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Sunrise Market Commentary

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Financial concerns about Freddie & Fannie hit Treasuries, equities and dollar

Mon, Jul 14 2008, 07:48 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Friday, US Treasuries had an ugly session, but so had global equities and the dollar. It doesn’t happen quite often that all three markets at the same time go the same direction. Concerns about the financial stability of Fannie Mae and Freddie Mac was the dominating trading theme, but also soaring oil prices on fears that Israeli air forces were practising for an attack on Iran and Treasury-unfriendly eco data were playing a role in the Treasury market. The European bonds weren’t immune for the price action in the US market either, but limited their losses.

Concerns about the financial stability of Freddie and Fannie might have been considered Treasury-friendly as it could have stimulated a flight-to-quality bid and pushed equities lower. However, in this particular case the remedy, a government bail out, means also a potential surge in the supply of Treasuries, an obvious negative for Treasuries (and for equities and dollar). As a consequence, swap did less bad and swap spreads narrowed quite sharply by 7 and 5 basis points for the 2- and 5-year maturities respectively. To a certain degree, the market might also have argued that a government bail-out would mean monetary policy was less burdened by the fears for systemic risks.

Intra-day, the Bund opened lower on the reversal of safe haven inflows and slid somewhat further. The NY Times ran an article suggesting that government officials are considering a plan to take Freddie Mac and Fannie Mae over in case their problems worsen, but the article said the officials see no imminent need to do so. The market however recouped these losses further out in the European morning session and in early US session, as oil prices started to rise on the rumours about the preparations of an Israeli attack on Iran and equities plunged. However, Treasuries reversed course and started to dive. A smaller trade deficit and higher import prices were a negative, but concerns on Freddie and Fannie re-surfaced. Treasury Secretary Paulson tried to calm markets, but his comments on the issue weren’t straightforward enough. So after a brief pause Treasuries and equities continued to tumble. Later on, Senate banking committee chairman Dodd said both companies were fundamentally strong and had options for accessing capital, while unnamed sources reported that Bernanke would allow both companies to use the Fed’s discount window, something which was effectively decided on Sunday (see headline for latest developments). Equities jumped higher, before giving partially their gain back, while Treasuries didn’t react much and closed with steep losses. We suspect that repositioning away from long positions ahead of the week-end played a role too.

Financial concerns about Freddie & Fannie hit Treasuries, equities and dollar

The market calendar is very busy and interesting this week. It contains key eco releases on the manufacturing, retail and housing sector, besides the newest inflation data (for June). Besides these, the Q2 earnings season gets into full swing and Fed chairman Bernanke holds his semi-annual testimony to Congress. The NY Fed will hold its 28 day TAF auction today and given recent developments at Freddie & Fannie, we keep a close eye of Freddie’s bill auction that takes place today. All other releases and events will take place in the Tuesday to Thursday time frame.

Regarding the eco data, we will preview them in more detail during the week. Summarizing, the market will get new info about the manufacturing sector via the July NY and Philly Fed surveys (Tuesday/Thursday) and the June industrial production data (Wednesday). The market expects the surveys to show a contraction in activity, but at a slightly slower pace than in June. Friday’s release of the trade balance showed that at least until May, exports were doing well and this is maybe the reason why the surveys are, while without any doubt weak, not showing the extreme low readings typically seen in recessions. From the housing sector, the July NAHB survey (homebuilders’ sentiment) (Wednesday) and the June housing starts (Thursday) are expected to show ongoing weakness in activity. However, the key release of the week will be the June retail sales. Sales already jumped in May on the spending of the tax rebate checks. As these were also distributed in June, consumers may have opened their wallets for the second consecutive month. The market consensus (0.3% M/M for headline and 0.9% M/M for sales excluding cars) hesitates a little bit on the extent to which households spend their money in June (very wide range of forecasts). So there may be an (upward?) surprise for the second month in a row. If it occurs, Q2 GDP should show some unexpected stronger growth, as also net exports seem to have contributed strongly to growth. Inflation is an important item currently, especially because of the impact of high commodity, especially oil, prices and the weak dollar. June PPI (Tuesday) and CPI (Wednesday) will both reflect the further rise in energy prices. So both, the headline PPI (expected 8.7% Y/Y) and headline CPI (expected 4.4%) will set respectively multi-decade and multi-year highs, keeping inflation concerns high, despite the bleak growth outlook. The core measures behaved better recently, as slow eco growth exercises some downward pressures. However, core PPI will be higher too (expected 3.2% Y/Y), while core CPI should have stabilized (2.3% Y/Y). Interestingly, core CPI has shown no downtrend until now despite weak domestic growth. So, the June inflation data won’t bring much relief for Fed and markets.

