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Sunrise Market Commentary

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US Treasury curve flattens in bearish fashion

Fri, Aug 29 2008, 07:33 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Thursday, global bonds remained under pressure, but now without a noticeable difference between US and EMU as was the case on Wednesday. Stronger eco data in EMU (higher-than expected M3 and lower-than-expected unemployment) and in the US (Q2 GDP) played a role, as was a rally in equities, even if the timing of the major moves in Treasury and equity markets wasn’t always synchronized. As in previous sessions, the curve bear flattened. In the US, yields rose between 8 and 1 basis points, in EMU by 6.5 basis points to flat at the 10-year sector, while the 30-year yield even dropped almost 4 basis points.

Intra-day, the Bund gained slightly after the opening, but fell sharply back, especially at the short end following the release of the M3 money supply and the German labour market figures. The reaction was however more an ongoing result on the hawkish comments of ECB Weber on Wednesday than on the eco data itself, also suggested by the bear flattening of the curve. Indeed, M3 continued to slow as did lending, but the decline fell a bit short to expectations. The German labour market data were encouraging, without doubt, but are a bit lagging and the vacancies statistics still point to a deterioration of conditions. Later on the Bunds stabilized. In the US session, Treasuries were a bit lower when the GDP report was published. The initial reaction was hesitant, despite a spike higher in equities, but later on Treasuries did drop lower, rebounded briefly before re-testing the lows again going into the 5-year auction. The latter was rather weak, but apparently the signal to ignite a rally that was led by the longer end (month end extension buying) occurred despite equities continuing to grind higher.

US Treasury curve flattens in bearish fashion

The eco calendar is well-filled today with the July personal income and spending, the Chicago PMI (August) and the final figure of the U. of Michigan consumer sentiment for August. In July, retail sales weakened from 0.3% to -0.1% which could indicate that tax rebate checks are effectively spent. As a result, also consumption spending, that includes retail sales, is expected to come out weaker than the June figure (0.2% from 0.6%), which will suggest that households are dampening their spending. Personal income was holding up very well in the previous months mostly due to the tax rebate checks, but is expected to drop (-0.2%) in July. The Chicago PMI jumped last month unexpectedly above its benchmark level of 50 for the first time in six months. Production and new orders were higher, but employment worsened. For August, the index is expected to fall back to its benchmark level. However it is important to note that in the previous months, figures might have been distorted due to the Midwest floods still effecting logistics, but the correlation with the manufacturing ISM loosened already earlier. As the Chicago PMI remained stronger than most other regional surveys, we put the risks on the downside of expectations, but are well aware that the Chicago PMI often surprises analysts. The Michigan University will publish its final report on consumer sentiment. The preliminary report showed a slight increase in the headline figure from July, when a bigger jump was reported on the back of lower energy prices. The Conference Board measure of confidence did jump in August, but was barely changed in July, suggesting that the August figure was mirroring the July advance in the Michigan measure. Therefore, we are cautious to put the risks for the Michigan measure on the upside of consensus.

Following a weakfish 2-year Note auction on Wednesday, also the 5-year Note auction went rather poorly. The auction stopped at 3.129%, 1.5 basis points above the bid in the WI, the bid/cover was light at 2.14 versus 2.46 in the previous auction (average 2.31), even if we have to take the increase size of the auction into account. One bright spot was buy-side participation. Indirect bidders took away 29.8% of the auction. The 50 billion $ TSLF auction (schedule 2) continued to suggest an absence of funding pressures. All bids were accepted at the minimum bid of 25 basis points, with a bid/cover of 0.56.

Yesterday, Treasuries came under pressure due to an upward surprise in the Q2 GDP report and a strong run of equity that was at least also partly driven by turnaround of oil prices during the day. Later on, once more the fortunes of Treasuries turned for the better without any specific trigger other than month-end extension buying. The weaker 5-year Note auction once more couldn’t push further down, but was the sign for an intra-day rally from the lows. It suggests that indeed month end buying is an important feature especially in those late holiday thin trading.

