. The 0.7831 reaction low remains the first support area on the downside, while 0.7766 is the key range bottom. We continue to see this area as providing strong support.

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Published on  Thu, Jul 3 2008, 08:18 GMT