Chairman Bernanke’s semi-annual testimony for Congress (Wednesday) is always a key event and this won’t be different this time around. The markets expect some forward guidance from him on policy. At the June FOMC meeting, the Fed suggested that the easing cycle was over. “Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased.” Governor Fisher dissented in favour of an immediate tightening. The FOMC didn’t point to a predominant risk in its statement. We concluded after the FOMC meeting “that the Fed has a neutral bias, but we admit that at the margin they seem to take the inflation risk as being slightly more important than the growth risk.” It seems that the statement upping inflation risks was the compromise to get a number of hawkish regional governors on board. Since, a number of regional governors suggested that the next move would be higher rates, but the timing of that was still open to discussion and the board governors didn’t spoke out on it, keeping their options open. The written testimony of Bernanke is in fact prepared inside the FOMC and thus a compromise text. We see little reasons why Bernanke would say many different things than in the June FOMC statement. Activity data have been mixed, but unless retail sales disappoint, Q2 GDP growth will surprise on the upside. Of course, the Fed knows that downside risks still exist, but based on the current data it seems that these risks have indeed diminished. Also for inflation, it seems that the upward risks have been confirmed since. Oil prices rose further and this will push headline inflation up in at least June (release on Wednesday) and July. The Michigan (consumer) 1-year inflation expectation has risen to a new multi-decade high in early July. So also here, there are little reasons to change tack. If Bernanke would signal clearly that the next step will be higher rates it would be big news. However, two developments will make the task of Bernanke extremely difficult on Wednesday. Firstly, the dollar is on the verge of falling to new lows against the euro, a development the Fed wants to prevent at any price, as it risks pushing oil prices still higher, an adverse factor for both inflation and growth. The chairman very unusual said early June that a fall of the dollar was highly unwelcome. If Bernanke is too dovish, the dollar may tumble. Suggesting that the next step in rates will be up might give the dollar support. However, on the other hand, the credit crisis has entered a new phase with heightened concerns about the financial stability of Freddie Mac and Fannie Mae. It is almost inconceivable that these institutions would become insolvent as it would have disastrous effects on the housing market and the economy. The government might need to bail them out and the decisions taken on Sunday point in that direction, but it remains obvious that this situation involves a systemic risk and the possibility of uncontrollable markets. Therefore, Bernanke should not sound too hawkish either, but he might supplement moderately hawkish talk on monetary policy with the promise that the Fed will be very generous with its liquidity policy towards the financial sector. Allowing Freddie and Fannie over the weekend to use its discount window is already such a step. It is obvious that the chairman will have to be very cautious in his remarks. Please note that after his testimony, there is a Q&A session in which he might speak more for himself than for the FOMC. Expect the Congressmen to grill him about Freddie and Fannie.

During last trading week, Treasuries continued to rally on financial market turmoil, at least until Friday when a severe correction took place, as markets feared that the government might need to bail out Freddie Mac and Fannie Mae. Extra supply of Treasuries and a monetary policy that was freed to take this situation into account were the drivers behind this steep correction. As a result of Friday’s correction, in a weekly perspective 2-year yields were up 7 basis points, 5-year yields were unchanged, while 10-year yields fell 2 basis points. Whereas the technical pictures had improved in the previous days, the correction puts that again into question. Swap spreads narrowed across the curve, especially on Friday, while corporate spreads widened. Regarding FF expectations, for the August meeting, only a marginal chance on a rate hike is discounted, while for the September meeting less than 40% is expected; one 25 basis point increase is discounted towards the end of the year and two more 25 basis points are priced in for H1 of 2009.

