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Sunrise Market Commentary

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US Treasuries profit from plunging equities

Fri, Sep 5 2008, 07:17 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Thursday, global bonds made more gains as plunging equities stoked demand for safe haven government bonds. The curve shifted in a more or less sideways fashion in both US and EMU, with only the very long end lagging somewhat. The absence of a clear outperformance of the short end may be due to the already rock bottom low level of the Fed funds in the US and market fears about the currently still hawkish stance of the ECB. In yield terms, EMU bonds dropped 6 to 8 basis points; US Treasuries fell 8 to 9 basis points. The very long end dropped 4 basis points in EMU and 6 basis points in the US.

It is not completely clear what pushed US and EMU equities up to 3% lower, but we suspect that forced selling and anxieties about the health of main market participants stood at the forefront. The US economic data were indeed mixed with claims higher than expected offset by an improvement in the Non-manufacturing ISM and productivity. The ADP report was in line with expectations. In EMU, the German factory orders were unexpectedly very weak.

The ECB kept rates unchanged, as expected, and in his press conference Trichet had no real new message for the markets. So, while there was some volatility, maybe also due to the claims that were released at the same time, there was no distinct lasting reaction of the market.

US Treasuries profit from plunging equities

Today, all attention will go to the August payrolls report. Last month, the payrolls reported a drop by 51 000, exactly like in June and slightly better than the expected decline of 75 000. In August, the consensus is again looking for a decline of 75 000, which would be the eighth consecutive month of job losses. Initial claims, which might give an indication for the payrolls report, came out very weak in August (constantly above 425 000), but there are some doubts on its reliability, and also manufacturing ISM showed a deterioration in employment (49.7 from 51.9), albeit it after a sharp jump in June. The ADP employment report came out broadly in line with the expectations at -33 000. Assuming that government payrolls rise about 20 000 in July, the payrolls would report a fall of 15 000. However, since the fall of 2007, the correlation between the ADP and payrolls survey loosened significantly, with the ADP reporting materially stronger figures than the BLS Payrolls report and therefore we decided to stick to the consensus estimate. If the payrolls would surprise on the upside, the market is expected to react negatively, but we put the risks on the downside of expectations as the August payrolls have come in below the median estimate in each of the past 11 years. A substantial weaker outcome might push Treasuries higher.

The 25 B USD TSLF auction (schedule one) generated bids of 45 B $ (bid/cover of 1.8) and a stop of 15 basis points. The higher bid/cover in recent auctions and the stop above the minimum of 10 basis points could but not necessarily point to creditrelated anxieties that incite dealers to prefer going to the Fed for funding than to the private sector.

Regarding trading, jitters in the equity markets brushed the prospect of some prepayrolls profit taking, on which we counted yesterday, off the table. On the contrary, safe haven flows into the safe government bonds supported Treasuries that closed considerably higher. Today’s payrolls report will dominate trading together with the internal market dynamics (distressed selling?). A weaker than expected outcome would in the current climate only exacerbates the gloom and doom dominating the markets and may initiate a big wash out in various markets, including forex, equities and commodities. Indeed, equities take again centre stage, as the drop lower yesterday was technical highly relevant and brings the cycle lows at 1200 (S&P) into reach. Most likely the market will be attracted by that level (if payrolls allows). A retest of the lows very often is needed before a bear market ends. Of course, there are risks that the low breaks and another down-leg in equities occurs. However, we look for signs that the market exhausts around the current lows (big wash out). Will there be another trigger for that from a government/Fed measure on the housing market/ GSE’s?

The bullish sentiment in the Treasury market remains of course intact, but given the recent strong gains and the overbought character of the market, there is scope for the inevitable profit taking and some congestion of recent gains. The 10-year yield stands at 3.60% currently, extending the drop below the key 3.76% level a few days ago that painted 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, that is under test overnight (117- 10 hit).

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). In case, equities hit the skids and Treasuries spike higher, shorter term investors might contemplate taking profit, as the market becomes overextended.

Bund breaks above recent highs improving the technical picture

The euro zone eco calendar is thin today with only German Industrial Production data (July). In June, industrial production increased for the first time (month-onmonth) in four months, but is expected to decline again in July (-0.5% M/M). It is however clear that the German industrial sector is cooling as the manufacturing PMI fell from 52.6 to 50.9 in July and deteriorated further in August to 49.7. Also factory orders, released yesterday, confirmed this trend, falling for the eighth consecutive month. Usually, the market impact is rather limited and today, markets will focus on the US payrolls report.

Today, a lot of ECB speakers are scheduled, as the ECB will hold its 10th conference ‘the ECB and its watchers’ and the new Austrian governing council member Nowotny will give his opening press conference. However, following yesterday’s ECB press conference, we shouldn’t expect them to break new ground. Yesterday, ECB’s Trichet signalled that the ECB remains concerned about the upside inflation risks and doesn’t plan any rate change in the near future. Their current hawkish stance should be seen in the light of the upcoming wage round in Germany. Once this is passed and the positive impact of lower commodity prices filters through into lower headline inflation rates, one can expect the ECB to focus more on the faltering growth outlook and to start contemplating rate cuts in early 2009. Currently, we expect the ECB to start cutting rates in March 2009 and a cumulative drop of 75 bps could be considered if economic growth prospects don’t improve. For more details, we refer to our flash on the ECB: ‘ECB signals no early rate change’.

