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Sunrise Market Commentary

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Sentiment in US Treasury market remains bullish

Thu, Aug 28 2008, 07:17 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Wednesday, EMU bonds tanked after ECB’s Weber had poured cold water on expectations that the ECB next move would be a rate cut due to sharply slowing growth. As a consequence the curve bear flattened with yields up 10 to 3 basis points. Following Weber’s comments, the market largely ignore the below expectation outcome of German CPI.

US Treasuries on the contrary recouped the early losses and finished the day moderately higher. Treasuries declined first on falling EMU bonds and strongerthan- expected durable orders, but the tide turned later in the session and Treasuries closed higher, the curve steeper with yields down between 5 and 1 basis point. This occurred despite a weaker 2-year Note auction. Jitters and rumours about the GSE’s appeared late in the session, while month-end extension buying might have been a factor too behind the rally, as was the inability of the weak 2-year Note auction to drag the market down.

Sentiment in US Treasury market remains bullish

Today, the market calendar contains the preliminary Q2 GDP report and the weekly initial and continuing claims. According to the advance report, Q2 GDP grew by 1.9%, compared to the consensus estimate of 2.3%. Consumption growth was weak (1.5%), but is expected to be upwardly revised to 1.6%. The advantages from the weaker US dollar became visible as net exports made a positive contribution of 66.8 billion $, which will even be substantially revised higher in the preliminary report. The headline Q2 GDP is expected to be upwardly revised to 2.7% (from 1.9%). Last week, both initial (432K from 445K) and continuing (3362K from 3379K) claims came out lower than expected after reaching 5-year highs earlier this month. This week, the consensus is looking for a slight decline in initial claims (425K from 432K), while continuing claims are expected to come out modestly higher (3390K after 3362K). We aren’t quite sure that the current reading of claims are very reliable, as changes to the system (extension duration) might have distorted the figures.

The 2-year Treasury Note auction did not go well yesterday. The auction stopped well above the bid in the WI trading at the moment of the stop and the bid/cover was light, even taken the size into account. The Indirect bidders showed up, but the Indirect bid was nevertheless off levels seen in recent months. The results of the auction raise concerns about the fate of today’s 5-year Note auction. The 22 billion $ (+1 billion $ compared to July’s auction) size will raise all new cash upon settlement next Tuesday. Last month’s auction went well even as the auction stopped marginally above the WI bid, but bid/cover was strong and the Indirect bidding aggressive. While the results of the 2-year Note aren’t a notoriously good pointer for the outcome of the 5-year, it is an element. Just as for the 2-year, 5-year yields (3.03% versus about 3.55% at the July meeting) are well below levels seen at the previous auction, but its longer duration might be a plus this time, as the Lehman Treasury index shows a very large extension (0.21 years) in August, the largest in many years, which might incite index-trackers to adjust their portfolios. From a technical point of view, the 5- year yield is testing the key resistance at around 3%. So overall, the 5-year Note auction is a wildcard that should weigh on the market at least ahead of the auction.

Yesterday, Treasuries performed well. Just like on Tuesday, early losses (due to losses in the Bund, strong durable orders) were easily recouped later in the session on not so strong drivers. There were rumours on the GSE’s, but their shares did well. The 2-year Note auction went poorly, but had no impact. Month-end extension buying might have been a better motive to explain the positive price action, as the relevant Lehman index shows a 0.21 years extension, the longest extensive for years. However, it was the short end of the curve that outperformed. Whatever the specific reason for yesterday’s price action, at the end of the day, we have to conclude that sentiment remains positive.

For today, an upside revision in GDP is expected, but even then, at 2.7% (consensus), it might have some impact on traders/investors attitude, especially as yields have declined sharply in recent weeks and important resistances are looming. The initial claims is a wildcard and while it is currently difficult to interpret, it might have some impact on trading, especially if it should confirm current sentiment (surprise on upside). The longer end could continue to profit from month-end extension buying. However, we still suspect that the key resistances immediately ahead (2.20%, 2.97/3% and 3.76% for the 2-, 5- and 10-year) may play their role and prevent more noticeable gains today and maybe in the next few days, but we admit that recent bullish price action does not support our view. So, short term, we go for some correction up in yields. In any case, we suspect that price action after Monday’s market holiday, that officially concludes the summer holiday season, will set the trend. Next week, the key August statistics like ISM and payrolls will be published.

Re-iterating our strategy, playing it from the long side, existing longs could keep their positions or take partial profit as key resistance (yields) loom. New longs might wait for a better entry point (after correction). Long term investors should contemplate however whether lower yields still give value, something on which we have our doubts. For momentum players, a break lower in yields might still offer an opportunity to jump the bandwagon.

