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Sunrise Market Commentary

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US Treasuries rally higher, as equities cannot hold on to their early gains

Wed, Sep 3 2008, 07:10 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Tuesday, the plunge in the oil price caused some huge volatility on all markets including the bond markets. These moved in first instance sharply lower, especially in Europe, but recouped most of the losses in afternoon, as US Treasuries turned north and US equities couldn’t hold on to their early gains. The data played only a minor role, even though the rally on the US bond market started following the release of the ISM manufacturing, which came out in line with expectations. In the US, yields fell between 11 bps at the short end of the curve to 7 bps at the 30-year segment. 10-year yields are now slightly below the neckline of a potential double top formation, which if confirmed would improve the technical outlook for bonds. In the euro zone, yields were still up at the official afternoon closing, but moved again lower in after hour trading. For now, it appears that lower oil prices are mainly seen as a deflationary bond positive development instead of a growth positive and thus bond negative development.

US Treasuries rally higher, as equities cannot hold on to their early gains

Today, the eco calendar contains mostly second tiers releases, notably the weekly mortgage applications and retail sales, the August Challenger lay-offs and the July factory orders. The challenger lay-offs aren’t seasonally adjusted and thus difficult to interpret. On top of it, it concerns announced and not actual lay-offs, which have little to no informational value for the payrolls reports of the next few months. The factory orders are more important, but as the most important part of the report, notably the cyclical durable orders have already been released, also here the new info for markets is limited. The durables were again quite strong, but part of it might be price effects.

The Fed’s Beige Book, is potentially more important as it is a preparatory document for the September 16 FOMC meeting that describes the current state of the economy via reports of the regional Fed banks based on anecdotal evidence. In general though, it reads alone the lines of the most recent released economic reports. We think that the Fed is happy with its current stance (2% Fed’s fund). The decline in oil prices will ease inflation concerns, also as inflation expectations plunge. However, the Fed has driven official rates already very low because of the financial turmoil and acted pre-emptively. Therefore, we suspect that the 2% Fed fund rate won’t be lowered anymore this cycle, unless new special circumstances intervene. If that’s true, the room for more gains on the short end of the curve may be limited.

Regarding trading, very interesting price action yesterday as the crude oil price plunged sharply to below 110 $/barrel. At first, the market considered it more for the angle of higher potential growth in the future than as lower inflation. As a result, bonds sold off and equities surged. However, the mood changed and markets started to see the sharp drop in oil prices as evidence of the sharp growth slowdown. Of course, we should mention that oil did recoup some of its early steep losses in US afternoon session (profit taking?). As a consequence, equities had to give back its gains and Treasuries turned north again, eking out noise gains in the close of 11 basis points at the short end and 8 basis points at the 10-year maturity. The outperformance of the short end occurred mostly when equities hit the skids. Today, the eco data should take second stage and attention will remain on the huge and important price action in currency and commodity prices. We believe that commodity prices are now clearly trading in a bearish environment and this remains the case as long as WTI crude is below 120/121 $, while the uptrend of the dollar is another feature of recent weeks that got confirmed yesterday.

While lower commodity/oil prices lift one of the two big adverse shocks (the other being the financial crisis) that took the economy down and is thus in due time a positive for the economy, in a first instance it is considered as evidence of economic gloom and doom. The bullish sentiment in the Treasury market was confirmed yesterday and the 10-year yield moving below 3.76% (to be confirmed today) painting a bond bullish double top on the chart. The targets of the configuration stand at 3.35% and 3.25%, or about the cycle lows at 3.28%. So from a technical point of view there is little in the way from moving lower. 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.

Regarding our strategy, playing it from the long side, existing longs could keep their positions. 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, the break lower in yields might offer an opportunity to jump the bandwagon. Today’s data shouldn’t be of utmost importance. There might be some profit taking following recent gains and depending how position occurs in commodity and equity markets, also as traders start to eye Friday’s key payrolls report.

European bonds uncertain how to react to oil price drop

Today, the calendar contains the July retail sales and the first breakdown of Q2 GDP growth besides the final figure of the Services and Composite PMI, but no major changes are expected here.

According to the flash estimate, euro zone second quarter GDP declined by 0.2% Q/Q, the first quarter-on-quarter contraction since the recession of the early 1990’s. Today, we will get a first breakdown of Q2 GDP. Detailed data available for Germany, France and Spain showed that the decline in investment was a key factor behind the contraction, but household consumption may also have been a drag on growth. Retail sales, which are a good pointer of household consumption, are also scheduled for release today and could give us a first indication of Q3 GDP growth. In July, a slight rebound compared to June is expected (0.1% M/M and -2.1% Y/Y), but given the volatility of the series market impact may remain limited.

On the supply front, Austria yesterday sold EUR 0.55 B of its 30-year RAGB 4.15% Mar 37 with a moderate bid/cover rate of 2.73. Overall, the widening trend in intra- EMU government spreads is still continuing. In this context, yesterday’s press reports about a smaller than expected growth in tax receipts in Belgium is no good news for the performance of Belgian bonds. The more as the fate of the current government is still uncertain given the problems to achieve a constitutional reform agreement between the French and Flemish-speaking regions.

