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Sunrise Market Commentary

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US Treasury trading resumes

Tue, Sep 2 2008, 07:09 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Monday, EMU bonds had a good run, unbothered by the closure of the US market, boosted by very bearish comments of the UK Chancellor of the Exchequer about the UK economy, a major trading partner for the euro area. Weak German retail sales, while not a strong driver, was of course no hurdle either for the bond market. In the morning session, following the initial spike higher, there was some profit taking that might have been exacerbated by sharply rising Italian wage growth, suggesting that second round effects are still a theme for the ECB. However, later on the Bund took off again and closed near the session highs. Lower oil prices later in the session were a positive, but not really the driver behind the bullish steepening of the curve, that occurred at the onset of trading. In a daily perspective yields dropped between 8 and 3 basis points. The price action happened in thin volumes though. Price action suggested that growth concerns currently outweigh inflation concerns (Italian wages).

US Treasury trading resumes

Today, the eco calendar contains the August ISM manufacturing survey and July construction spending. Last month, the ISM manufacturing survey came out slightly lower (50.0 from 50.2), but the underlying picture remained pretty weak, even if the index has until now not revisited levels below 45 that are traditionally associated with a recession. New orders, inventories and new export orders fell sharply, while there was a significant, but suspicious, rebound in employment (51.9 from 43.7). For August, various regional manufacturing surveys showed a slight improvement in conditions, while the Chicago PMI came out unexpectedly strong due to strong production figures. The consensus is looking for an unchanged 50.0, but the headline index might surprise on the downside as new orders were very weak last month. However a stronger outcome should excluded either, as durable orders and the Chicago PMI showed unexpected strength last week. An upside surprise would probably have a bigger impact, following a strong Q2 GDP and a number of other data that showed some early and to be confirmed signs of stabilization.

Regarding trading, it might be an important week. Firstly the summer season is over and the real underlying sentiment may show up, after some doubts appeared in that regard in last week’s sometimes erratic trading. Secondly, recently there has been some less bad eco news, suggesting some fragile stabilization in conditions. These may have been only due to noise, but if this week’s key eco data like the ISM and especially payrolls would surprise on the upside, it wouldn’t put aside too easily. Third, after hurricane Gustav passed without major causalities for oil installations, the oil price dropped to below 111 $/barrel and now testing a crucial support area. A sustained drop below 111/110.30 would point to the risk of another down-leg in oil prices and possibly cheer equities up. These will be the main ingredients for this week’s trading.

Looking at the technical picture, these are bullish for Treasuries, which might suggest an inclination to look to the above mentioned factors with rosy glasses. The Dec Note future broke through the neckline of a double bottom (114-24) and has little resistance ahead of the 117-08 contract high. However, as stated recently, the bullish isn’t yet entirely confirmed by the 10-year yield chart. The 10-year yield is testing already for some sessions the key area of 3.76/79% (currently 3.79%) which if broken would point to another down-leg in yields (double top formation) that might theoretically even lead to a re-test of the cycle lows around 3.30%.

Regarding 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 a potential 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 higher within recent ranges

Today, the euro zone eco calendar is as good as empty, as only the July PPI is scheduled for release. Following the release of the August CPI last week, the PPI will probably be too outdated to move the market. Like the CPI, PPI is expected to reach its cycle high in July at 9.1% Y/Y from 8.0% Y/Y in June. More worryingly is however that also the core PPI, excluding energy, is accelerating. A further rise in the core PPI may raise concerns at the ECB that past increases in commodity prices are filtering through into the economy and may prevent inflation from falling below the 2% level in the medium term. So although the recent drop in oil prices is a very welcome development, the ECB is still likely to remain concerned about second round effects for some period of time. In this context, yesterday’s sharp rise in the Italian hourly wages in July indicates that there is still a risk for wage-price spiral in spite of the weak growth environment.

Yesterday, ECB Vice President Papademos defended the inflation-fighting role of the ECB and said that ‘the unwavering commitment of a central bank to achieve this objective can also provide confidence’. So far, he also saw ‘little evidence’ that the availability of bank credit has been ‘significantly’ affected in the euro area. Ahead of Thursday’s ECB rate decision and press conference, he however refrained from providing guidance on the interest rate outlook.

On the supply front, Austria will tap its 30-year RAGB 4.15% Mar37 for an amount of EUR 0.55 B. Over the summer, the intra-EMU government bond spreads have continued to widen and are currently close the cycle highs. This is also the case for the spread between German and Austrian yields, which has risen from about 5 bps to around 13 bps currently on a 30-year maturity, although both have the same AAA credit rating.

Regarding trading, although European bonds had a strong session yesterday, we would be careful to draw many conclusions, as the volume was very thin in absence of the US markets and no important technical levels were broken. Indeed, since the end of August, the rally higher on the European bond market has run out of steam and bonds have settled within a sideways trading range. Although we have a bullish view on the European bond market in a longer term perspective, we are not yet sure whether the European bond market is ready for another up-leg or whether first some downward correction will occur. In this context, we abstain from adding to long positions at current levels and prefer a buy on dips approach towards the necklines of the major double bottom formations at respectively 112.88, 107.31 and 102.95 in the Bund, Bobl and Schatz. A break above the recent highs at 114.96, 109.135 and 103.56 would however signal that the European bond market is ready for another up-leg and new longs can be installed.

In the US, yields are also still close to important resistance levels and a clear break lower, not our favourite scenario, would improve the outlook for the European bond market too.