For today, the eco data might come out a bit mixed for the market, even if all in all they aren’t the most important market drivers. The Chicago PMI and PCE might disappoint, but the Michigan consumer sentiment might surprise on the upside (even if we hesitate on that). However, more important may be that traders face a shortened session today ahead of the Labour Day holiday on Monday that officially closes the holiday season. So, many traders will be nervous to see what will be the new trends when trading returns to normal next week amid the release of the key August eco data, the Fed Beige Book and various Fed speeches, the last few speeches before the blackout period ahead of the Sep 16 FOMC meeting kicks in. So we expect some re-positioning to occur and as the market is long we should see some selling. To some extent, month end buying may be a counterforce, but we suspect that most funds should have finished extension buying. Given also the proximity of major resistance at the longer end of the curve, we favour the downside for Treasuries today. However, next week will be more interesting. The key resistances to look out for are 2.20%, 2.97/3% and 3.76% for the 2-, 5- and 10-year.

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.

ECB related follow-through selling hits short end

Today, the eco calendar is exciting with the CPI estimate and EU Commission confidence indicators for the month of August and the July unemployment rate.

Based on the lower than expected national inflation data out of Germany, Spain and Belgium, the euro zone headline inflation rate can be expected to fall back below 4.0% Y/Y in August. A decline would raise hopes that inflation has reached its peak in the euro zone on the back of the fall in oil prices. At the same time, fears for second round effects from past commodity price increases should ease over time, as the growth outlook has deteriorated sharply over the past months. This will also be reflected in the EU Commission confidence indicators, which dropped to their lowest level since March 2003 in July, as business sentiment deteriorated in all sectors. In August, the consensus is looking for a slight decline in economic confidence (89.3 from 89.5). This would be in line with data released earlier this month, which showed a mixed picture, as business confidence stabilized or improved in the euro zone PMI’s, Belgian and Dutch business surveys, but fell sharply in the German IFO report. Although one can expect the weaker growth outlook to affect the labour market, the low levels in the unemployment rate are still likely to keep the ECB concerned about upside inflation risks stemming from higher wage demands in the labour market for now.

Today, ECB’s Liebscher will hold its closing press conference, as his term ends at the end of August. From September on, Nowotny will be his successor. Liebscher is known as one of the most hawkish members within the ECB governing council, which may also be reflected in his comments today. At the end of July, he suggested that the ECB may still have some room for manoeuvre to hike rates again. Yesterday evening, ECB’s Bini Smaghi defended the current level in interest rates, as he refused to call the monetary policy ‘too restrictive’ and added that high inflation is a hindrance to economic growth.

Regarding trading, European bonds lost further ground yesterday, as the hawkish ECB comments caused some follow-through selling, especially at the short end of the curve. So, although bonds rebounded later on in the session, there is still a risk for a short-term double top formation, if the Bund, Bobl and Schatz would fall below respectively 113.50, 107.90 and 103.08 in a sustainable manner. In a longerterm 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 Gilt market outperformed the European bond market yesterday on the back of a sharp fall in house prices and a very weak CBI distributive trades report, which suggests that the problems in the housing market are weighing on consumer demand. Gilts also rose on comments of BoE’s Blanchflower, who repeated his call for a ‘substantial fall’ in interest rates, as he expects ongoing ‘negative growth in several further quarters’. Overnight, UK consumer confidence rebounded, but is still at its second lowest level since the series began in 1981.

Currencies: USD extends consolidation pattern

On Tuesday, EUR/USD basically held a sideways trading pattern, with oil explaining most of the intraday swings. EUR/USD started the session close to 1.48 level and was locked within the bounds of 1.4750/1.48 during the morning session. The Europe data (German labour market data and EMU money supply) were not able to give trading a clear direction. The revision of the Q2 US GDP ‘surprised’ on the upside. The dollar tried to gain ground immediately after the release, but at first those gains could not be sustained and EUR/USD returned to the above mentioned trading range. However, a sharp decline in the oil price finally pulled the trigger for EUR/USD to leave the earlier trading band with the pair closing the session at 1.4706, not that afar away from the 1.4726 close on Wednesday. Overnight, the correction in the oil price lost momentum and EUR/USD is again traded in the 1.4750 area this morning.