Regarding trading, the plunge in the oil price caused some considerable volatility in trading yesterday, as investors were uncertain whether the drop in oil prices would primarily affect the growth outlook or the inflation outlook. In first instance, bonds dropped lower and the Bund tested the important support levels at around 113.50, the neckline of a potential double top formation. This level held and bonds rebounded in the afternoon tracking US Treasuries higher, as US equities couldn’t hold on to their early gains. As such, the Bund is now coming closer towards the recent highs at 114.96. The break higher in the US (to be confirmed) put the risks also on the upside in the European bond market. Such a break higher in the Bund would signal that sentiment is still quite bullish and may be the beginning of a new up-leg. However, ahead of the ECB meeting tomorrow, where Trichet is expected to diminish any market expectations of an easing in policy, and the US Payrolls report on Friday, we certainly do not front-run such a break higher.

In the UK, the calendar contains the August Services PMI. The manufacturing PMI, released earlier this week, surprised on the upside (45.9 from 44.3), led by a sharp increase in output. In July, Services PMI showed a slight rebound (47.4 from 47.1), but the underlying picture remained very weak. This month, the consensus is looking for a modest decline (47.0 from 47.4).

Currencies: dollar extends rebound

On Monday, trading on global markets in general and on the currency market in particular was dominated by one single factor: the sharp decline in oil prices as hurricane Gustav caused only limited damage to the oil platforms in the Gulf of Mexico. The oil price was already sharply lower overnight and collapsed further early in European trading. In line with recent price action, this triggered additional unwinding of USD short positions and EUR/USD dropped below the 1.45 mark during the morning session in Europe. The correction in the oil price lost momentum later in the session and this also slowed the ascent of the dollar during the US trading hours. The only economic report of importance, the US manufacturing ISM, was perfectly in line with expectations and had no lasting impact on EUR/USD trading. EUR/USD closed the session at 1.4520, still a decent gain compared to the 1.4617 close on Monday.

However, the story obviously wasn’t finished as the dollar regained further ground overnight against most other major currencies. It is still early days to draw conclusions, but this time the move was not immediately linked to a further decline in the oil price. The dollar gains were driven by investors fleeing the Asian region on growing worries that this region also won’t escape from the global downturn. It may sound a bit strange, but from an Asian point of view, the dollar apparently tends to regain some kind of safe haven profile. Of course all this is still very fragile, but who could imagine a few months ago that we would consider this kind of assessment on the US currency already at this point.

Today, the US calendar only contains the Beige Book. In Europe the retail sales are on the agenda but this is also no market mover. So, the impact of the eco data on EUR/USD trading should be limited. However, as illustrated over the previous sessions, this shouldn’t prevent currency markets to make some sharp swings.

Since mid-July, the decline in the oil price and growing signs of a deterioration in the European economy (and elsewhere outside the US) were the major drivers for the decline in EUR/USD. In the second half of August; the EUR/USD correction shifted into a lower gear, but the price action since the end of last week indicates that the dollar is again in the driver’s seat. Another sell-off in the oil price and growing worries on the economy outside the US (especially in Asia) all give the US currency a comparative advantage against most other major currencies and apparently also against the euro. From a euro point of view, markets today will also prepare for tomorrow’s ECB interest rate decision and press conference and for the new ECB staff forecasts. The recent decline in the oil price probably won’t be fully captured by those forecasts so the inflation forecast might show no improvement yet, but one can expected a material downscaling for the European growth forecast going forward. If so, this probably also won’t be a support for the single currency.

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 any up-ticks in EUR/USD were used to further off-load EUR/USD long exposure. 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. The swift break below the 1.4570 previous low suggests that EUR/USD is heading for 1.4365 (Year low)/1.4310 (December reaction low). The pair needs to return above the MTMA moving average in a sustainable way (currently at 1.4689) as a first indication that the downward pressure is easing.

Yesterday, USD/JPY also gained ground in line with the global rebound of the US dollar due to sharply lower oil prices. However, the gains in USD/JPY were far less spectacular compared to what was seen in most other US cross rates, especially in the USD/Asia cross rates. So, one might assume that Asian safe haven flows and unwinding of carry trades (for example against the Aussie dollar) go not only to the US dollar, but to some extent also still trigger some yen buying. This makes the swings/gains in USD/JPY less pronounced compared to a lot of other (Asian) cross rates.

This morning, there were no important eco data in Japan. The Japanese stock market showed limited gains this morning and in this respect was an outperformer compared to most other markets in Asia.

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 even set a new minor low in the 107.65 area on Monday. For now the downmove peters out. Compared to other USD cross rates, USD/JPY currently is an area of relative calm. We are neutral short-term for this pair with range trading captured within the bounds of the 107.65/110.66 range. In a day to day momentum the pair tries to move somewhat higher within this range.

After steep sterling losses early in Asian trading yesterday morning, EUR/GBP yesterday during the European and US trading hours developed a sideways trading pattern, between 0.8110 and 0.8150. However, sentiment towards sterling obviously remains negative and the UK currency is not able to really move away from the new lows against the single currency set earlier yesterday morning. Government initiatives aimed at supporting the housing market currently fail to give the sterling any additional support. EUR/GBP closed the session at 0.8139 compared to 0.8113 on Monday. Overnight, the Nationwide consumer confidence stabilised at the cycle lows, only conforming the poor state of the consumer sector in the UK.

Today, the UK calendar only contains the services PMI. The figure is expected to stay in contraction territory (47.0 from 47.4) and any negative surprise might add to the sterling negative 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 was broken earlier this week 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 still 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 0.8100) could be rewarding. The targets of the multiple bottom formation are in the 0.8430 area. A drop below the 0.8022 neckline is needed as a first indication that the pressure is easing on sterling.

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Published on  Wed, Sep 3 2008, 08:35 GMT