Like in the EMU, there was a sharp bull steepening of the UK yield curve yesterday, as Chancellor Darling sounded very pessimistic on the outlook for the UK economy and the manufacturing PMI remained close to the recent very low levels, albeit slightly better than expected. Today’s construction PMI is usually no market mover, but PM Brown is expected to outline its stimulus plan.

Currencies: dollar survives Gustav. Sterling sinks

On Monday, EUR/USD drifted lower throughout the session. US markets were closed for the Labour Day holiday and the European eco data (Final PMI for August) had no impact on trading. So, the focus was on the potential impact from Hurricane Gustav on the US economy and on the oil price. However, during the day markets came to the conclusion that consequences from hurricane Gustav could be more limited that previously anticipated. Oil declined sharply and in the afternoon this oil price decline dragged the EUR/USD pair below the 1.46 barrier. It even looked as if the pair was going for a test of the 1.4570 reaction low, but the move stalled just head of this key level and EUR/USD closed the session at 1.4617 compared to 1.4673 on Friday. However, the real test of the lows was only delayed. Gustav moving out of the market focus helped the dollar to some additional gains and EUR/USD currently tests the 1.4570 area. The ongoing rift between the European Union and Russia might have been a (secondary) source of euro weakness.

Today, today the European calendar is thin, but in the US the manufacturing PMI is scheduled for release. After the spectacular (suspicious) rebound in the Chicago PMI markets will look out whether this Chicago PMI was a spectacular blip or whether the fundamentals of the US economy are indeed improving. One might also expect that US investors still have some catching up to do on yesterday’s events. If the ISM doesn’t disappoint, this should again be a positive context for the US dollar.

Since mid-July, the decline in the oil price and growing signs of deterioration in the European economy (and elsewhere outside the US) were the major drivers for the decline in EUR/USD. Since mid August, the EUR/USD correction shifted into a lower gear, but yesterday’s price action indicates that the dollar is still in the driver’s seat. 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 US data (including today’s ISM) would again come out better than expected, this could also become an additional factor of support for the dollar.

From 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 rebound was not convincing at all and the recent lows remain under pressure. The ST picture for EUR/USD remains negative as long as the pair holds below the 1.4908 reaction high. 1.4811 is an interim resistance. We stay cautiously USD positive medium term.

In a day-to-day perspective, last week we tried to buy back/add to USD 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. A sustained break below the 1.4570 area could open the way to the 1.4365 (year low) and the key 1.4311 December low. A sell on-up-ticks approach is still preferred.

Yesterday morning, it looked as if the yen would be the exception to the rule on global Asian currency weakness. Despite overall dollar strength, the yen even gained ground on global uncertainty. Let’s call it the yen as safe haven in times of Asian uncertainty/ tensions. USD/JPY even dropped to the 107.65 area early in the session. However, in the after noon, the announcement of the resignation of Japan’s Prime Minister Fukuda broke the positive momentum towards the yen and USD/JPY returned above the 108 barrier, maybe also supported by the overall dollar gains due to lower oil prices at the time. However, we have the impression that currently the impact of oil on USD/JPY is less, for example compared to USD/EUR. After all, the impact of the Japanese political turmoil still should be considered as rather limited. USD/JPY closed the session at 108.14 compared to 108.80.

This morning, in Japan there is some debate on the potential impact of the PM change on economic policy and commentators focus in particular on the consequence for the Japanese budget. Of course, the subsequent changes in top policy makers don’t support the credibility on Japan’s ability to execute necessary reforms. However, at this stage, we don’t draw long term (negative) conclusions for the yen, yet.

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 and yesterday, despite the political turmoil the yen even dropped below the 108.12 support area/neckline. Recently, we advocated waiting how the 108.12 support area would fare before buying back into USD/JPY. Currently it looks as if this support will give away and this suggests that the correction could still go somewhat further. 106.50 is the next important support on the charts.

The combination of an ongoing decline in EUR/USD and a gradual slide in USD/JPY of course also reinforced the negative momentum in EUR/JPY. The pair now clearly trades below the 158.50 area.

Elsewhere in the region the RBA as expected cut its key interest rate from 7.25% to 7.00%. AUD/USD set a new reaction low in the 0.8460 area after the decision.

Yesterday, EUR/GBP remains under pressure. The negative news headlines over the weekend and a series of poor eco indicators (house price data/mortgage approvals and PMI manufacturing) kept the pressure on the sterling. EUR/GBP yesterday held above the previous high in the 0.8100 area and this morning, the pair even set a new short-term high in the 0.8162 area.

Today, the UK calendar only contains the construction PMI. However, the steep losses in cable continue to trigger additional losses in most other sterling cross rates. The uncertainty going into this week’s BoE meeting is also no help for the sterling.

Today, the UK calendar only contains the construction PMI. However, the steep losses in cable continue to trigger additional losses in most other sterling cross rates. The uncertainty going into this week’s BoE meeting is also no help for the sterling.

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 was broken yesterday morning and at this stage it doesn’t look as if EUR/GBP will easily fall back in that previous range. So, the technical charts give a high profile red alert for the sterling against the euro (and against a lot of other currencies). We feel a bit uncomfortable to buy back into EUR/GBP at this level, but the trend in sterling is obviously negative. So, a buy-on-dips approach (e.g. in case of return action to the STMA, currently at 0.8075) could be rewarding. The targets of the multiple bottom formation come in in the 0.8430 area.

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Published on  Tue, Sep 2 2008, 12:08 GMT