Friday’s market reaction on the financial concerns about Freddie and Fannie makes it clear that the situation is very serious and tricky. The safe haven motive didn’t play in favour of Treasuries. Firstly, there is the prospect of an expensive taxpayer funded rescue package that raises the supply of Treasuries. Secondly, the Agency market is to a large extent driven by foreign (official) creditors and a loss of fate in the dollar might unnerve these investors and trigger a confidence crisis in the dollar. That may push US yields up across the board. Overnight, US authorities took measures to calm markets. Later today, Freddie will hold its regular 3 Bn. $ bill auction. We don’t expect problems as it seems the Treasury has looked for support from Wall Street to make the debt sale a success. The dollar strengthens modestly overnight, a signal that indeed the measures might calm the markets, just like the Bear Stearns rescue in mid- March did. So, it might be greeted by some kind of a relief rally later on Wall Street. However, we wouldn’t front-run a happy end of this latest episode of the credit crisis that now reached the centre of the system. Indeed, even if the dollar doesn’t crash and equities stage a relief rally, that wouldn’t necessarily be good news for Treasuries.

European bonds cannot escape sell-off in US Treasuries

Today, the euro zone data calendar is rather thin and only contains the industrial production data. Based on the national data released last week, a sharp monthly decline can be expected, which would underscore the rapid deterioration of the growth outlook in the industrial sector. But while it is clear that the euro zone economy is slowing down quite sharply, the ECB is still concerned about the inflation outlook. The ECB still fears that the current elevated inflation levels will push up longer-term inflation expectations above levels consistent with price stability. Friday’s new high in the oil price isn’t a good signal in this context given the close relationship between oil prices and euro zone financial inflation expectations. In the euro zone, the surge in the euro however prevented the oil price from setting new highs in euro terms. As such, financial break even inflation rates rebounded from 2.60% to 2.70%, but are still away from the highs at 2.80%.

On the supply front, Italy will tap its 5- and 15-year BTPs for a total amount of EUR 4.5 B. This week, the net cash flow will be highly positive, but whether this will be sufficient to improve demand remains to be seen. Over the past weeks, demand for government bonds has remained rather weak, especially for German bonds, despite the rise in yields.

Regarding trading, European bonds fell lower too on Friday on the back of the sell-off on the US Treasury market, as government bonds couldn’t benefit from the problems in the US financial sector. Hence, the European bond market failed to build out the gains following last week’s technical break higher above the necklines of the double bottom formations in the Bund, Bobl and Schatz. In the latter two, we are back below these necklines, in the Bund the neckline comes in at 111.54. This illustrates that sentiment on the European bond market is still very fragile. The problems in the US may also push the euro new all-time highs against the dollar, but whether this will support the European bond market much is very uncertain, as the weakness in the dollar will also drive the oil price to new record highs and increase the inflation risks in the short-term.

In the UK, the PPI are expected to rise at their fastest pace since the 70s, as the weakening of sterling intensifies the rise in imported commodity prices. Over the weekend, BoE’s Barker however warned that keeping monetary policy too tight could weaken the economy more than is necessary to get inflation back to target. Her comments suggest that the Bank isn’t eager to hike rates in response to higher inflation data at a time the economy is slowing sharply.

Currencies: Dollar feels the heat

On Friday, markets were again in crisis and this time the currency markets didn’t escape. The ongoing flow of negative credit headlines (Freddie Mac and Fannie Mae and IndyMac) also hit the US currency. EUR/USD that already cleared a series of important resistance levels on Thursday held stable in the 1.58 area during the morning session in Europe, but as soon as US traders got involved and as the negative news headlines/rumours multiplied, the dollar was sold aggressively. The steep rise in oil prices only aggravated the situation. This factor subsided somewhat later in the session, but as credit woes persisted, there was no respite for the dollar and the US currency closed the week at 1.5937, compared to 1.5788 on Thursday. The measures taken by the Fed and the Treasury in the weekend to address the problems at Freddie Mac and Fanny Mae take some of the heat from the dollar. However, with EUR/USD trading in the 1.59 area, the all-time highs are still within striking distance.

Today, the US eco calendar is empty while in Europe only the May production data are on the agenda. However, all eyes in the market for sure will be on the developments in the US credit markets and, to a lesser extent, on the oil price.