European bonds plunge on Weber’s comments

Today, the eco calendar is very well packed with the euro zone M3 money supply and credit growth data (July), the retail PMI (Aug), the German labour market data (Aug) as well as the Belgian and Spanish inflation data (Aug).

M3 money supply growth slowed over the previous months, but was nevertheless still at elevated levels of 9.5% Y/Y in June. Regarding credit growth, growth in household lending and lending to non-financials slowed too, although the latter is still very strong. It will now be interesting to see whether lending to non-financials is slowing further in response to the deteriorating growth outlook and the tightening of credit standards. According to the ECB bank lending survey, a further slowing can be expected over the coming months. A further slowing would add to concerns that economic growth is slowing quite sharply, but it probably will still take some time before it eases ECB concerns about medium-term inflation risks, as money and credit growth have been so strong for so long.

Among the other data, the euro zone retail PMI have been very volatile over the past months, but the overall trend has been downwardly oriented, which is in line with other business surveys. The recent decline in oil prices may however support the outcome in August. The German labour market on the other hand is expected to weaken further. Labour market data are a typical lagging indicator and given the recent sharp deterioration in the economic outlook a further decline in employment growth and a smaller decline in unemployment can be expected.

Yesterday, the German inflation data fell more than expected, which provides some hope that inflation has peaked in the euro zone in July. Today, the Belgian and Spanish CPI data will be released. A decline would raise the odds that the euro zone flash CPI will fall back below the 4% level on Friday.

Although recent inflation developments have been favourable, yesterday’s comments of ECB’s Weber indicate that the ECB is not yet comfortable with the inflation outlook and still doubts whether the growth slowdown will be sufficient to bring inflation down. Indeed, Weber warned that it’s not yet sure that inflation on average will be below 2% even in 2010 and suggested that the ECB could still raise rates further if the economic outlook brightens again. In the short-term, he called rates ‘roughly adequate’ suggesting no change should be expected over the coming months. This was also the message of ECB’s Bonello who said that current market expectations for a no change are in tune with the ECB’s thinking. ECB’s Bini- Smaghi on the other hand warned that a rate cut would lead to an increase in inflation. Today, ECB’s Bini-Smaghi will speak again.

On the supply front, Italy will tap the market. Italy will issue a new 3-year BTP 4.25% Sep11 for (4 B) and will tap its 10-year benchmark 4.50% Aug (2.5 B) as well as its 7-year CCT Sep15 (2 B). Yesterday’s demand for the Italian linkers was rather weak and this may be also the case today, as the net cash flow is highly negative this week and credit spreads are still widening. Indeed, over the past month, intra-EMU government bond spreads have widened again. Spreads between German and Italian and Greek yields are again approaching the cycle highs set in March this year and for now the recent spread widening hasn’t yet improved demand, as was indicated by the weak Greek 10-year bond auction earlier this week.

Regarding trading, ECB’s Weber comments provided a wake-up call to the European bond market, which had been rallying higher over the previous month on the deteriorating growth outlook and the drop in oil prices. His comments may cap the upside for now and even risk putting a short-term double top formation on the screens if the Bund, Bobl and Schatz would fall below respectively 113.50, 107.90 and 103.08. In a longer-term perspective, we hold on to our bullish view on the European bond market, but prefer a buy-on-dips approach following the recent rally higher and the hawkish comments from the ECB. Therefore, we look towards the necklines of the major double bottom formations in the Bund, Bobl and Schatz at respectively 112.88, 107.31 and 102.95. In the US, yields are still close to important resistance levels and a clear break lower, not our favourite scenario, would still improve the outlook for the European bond market too.

In the UK, the Nationwide house price index added to the gloom and doom in the housing market, as prices plunged 1.9% M/M and 10.5% Y/Y in August. Today’s CBI distributive trades report should give some indication to what extent the weakness in the housing market is affecting consumption growth.

Currencies: FX: EUR/USD extends rebound

On Wednesday, EUR/USD extended the correction that started after setting a new low on the back of the poor IFO release on Wednesday. We see the move in the first place as a technical correction on the steep dollar rebound from the previous weeks. However, there were some good excuses for traders to cash some gains on EUR/USD shorts. Despite a decline in German (regional) CPI data, ECB’s Weber in a Bloomberg interview maintained a very hawkish tone as he indicated that speculation on ECB rates cuts is premature. He even suggested rates might be raised further in case the economy recovers at the end of this year. This kind of remarks caused investors to scale back the hope for an ECB rate cut and helped the euro to regain ground. Last but not least, the higher oil price was also a good excuse to reduce dollar shorts. Regarding the US eco data, the durable orders came again out better than expected but, more or less in line with the market reaction of late, US data were not really a strong driver for the EUR/USD price action and the cross rate still closed the day with decent gains at 1.4727 compared to 1.4653 on Wednesday.