Today, the calendar is well-filled, both in the euro-zone and in the US. In Europe markets watch out for the August CPI release and the EU confidence indicators. In the US, the spending and income data, the Chicago PMI and the final Michigan consumer confidence are all scheduled for release. The European inflation data are an important input for ECB monetary policy. However, taking into account the recent hawkish ECB talk, one should not expect the (currency) market to draw firm conclusions from a moderate decline in headline European inflation figure, which remains far away from the ECB target. While not the most important ones, also US data are interesting, but recently currency markets often showed only a subdued reaction to (second tier) US data. So, we don’t expect today’s release to really change the course of events for EUR/USD trading. The news on tropical storm Gustav, through its impact on oil prices, probably will continue to be an important factor for EUR/USD trading going into the prolonged US holiday weekend.

Since mid-July, the decline in the oil price and growing signs of deterioration in the European economy (also elsewhere outside the US) were the major drivers for the decline in EUR/USD. However, over the previous sessions, the decline in the oil price petered out, blocking an important engine of the dollar rebound/euro decline. European eco data are expected to 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 is already enough of a reason for a rate cut. In this context, a consolidation on the recent EUR/USD decline looks reasonable. In a longer term perspective, we hold on to our view that the cycle lows in the dollar are behind us. Recently, US data were not that bad, but apparently more convincing signals are needed for a US-driven extension of the USD rebound. For now, oil and to a lesser extent the (negative) news from the rest of the world (Europe/UK) should help the dollar to preserve most of this month’s gains.

For a technical point of view, the break below the range bottom at EUR/USD 1.5285 was an outright positive signal for the US dollar with the pair setting a shortterm low in the 1.4630 area last week. A technical rebound was blocked in the 1.4900 area and the pair even set a new minor low in the 1.4570 area after the IFO release. However there was no follow-through price action on this move. Next high profile support levels are in the 1.4530 area (target multiple top) and in the 1.4310 area (December lows). The ST 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 are 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, in line with the previous days, USD/JPY trading showed some intraday swings, but at the end of the day the consolidation pattern was confirmed. The oil price and the US data were behind the intraday swings and, also in line with the recent price action USD/JPY was slightly more sensitive to the US data compared to USD/EUR. However, in a daily perspective nothing happened at all with the pair closing the day unchanged at 109.50.

This morning, the Japanese eco calendar was heavily loaded. The economic activity data (spending, production, retail trade and unemployment amongst others) mostly came out better (less negative) than expected. The August Tokyo CPI slowed, but the news wires still give some attention to the national headline CPI (July figure) rising to 2.3% Y/Y. However, these data won’t change the wait-and-see attitude from the BOJ that keeps a close eye on the deteriorating economic situation. The yen trades stronger against the dollar overnight, but this was probably due to (oil-related) dollar weakness rather than yen strength.

On 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 consolidation pattern between 108.15 and 110.68. For now, the USD/JPY uptrend is not really questioned, but the momentum is slowing. We remain cautiously positive USD/JPY long-term but we with up-move losing some of its vigour, we first want to 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).

Yesterday, EUR/GBP showed again remarkable price action. Over the previous days, sterling came again under pressure as investors grew more worried on the UK economy after the poor GDP figures last week. Yesterday, this picture was confirmed by a steeper than expected decline in house prices (Nationwide). The CBI distributive trades report also painted an awful picture of the UK retail sector. However, quite surprisingly, sterling hardly showed additional losses on these data. Later in the session, BOE’s Blanchflower in an interview painted a grim picture on the state of the UK economy and advocated an aggressive easing in monetary policy, but coming from Mr. Blanchflower, the ultra-dove in the MPC, these kinds of remarks are not really a surprise. EUR/GBP closed the session at 0.8037, compared to 0.8022 on Wednesday. Overnight, the GFK consumer confidence report showed an improvement in the headline index from -39 to -36. While better than expected, the indicator is still at very distressed, close to multi-year low levels. EUR/GBP (in line with EUR/USD) trades slightly higher this morning (0.8050 at the moment of writing).

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. Recently, we advocated range trading for EUR/GBP within wellestablished 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  Fri, Aug 29 2008, 08:24 GMT