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Sunrise Market Commentary

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Inflation decline supports short end European yield curve

Mon, Sep 1 2008, 07:16 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Friday, global bonds closed the summer trading season with a mixed session. European bonds managed to eke out some, albeit it insignificant gains while US Treasuries ended all under water, be it that losses were partly recouped in later trading. The difference may have been due to US eco data surprising on the upside, while the European ones showed economic weakness, combined though with some easing in inflation.

EMU inflation fell in August, suggesting that the peak is set, but the outcome was not a complete surprise following some national CPI releases earlier in the week. The economic confidence data were weak and largely confirmed the PMI report, reported earlier in the month. All in all, this resulted in largely sideways trading during the European morning session with the only noticeable exception of the shorter end, that outperformed after some days of underperformance caused by hawkish ECB talk.

US Treasuries fell in early US session, after a brief up-tick in the first half hour of trading. The PCE and PI data were quite innocent, but also earlier in the week, we saw early profit taking on Treasuries in the session. The mid-morning data were a good deal better than expected and drove prices to the lows of the day. Treasuries got no support from falling equity prices, as is often the case. Later on, Treasuries grinded higher again, surprisingly, as at that time equities were moving up too, erasing part of the losses. Treasuries ignored a late session selling wave of equities. We wouldn’t give these price movements much significance, as thin summer trading conditions reigned.

Inflation decline supports short end European yield curve

Today, the eco calendar is thin with only the final figure of the August manufacturing PMI and the July German retail sales. Although the final figure is expected to confirm the flash outcome at 47.5, the details should indicate that the weakness within the euro zone is spreading from countries alike Ireland, Spain and Italy towards France and Germany. Indeed, although the euro zone manufacturing is already three months below the 50 level and even rose slightly in July (47.4), August will mark the first month that the German manufacturing fell just below the 50 boom/bust level. The rapid deterioration in the largest economy of the euro zone was also highlighted last week by the third consecutive drop in the German IFO indicator. This morning, the German retail sales showed sales falling 1.5% M/M and flat year-on-year.

Further out this week, the focus will be on the ECB rate decision and press conference. A no change decision is expected. But at same time, the ECB can be expected to continue stressing the upside inflation risks and to downplay the recent decline in the headline inflation rate. Indeed, like ECB’s Weber last week signalled the ECB is still uncertain whether the slowdown in growth be will be sufficient to bring inflation down in line with the ECB’s definition of price stability in the medium term of close to but below 2%. As this is not likely to happen yet next year, the ECB will refrain from giving the all clear on the inflation outlook. This is also likely to be reflected in the new ECB staff projections for growth and inflation for this and next year, which will be released during the press conference on Thursday. This is likely to put a bottom in short-term yields for now. Today, ECB’s Tumpel-Gugerell and Papademos will speak, but ahead of Thursday’s ECB meeting, they usually abstain from commenting on the monetary policy outlook.

Regarding trading, last week the rally higher on the European bond market ran out of steam as the bond market focused on the hawkish comments from the ECB and better than expected US eco data and largely ignored the weak euro zone confidence data and decline in inflation. At the end of the week, bonds were even approaching the necklines of potential double top formations at respectively 113.50, 107.90 and 103.08 in the Bund, Bobl and Schatz. A break lower would deteriorate the short-term technical picture. We wouldn’t however go short given the rapid deterioration of the euro zone economic outlook and the increased chances that the inflation rate has peaked, but prefer a buy on dips strategy towards the necklines of the major double bottom formations in the Bund, Bobl and Schatz at respectively 112.88, 107.31 and 102.95. The negative net cash flows on the European bond market this week support such a view. 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 calendar is well-filled today with the August manufacturing PMI, net lending secured on dwellings (July) and the July mortgage approvals. The Manufacturing PMI is expected to fall from 44.3 in July to 44.0 in August, which is in line with the CBI industrial trends survey and the European Commission industrial confidence.

Currencies: USD remains well bid; sterling hammered

On Friday, EUR/USD again showed no clear direction during the morning session in Europe. At first, the euro tried to gain ground testing offers in the 1.4765 area. However, the move lacked conviction. The lower than expected European CPI and the weak commission sentiment indicators also were of no help for the euro, even if one had to admit that the reaction to these data was very moderate. The same was also true for the early morning releases in the US (spending and income). However, later in the session, the Michigan consumer confidence and even more the Chicago PMI came out stronger than expected. The rebound in the Chicago PMI was quite spectacular (from 50.8 to 57.9), but also a bit suspect if compared to other economic data from the US recently. Nevertheless, the dollar gradually gained some ground after the publication of those releases. The move was also supported by a decline in the oil price at that time. EUR/USD closed the session at 1.4673 compared to 1.4706 on Thursday.

