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Sunrise Market Commentary

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US Treasuries eke out more gains on technical grounds

Thu, Sep 4 2008, 07:12 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Wednesday, global bonds traded mainly sideways digesting Tuesday gains. In the US, Treasuries still had an upside bias. That might have been due to technical buying after the 10-year yield fell below a key resistance level of 3.76% on Tuesday eve. In EMU, the sideways trading had a slightly negative bias, due to the key resistance (in price) of the Bund at 114.96 and traders eyeing the ECB meeting today. This resulted in a decline by 3-to-4 basis points in the US, with the exception of the 2- year yield that stabilized. In EMU, the wings were up about 3 basis points, the belly of the curve was flat to minimal lower.

Economic data, weak retail sales in EMU, stronger factory orders & car sales in the US, had no noticeable and lasting impact on trading and also a downbeat Beige Book went unnoticed. The intra-day relationship with equities was quite weak.

US Treasuries eke out more gains on technical grounds

Today, the calendar is exciting with the August ADP employment report, the weekly claims and non-manufacturing ISM. Beside these there are speeches of  Fed governors Fisher and Yellen. Dallas Fed governor Fisher is a hawk, who dissented in favour of a more restrictive policy in the recent few FOMC meetings, while San Francisco Fed governor Yellen is more a middle of the road figure, who is often close to the Washington board governors in her views on the economy and inflation. Yesterday, Boston Fed Rosengren, who voted last year in favour of more aggressive rate cuts (and hasn’t a vote in the 2008 FOMC meetings), was quite dovish in his comments as he noted that the Fed rate cuts have had only muted effects due to the credit crunch. He defended the aggressive rate cuts the Fed decided in H2 of 2007 and H1 2008 and while he didn’t give his views for policy going forward, he probably would vote as the first for another rate cut, if the economy would slow much further.

The employment data might be a predictor for the payrolls, to be published tomorrow, but recently the correlation between the ADP employment report and the payrolls loosened considerably. In July, the ADP employment report came out unexpectedly strong, with employment rising 9 000, but this strong figure was not confirmed by the payrolls report, showing instead a decline of 51 000. In August, employment is expected to fall 30 000 according to the ADP report, which is in line with the initial and continuing claims reports that showed weak labour market conditions in August, with the continuous claims at the highest level in five years. Last weak, initial claims fell slightly from an upwardly revised 435 000 to 425 000, which was in line with the expectations. Continuing claims rose a more than expected 64 000 to 3 423 000. In the last week of August, initial claims are expected to come out at 420 000, while the consensus is looking for only a modest decline in continuous claims (3 420 000 from 3 423 000). In recent months, there might have been some distortions to the figures, but these have gradually been unwinding, we think. Non-manufacturing ISM came out stronger than expected in July (49.5 from 48.2), but the details remained weak. In August, the consensus is searching for an unchanged 49.5, in line with the manufacturing ISM which was also unchanged in August, but we put the risks slightly on the downside as new orders and especially new export orders deteriorated last month.

The Fed’s Beige Book, released yesterday eve, showed a weak picture of the economy. Activity was described as slow in most districts amid weak consumer spending. Residential real estate conditions remained dreadful, as all districts reported tightening loan conditions. At the same time, there is little respite for inflation as all districts also reported continuing upward price pressures from elevated input costs, even as some districts reported a retreat in some commodity prices. On the other hand, wage pressures were characterized as modest, unchanged from previous Books. For the FOMC decision on September 16, based on the Beige Book, an unchanged decision remains the most likely outcome. We might get a sense of the voting attitude of Fed Fisher, who dissented in previous meetings, when he speaks later today.

Regarding trading, it was an encouraging session yesterday as some more gains were eked out in the absence of strong favourable drivers. The technical break in the 10-year was confirmed keeping sentiment bullish. Overnight there was some profit taking and that might be the inclination of the market further out today, especially should the ADP and or initial claims come out stronger. Recent gains may convince some traders to take some profit and position themselves more neutral ahead of tomorrow’s payrolls report. The possibly somewhat weaker Non-manufacturing ISM should not be able to resist the temptation for some profit taking. However, it will be on Friday that the sentiment for the next period will be set.

The bullish sentiment in the Treasury market was confirmed yesterday and the 10- year yield moving below 3.76%, 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 already for some sessions (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.

