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Sunrise Market Commentary

European bonds rally higher on Trichet's comments

Fri, Jul 4 2008, 07:56 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Thursday, European bonds rallied higher on the back of the ECB press conference. The ECB as expected raised rates by 25 bps to 4.25%, but markets reacted relieved to the ECB press conference, as Trichet sounded less hawkish than expected. Trichet said that following the rate decision ‘the monetary policy stance will contribute to achieving our objective of price stability’ and added that the ECB has currently ‘no bias’. These comments dampened fears of further rate hikes to come and sent short-term yields sharply lower. As a result, there was a sharp steepening of the European yield curve. In the US, Treasuries traded narrowly mixed with the short end outperforming the longer end of the curve. Treasuries mirrored the movements in the equity markets, which gained on the back of the Payrolls report that came out in line with the expectations, but stronger than feared after the very weak ADP report. Bonds and equities however reversed course on the back of the larger than expected fall in the ISM non-manufacturing, but the moves did not last long and both bonds and equities settled within narrow ranges ahead of today’s National Holiday.

European bonds rally higher on Trichet’s comments

Today, the euro zone calendar is very thin and only contains the German factory orders and a few ECB speakers. In the US, markets are closed in observance of Independence Day. As such, the European bond market may continue to digest yesterday’s ECB rate decision and press conference.

At yesterday’s July policy meeting, the ECB as expected raised rates by 25 bps to 4.25%, but during the press conference Trichet was keen to avoid any signal of further rate increases to come, but nevertheless left all options open as he said that the ECB ‘has no future bias’. So, we can be fairly sure that the ECB doesn’t envisage a rate rise in August, but beyond that, a further rate hike is still possible. In this context, it’s noteworthy that Trichet did not repeat previous comments that ‘the ECB is not signalling a sequence of rate hikes’. This suggests that yesterday’s press conference was very much a case of attempting to calm markets by avoiding any threatening comments, but being careful to avoid any definitive promise not to raise rates further. Today, ECB’s Liebscher and Gonzalez-Paramo will speak.

In coming months, persistent inflation worries may make markets fear more aggressive ECB action. We still think there is a strong possibility of a further ECB rate rise in September or October. This threat will keep yields under upward pressure over the Summer, although there could still be some follow-through action today on yesterday’s rally higher. Further out, a sharp economic downswing may force the ECB to reverse course and cut rates significantly during 2009, but that now appears a too distant prospect to drive the market.

From a technical point of view, yesterday’s rally didn’t improve the technical picture as both the Schatz and the Bund are still within recent ranges. Therefore, a sustained break above the recent highs at respectively 102.705 and 111.54 is needed.

In the UK, the Gilt market tracked the European bond market higher. Today, the UK calendar is empty.

Currencies: EUR/USD reverts inside trading range: Fears of dollar sell-off don’t manifest themselves

On Thursday, EUR/USD couldn’t confirm the break higher it made on Wednesday and returned inside its sideways trading range of 1.5286 to 1.5842. While the ECB did raise rates, as expected, president Trichet wasn’t as hawkish as many expected. Indeed, he was keen to avoid any signal of further rate increases. Secondly, the US payrolls were weak, but not much weaker than expected and certainly not weaker than the whisper number. EUR/USD broke above a key resistance level (1.5842) on Wednesday in anticipation of these events and as expectations were not matched, it was no surprise the euro was sold and the pair slid again in the existing trading range.

Today, trading will be quiet as the US markets are closed and only the German factory orders figure on the agenda. Therefore range-bound trading is likely.

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, but yesterday Trichet gave at least the impression that also he will be cautious in modeling its monetary response to the inflation threat. Technically, EUR/USD trading above the previous short-term highs in the 1.5655-area and is a euro positive, but the inability to hold above 1.5840 diminish the chances on a near term test of the 1.6020 all-time high. 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 antiinflationary approach, it might push the economy over the cliff, killing growth and laying the groundwork for a euro decline.

On Tuesday, USD/JPY moved higher and closed at 106.74 versus Wednesday’s close at 105.91. We wouldn’t look for too many explanations. We suspect that the overall dollar gains were the driver, as the payrolls report was not as weak as feared. The dollar gains against the yen were more limited though, as the ECB-factor was common for dollar and yen. Intra-day, the movements of equities were also reflected in USD/JPY movements. Overnight, the pair moves sideways close to Thursday’s closing levels. The leading indicators came out somewhat weaker than expected, but this isn’t a driver. Equities show only insignificant losses, leaving investors with little incentives to enter the market either way, especially not with the US markets closed.

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 (107.03 today) or even better above the 108.58 high is needed to become again more optimistic on the dollar.

EUR/GBP returned into its very narrow trading range it had left the day before on very weak UK data.

Intra-day, EUR/GBP started the session on a strong footing, as some follow through buying occurred following Tuesday’s very weak UK data. The up-move was prolonged after the UK Services PMI printed very weak, again emphasizing the precarious situation of the UK economy. However the rally ran out of steam rapidly at around 0.80 and turned in the afternoon, as Trichet while raising rates eased concerns about a series of rates by avoiding signals of further rate increases. The euro was sold and EUR/GBP followed the direction of EUR/USD down. The dollar outperformed sterling though.

Today, only the German factory orders are on the calendar. Following five straight months of declines, a rebound shouldn’t surprise and the rebound might even surprise on the upside of consensus (0.8% M/M). However, it shouldn’t be a major driver. The market may still chew on yesterday’s events, but by and large we expect range-trading within the narrow existing range that was temporarily left on Wednesday.

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 the failure to stay above the 0.7955 resistance is a short term disappointment for the euro. Wednesday’s move opened the way to the 0.8033/34 reaction highs, but this prospect has at least been delayed by yesterday’s performance of the euro. The 0.7766 is the key range bottom that should provide strong support.

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Published on  Fri, Jul 4 2008, 08:16 GMT

Archive

• US Treasuries profit from plunging equities
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  Published On Thu, Sep 4 2008, 07:12 GMT
• US Treasuries rally higher, as equities cannot hold on to their early gains
  Published On Wed, Sep 3 2008, 07:10 GMT
• US Treasury trading resumes
  Published On Tue, Sep 2 2008, 07:09 GMT
• Inflation decline supports short end European yield curve
  Published On Mon, Sep 1 2008, 07:16 GMT

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