Overnight, the EUR/USD rebound was extended. A Japanese news paper report that the US, Europe and Japan put in place a plan to support the dollar by coordinated currency interventions mid March (at the time of the Bearn Stearns crisis) had no immediate impact on USD trading.

Today, markets look out for the German labour data and the EMU money supply data. In the US the first revision of the Q2 GDP and the claims are scheduled for release. A further deceleration of Money supply growth could be a factor in the global ECB assessment, but usually this figure is not a mover for currency trading. Also the (probably upwardly revised) Q2 US GDP figure will be in of the financial headlines today, but as mentioned earlier, US data recently only had a limited impact on trading. The swings in the oil price will continue to have an important say on the fate of the dollar short-term, with markets pondering whether storm Gustav will move towards the US oil fields in the Golf of Mexico.

Over the previous weeks, the decline in the oil price and growing signs of deterioration in the European economy were the major drivers for the decline in EUR/USD. However, over the previous sessions, the decline in the oil price petered out, blocking one, if not the most important, engine of the dollar rebound/euro decline. European eco data will probably remain weak, but part of this is probably priced in after the recent euro decline. On top of that the ECB still gives no sign at all that this slowdown will trigger a rate cut any time soon. Within this framework, some profit taking on the recent EUR/USD decline should not come as a bit surprise. In a longer term perspective, we hold on to our view that the cycle lows in the dollar are behind us.

Looking at the charts, the break below the previous range bottom at EUR/USD was an outright positive signal for the US currency against the euro with the pair setting a short-term low in the 1.4630 area last week. A technical rebound was blocked in the 1.4900 at the end of last week and the pair even set a new minor low in the 1.4570 area after the IFO release, but the move could not be sustained. Next high profile support levels are seen in the 1.4530 area (target multiple top formation) and in the 1.4310 area (December lows). The picture for EUR/USD remains negative as long as the pair holds below the 1.4908 reaction high. We stay cautiously USD positive medium term but indicated that we were not in a hurry to aggressively buy the dollar at the current levels. We look for return action towards that 1.49 area before stepping in/adding to EUR/USD short positions.

Yesterday, USD/JPY first joined the global dollar correction and tested bids below 109 at the start of the Europe trading session. However, the strong US durable orders release had more impact on USD/JPY trading compared to USD/EUR and even helped the pair to close the session almost unchanged at 109.50 (compared to 109.60 on Tuesday). However, the overall ST dollar headwinds also weigh on this pair with USD/JPY sliding the 109 area in Asian trading this morning.

This morning, there were only some second tier Japanese data. BOJ’s Suda repeated to favour an early rate hike once downside risks diminish. However, for now this minority view is not really an item yet for Japanese markets.

Looking at the technical charts, USD/JPY staged a gradual rebound from the mid- July reaction low to set a new reaction high at 110.68 on August 15. Since then, the pair entered a ST term sideways trading pattern between 108.14 and 110.68. For now, the USD/JPY uptrend is not really questioned yet, but the momentum is slowing. MT we remain cautiously positive USD/JPY long-term but we with upmove losing some of its vigour, we first want the see how the 108.15 support area fares before adding to USD/JPY long positions. A break below this level would signal that the correction has to go somewhat further. (Stop loss for short-term players).

On Wednesday, EUR/GBP showed a remarkable upswing. There were no important eco data on the UK eco calendar. However, the global euro rebound and negative news headlines form the homebuilding sector again undermined the confidence in the UK economy and the sterling. In a late session rise, EUR/GBP regained the 0.80 barrier and close the day at 0.8022, compared to 0.7965 on Tuesday.

This morning, the concerns on the housing sector were reinforced as the Nation wide house prices again came out weaker than expected at -1.9% M/M and -10.5 Y/Y. This caused EUR/GBP to test the key 0.8051 resistance (last barrier before the lifetime high of 0.8098) at the moment of writing. Later today, the CBI distributive trades report is scheduled for release. A negative report could be a good excuse to revisit the range top in the 0.8100 area.

We are a bit surprised by the sharp losses of the sterling against the euro of the previous days. The eco news from the UK is far from good, but over the previous weeks, it looked as if markets made some kind of reappraisal of the deterioration in the eco situation in the euro-zone. This was partially mirrored in the EUR/USD price action, but not in EUR/GBP. Yesterday’s hawkish ECB rhetoric might have fuelled market speculation that the BOE might cut interest rates before the ECB.

Recently, we advocated range trading for EUR/GBP within well-established sideways range. For now we hold on to that tactics, but are aware that the risks of a break higher are growing. It is not our preferred scenario, but a sustained break of the 0.8100 barrier would be very important from a technical point of view.

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Published on  Thu, Aug 28 2008, 08:29 GMT