Over the weekend, the dollar remained rather well supported. Concerns on global economic weakness outside the US support the US currency. A pessimistic comment from the UK Chancellor of the Exchequer on the UK economy was a good illustration of this factor. Also most Asian currency trade weak against the dollar. EUR/USD trades in the 1.4640 area at the moment of writing.

Today, US markets are closed for the Labour Day holiday. However, this won’t prevent that the market focus will continue to be on the US with all eyes on hurricane Gustav. In Europe the final release of the PMI data will be published. While interesting, they probably will not have a major impact on trading as we already got several series of European (Business) sentiment indicators recently. With respect to Gustav, at least for now, one can only conclude that the impact on the oil price and on the dollar was very limited. So, the performance of the dollar should be considered as rather resilient.

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. Since mid August (and also last week); EUR/USD basically held a sideways trading pattern. However, given the steep gains since mid July, the correction in the dollar should be considered as limited. Ongoing hawkish ECB talk gave the single currency some temporary support but didn’t really change the course of events for EUR/USD. Recently, the dollar only showed a limited reaction to US data. However the US data tended to surprise on the upside. In some cases, one could suppose that special factors were at work, but if this week’s key would again come out better than expected, this could also become a factor of support for the dollar. The developments regarding Gustav (and its impact on the oil price) of course create a high degree of uncertainty regarding the US currency short-term. However, if the worst case scenario can be avoided, the impression is that the dollar could remain well bid.

For a technical point of view, the break below the 1.5285 range bottom was an outright positive signal for the US dollar with the pair setting a reaction low in the 1.4570 area after the IFO release. Some consolidation occurred last week, but the euro gains were far from spectacular. Next high profile support levels beyond 1.4570 are in the 1.4530 area (target multiple top) and at 1.4310 (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. In a day-to-day perspective, last week we tried to buy back/add to US long exposure in case of return action higher in the 1.4575/1.4908 consolidation range. However, a test of the top of that range didn’t really occur. The ST momentum remains USDconstructive, but we wait how the 1.4570 support fares. A break below could trigger a new short-term upleg.

The same factors that were at work in USD/EUR also played a role in USD/JPY. The dollar started under pressure on Friday but stabilised during US trading as strong US data and a lower oil price gave the US currency some support. However, a poor stock market performance and negative pressure form EUR/JPY also prevented USD/JPY from regain the earlier losses. USD/JPY closed the session at 108.80 compared to 109.50 on Tuesday

In overnight trading, the picture for USD/EUR and USD/JPY is gain different. While the dollar continues to trade strong against the euro, USD/JPY slips lower again on global economic uncertainty. In this respect, the Japanese yen clearly is the exception to the rule as a lot of other Asian currencies (Won, Bath, Singapore dollar, amongst others) are under pressure this morning both due to local factors and to the fact that markets fear more fall-out from the global economic downturn in the region.

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 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 remains under pressure. The GfK consumer confidence published early in the session was slightly less negative than expected. However the figure still was at historically very low levels. So, sterling continued to face headwinds with the pair holding above 0.8040 for most of the day on Friday. Over the weekend, UK’s Chancellor of the Exchequer in an interview painted a very grim picture of the UK economy. This pulled the trigger for another sterling selling wave, with the EUR/GBP pair already testing offers in the 0.8140 area in Asia this morning.

Today, the UK calendar again contains some important release, with the final money supply data and the manufacturing PMI on the agenda. The latter of course could be key for the fate of sterling short-term. Another negative surprise of course only would at the negative sterling sentiment.

Last week, we indicated to be a bit surprised by the sharp losses of sterling against the euro. 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. The longstanding sideways 0.7760/0.8098 trading range in EUR/GBP is broken this morning. We think it’s a bit too early to conclude that this will mark the start of a new powerful up-leg in EUR/GBP. However, the least one can say is that the technical charts give a very strong warning on sterling. Last week, we took profit on EUR/GBP long exposure as the pair came closer to the range top. For now we stay sidelined. We look out whether the break will be confirmed. In any case, we avoid EUR/GBP short exposure for now.

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Published on  Mon, Sep 1 2008, 14:32 GMT