Already for some time, 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. We assumed that the eco picture in both regions was more or less similar as high inflation prevents both the Fed and the ECB to support their ailing economies and this joined inability to act was also mirrored in the EUR/USD price action. However, the latest episode in the credit crisis clearly puts the dollar under heavy pressure again. The problems at Freddie and Fannie pose a direct threat to the dollar as their debt is widespread owned amongst all kinds of major (foreign) investors (also central bankers) and a loss of confidence in the solvency of those institutions would lead to a major sell-off of their bonds and thus also of US dollars. In this respect, it will be interesting to see to whether the new measures will be able to ease the pressure in a sustainable way. The most recent developments are of course not really a strong argument for major surplus investors/countries to maintain a high/excessive USD weight in their long-term investment portfolios. The sharp rise in the interest rate rates of US Treasuries (market fears that the Treasury will need more funding to finance ‘the bail-out’/support of the US financial system) in this respect is not really comforting. So, in this context, we don’t see this rise in the US risk premium as a big help for the US currency, on the contrary.

Looking at the technical charts, the 1.6020 all-time high now is the key point of reference. A break above this level would suggest a further loss of confidence in the US currency and contain the risk of a (massive?) reposition of investments away from the US currency. Until now, this was not our preferred scenario, but with the new episode of the credit crisis such risks have clearly grown. For now, we hold on to our view that the macro fundamentals don’t call for break above 1.6020. On top of that, also for US authorities, the incentive to contain the (USD) damage, is rising. A global loss of confidence in the dollar only would make the situation more complicated. However, we wait for a cooling in the current tensions before buying/adding to USD long positions and would firmly advise to put stop-loss protection on the dollar in case of a break above the 1.6020 barrier.

At the end of last week, the tension on the credit markets and the spike higher in the oil price also hammered USD/JPY. The pair dropped from levels above 107.00 to test bids below 106.00 at the open of the US stock markets. However, later in the session, the pressure already eased (partially due the fact that the rise in oil prices was blocked, at least for now). USD/JPY closed the day at 106.27, compared to 107.08 on Thursday.

The dollar opened rather weak this morning in Asia, but at least for now, the measures from the Treasury seem to be able the limited the damage on global markets. The losses on the Asian stock markets are not that excessive and USD/JPY quite easily holds above the Friday lows.

Recently, we turned neutral on USD/JPY. The rejected test of the 108.58/62 area triggered a correction, but also this move found a bottom soon (correction in low the 104.99 area on June 30). The resurfacing of credit woes due the developments at Freddie Mac and Fannie Mae also left their traces on USD/JPY, but after all, given the gravity of the problems, the damage for USD/JPY should be still be considered as not excessive. Of course, the technical picture for USD/JPY shows some cracks, but as long as the pair holds above the 104.99 reaction low, the range trading hypothesis survives. Dollar optimists might see the fact that even the current turmoil isn’t able to push USD/JPY below a first technical important support level as a slightly ‘positive’ for the US currency. We look out whether the dollar can indeed hold up after the Fed measures. Courageous short-term players can try to play the established trading range in a buy-on-dips approach. However, stop-loss protection to defend a break of the 105 support area is highly warranted.

On Friday, there were no important UK eco data on the calendar, but the return of the credit crisis obviously is also no good news for the sterling. For most of the session the focus was on the dollar cross rates and EUR/GBP held a rather tight range in the high 0.79 area. However, another spike higher in the euro late in US trading also pushed EUR/GBP above the 0.8000 mark. The pair closed the session at 0.8013, compared to 0.7981 on Thursday. The pair still trades in that area this morning.

Since mid April, EUR/GBP developed a very uninspiring consolidation pattern (0.7766/0.8098). We turned neutral on EUR/GBP as the pair shows no trading momentum at all. An attempt to move higher early this month again ran into resistance soon. However, currently the pair comes again closer to the key 0.8033/34 area. The combination of rising tensions on the credit markets and an ongoing flow of negative news headlines for the UK economy and the UK housing market again seriously cloud the picture for the UK currency. The risk for a rest of the all-time highs in the 0.81 area are again rising and we would not be surprised on a break in case the global credit concerns persist.

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Published on  Mon, Jul 14 2008, 13:04 GMT