Trichet to downplay decline in headline inflation

Today, the focus will be on the ECB rate decision and press conference. A no change decision is expected, but markets will look out for the ECB press conference for some hints whether recent changes in the growth and inflation outlook have altered ECB thinking on how interest rate policy might evolve in the future. In this context, the new ECB staff projections on growth and inflation may play a central role, although they should be treated more carefully, as they probably won’t take into account the latest 10% decline in oil prices.

Based on recent data, a significant downward revision of the growth projections can be expected from the previous forecasts of 1.8% this year and 1.5% next year. A key question is whether the ECB feels slower growth will alter inflation prospects. In June, the mid-point of the inflation forecasts stood at 3.4% this year and 2.4% next year. Although the decline in oil prices since mid-July will have a huge impact on the headline inflation rate over the coming months, the ECB is likely to remain concerned about the potential second round effects from past increases in commodity prices, mainly via higher wages. Last week, ECB’s Weber highlighted these concerns, as he questioned whether the average inflation rate will fall below the 2% level in 2010 and added that the ECB may have to raise rates again once the growth outlook improves.

As regards today’s press conference, we expect Trichet to downplay the recent decline in headline inflation given the threat of second round effects. The positive impact of the oil price on the growth outlook may even buy the ECB some time to await further developments. At the same time, the decline in the euro also calls for some cautiousness, as it is not only positive for the growth outlook, but also negative for the inflation outlook. As such, we expect the ECB to be quite comfortable with the current market expectations for no change until the middle of next year when a first rate cut is expected. Recent hawkish comments of the ECB have however indicated that the ECB wants to prevent any speculation on an early rate cut, which makes that the risk still is for a slightly more hawkish than expected press conference.

As such, we continue to prefer a buy-on-dips approach towards the necklines of the double bottom formation in bond prices. In 2-year yields, this level stands at 4.25%. For more details, we refer to our ECB flash: Trichet to downplay decline in headline inflation.

Outside the euro zone, the Swedish Riksbank will announce its rate decision. After lifting its main interest rate from 4.25% to 4.50% in July, expectations are split about a new hike. Last month, three of the six policy makers voted for another rise in the benchmark interest rate, while the three other argued that slowing growth indicates no new rise is necessary. In the meantime inflation rose to 4.4% Y/Y, the highest level in 15 years. A decision to hike rates could be a negative for the European bond market too.

At the longer end of the curve, the Bund is still within recent ranges, despite recent large swings. Over the past days, the Bund has tested both the downside at 113.50 and the upside 114.96, as investors were uncertain whether the drop in oil prices would primarily affect the growth outlook or the inflation outlook. In a longerterm perspective, we hold on to our bullish view following the break above the neckline of a major double bottom at 112.88, but do not front-run on a break higher. As such, we still prefer a buy-on-dips towards this neckline, but a break above the recent highs would signal that sentiment is still quite bullish and may be the beginning of new up-leg. In the US, Treasuries yesterday built out their gains following the break below the 3.76% level in 10-year yields. On the supply front, France and Spain will tap the market. Especially for Spain, the outcome of the auction may be important, as Spanish bonds have been underperforming their European counterparts consistently over the past months.

In the UK, the Bank of England is also expected to keep rates on hold. Despite the sharp slowing in growth, the Bank is still concerned that rising inflation levels may adversely affect longer-term inflation expectations. The drop in oil prices may however diminish this risk over the coming months and open the door for a further easing in policy later this year. As such, we don’t go against current market expectations for a rate cut at around the November/December meeting.

Currencies: EUR/USD nears key support levels going into the ECB meeting

On Wednesday, the dollar again started the session on a strong footing. Ongoing tensions in Asian markets spurred more save haven dollar buying and the oil price was also still downward oriented even if the pace of the decline was much slower than on Tuesday. The European data (especially the retail sales and the Q2 GDP data/details) are not really market movers, but confirmed that the European economy is heading for a material slowdown and this was no help for the single currency. So, after declining to the low 1.44 area in Asian trading, EUR/USD set a new reaction low (1.4385) in Europe after the publication of the European data. The US traders joining the price action this time didn’t provide any new impetus. Oil stabilized and also the US data (factory orders) were not able to change the course of events. So, the dollar momentum eased and EUR/USD fell victim of profit taking. The correction was again more or less in line with a (albeit very moderate) rebound in the oil price. Later in the session, a soft Fed Beige Book was also a good excuse to cash in some gains on recent USD gains ahead of today’s ECB interest rate decision. EUR/USD closed the session at 1.4409, compared to a close of 1.4520 on Wednesday.

Today, the US calendar is well filled with the ADP employment report, the claims and the ISM non-manufacturing scheduled for release. However, while interesting, the market focus will be on the ECB interest rate decision and press conference. We expect the ECB to acknowledge the slowdown in the European economy, but at the same time to continue warning on inflation risks (second round effects). We also suspect that the ECB will try to prevent markets from front running on potential ECB rate cuts next year. As such this ‘balanced’ message should be rather neutral for the euro. However, we hold on to the view that interest rate support resulting from inability to act (due to unfavourable inflation) is not really a reason for optimism on a currency. So, we don’t expect this scenario to yield a sustained support for the single currency.

Since mid-July, the decline in the oil price and growing signs of deterioration in the European economy (and elsewhere outside the US) gave the dollar a comparative advantage against most other major currencies. Recently the market focus was more on the deterioration in the economy outside the US. However, in the near future, it will be interesting to see whether the US economy will be able to take advantage from the recent decline in oil prices. which would be an additional support for the dollar. However, it is probably too early to expect this factor to play already a role in today’s ADP report or tomorrow’s payrolls. Nevertheless, a positive surprise from the key US data won’t pass unnoticed.

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 another sharp correction in the oil price also triggered a new down-leg in EUR/USD with the pair setting a new low in the 1.4385 area. So, the pair yesterday already came close to the key 1.4365 (year low)/1.4308 (Dec 2007 low) support area. One might expect markets to take a breather ahead of those key levels short-term and probably some high profile factor (like another sell-off in oil, a u-turn at the ECB or an upward surprise in the payrolls) is needed for this hurdle to be cleared. However, longer tern, we consider EUR/USD to have entered a convincing sell-on-up-ticks pattern. A return above the MTMA moving average in a sustainable way (currently at 1.4679) would be a first indication that a short-term correction has some further to go. Return action above the 1.4908 reaction high would question the short-term USD positive momentum. This is not our favoured scenario.

Yesterday, USD/JPY to some extent showed a similar pattern as described in USD/EUR. However, USD/JPY again underperformed the performance against the euro, so, EUR/JPY extended its downtrend. Especially early in the session, the Asian tensions apparently helped the yen to play some kind of save haven role in the region. Later in the session USD/JPY tracked the global USD correction and the pair closed the session at 108.29, even slightly lower compared to the 108.61 close on Tuesday. In this respect, the daily ‘loss’ in USD/JPY was somewhat of an exception to the global rule as the dollar, despite the correction later in the session, still showed some (moderate) gains against most majors.

This morning, sentiment on Asian (stock) markets was still fragile, but some other currencies in the region that were hard hit recently are of the lows (among them the Korean Won).

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. USD/JPY currently remains an area of relative calm. We are neutral short-term for this pair with range trading captured within the bounds of the 107.65/110.68 range. Overall, we turned to a USD-positive view, but obviously there are better opportunities to play this theme elsewhere. A drop below the 107.65 reaction would raise an additional question mark on the upward potential for this pair short-term.

On Wednesday, the sterling remained under pressure. A better than expected UK services PMI in this respect didn’t bring any lasting relieve to the UK currency. EUR/GBP developed a sideways trading pattern between 0.8130/50 during the European trading hours, but a new wave of selling after the European/UK close and this morning Asia (further unwinding of carry trades, e.g. GBP/JPY) made EUR/GBP to set a new life-time high.

Today, the UK calendar contains the HBOS house price and the BOE interest rate decision. As an unchanged decision is expected, the BOE won’t give a communiqué.

EUR/GBP broke out of the longstanding sideways 0.7760/0.8098 trading range earlier this week. Even if the European data are far from convincing, sentiment on sterling remains even worse. Ongoing poor eco data, fears that the BOE might cut rates sooner than the ECB and the sterling being victim of a new wave of carry trade unwinding all weigh on the UK currency. Even if a lot of bad news for the sterling should already be priced in at the current levels, it doesn’t look as if EUR/GBP will easily fall back in the previous range. We still feel a bit uncomfortable to buy back into EUR/GBP at this level, but the trend in sterling is obviously negative. A buy-ondips approach (e.g. in case of return action to the 0.8100 area) 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  Thu, Sep 4 2008, 07:26 GMT