This implies that we continue to have a bullish view on the European bond market, as markets currently expect the first rate cut to occur by the middle of next year. Yesterday’s break higher in the Bund indicates that sentiment on bond markets is still bullish too. If this break is confirmed following today’s US Payrolls report, then new longs can be considered. The targets of the major double bottom formation in the Bund with neckline at 112.88 come in at 116.06/11. Today is also the last full trading day of the September future. From Monday on, we switch towards the December future.

Regarding intra-EMU spreads, the spread between German and Spanish yields continued its widening trend yesterday, following only modest demand for the Spanish 3-year Bono. Demand for the French OATs was slightly better, but also here the spread is again widening somewhat.

Currencies: Euro hammered. EUR/USD tests key long-term support levels.

On Thursday, the calendar was well packed on both sides of the Atlantic with the German factory orders, the ECB (and BOE) interest rate decision and a series of US data. However, early in the session, EUR/USD showed an indecisive trading pattern. The pair reached intraday highs early in European trading on USD-profit taking, but there was no follow through price action. On the contrary, EUR/USD soon drifted lower again reinforced by poor German factory orders. The US data were mixed and also the ECB press conference (soft on growth, but tough on inflation) was not able to give EUR/USD trading a clear trend. However, a sharp decline on the US stock markets (probably fuelled by force selling) showed resurfacing investor concerns on the global economy. At the current juncture, this obviously is a euro negative. Europe is now considered to have some catching up to do on the negative US eco news from the previous quarters and this makes the euro very vulnerable to global negative headlines and risk avers investor sentiment. So, EUR/USD in this global sell-off was hammered again and already tested the key 1.4365/08 support area (this year low/ Dec 07 low) yesterday evening to close the session at 1.4325 compared to 1.4498 on Wednesday. Overnight in Asia, EUR/USD even dropped below this key area, raising a new red alert for the currency pair. In a daily perspective, oil traded also slightly lower again, but this time was not really the main driver for EUR/USD.

Today, the calendar contains the German July production data, but the focus of the markets will be on the key US payrolls report. The consensus expects a loss of 75K jobs and we don’t have strong arguments to question this consensus figure. However, in an environment that is becoming ever more dollar friendly, a positive surprise probably will have more impact than a negative one. The flaring up of global risk aversion of course will continue an important factor, too.

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. As extensively illustrated yesterday, headlines on a global economic downturn currently are considered a dollar supportive and a euro negative factor. The dollar regains part of its reputation as safe haven. After yesterday’s market panic, the market focus probably will be on global themes. In a medium term perspective, we continue to look out whether the US economy will be able to take advantage from the recent decline in oil prices. If so, this would be an additional support for the dollar. It is probably too early to expect this factor to play already a role in today’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 long term 1.5285 range bottom was an outright positive signal for the US dollar. There was a temporary slowdown/ consolidation in the second half of August, but the swift break below the corrective bottom of 1.4570 triggered a new down-leg in EUR/USD with the pair already testing the key 1.4308 area. Yesterday, we suggested that some kind of high profile event was needed to clear this important barrier. Yesterday’s global market panic apparently was enough a reason for this test/break to happen. EUR/USD is now heavily oversold, but we don’t feel any need to row against this strong tide. Yesterday’s break below a key support only highlights the red alert in this pair! Longer-term, EUR/USD has entered a convincing sell-on-up-ticks pattern. A return above the MT moving average in a sustainable way (currently at 1.4618) would be a first indication of easing pressure. Return action above the 1.4908 reaction high would question the short-term USD positive momentum. This is not our favoured scenario.

Recently, USD/JPY was an area of relative calm but yesterday’s resurfacing global economic concerns and the sharp sell-off on the stock markets confirmed the yen hasn’t lost its attractiveness as the ultimate safe haven on the currency markets, even as the dollar has become a good second best. So, yesterday’s global sell-off also left its traces on USD/JPY and the pair dropped below the ST support at 107.27. The pair closed the session at 107.08 and this morning, the 106 support was already tested.

This morning in Asia, stocks remain under heavy pressure. Japanese capital spending for Q2 was very weak, but in the current environment this has no negative impact on the yen, even if the Japanese currency is currently off the highs set in early trading this morning.

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 and gradually slipped through a series of support levels. The break below the 108.15/107.65 area now makes the ST picture for this pair again negative. Global USD sentiment obviously turned positive recently, but in times of stress (and of unwinding of carry trades) the yen apparently is still favoured

On Thursday, for the first time in almost three weeks the sterling didn’t yield additional losses against the euro and even gave the impression that some kind of technical correction could be possible. There was not that much in the way of eco news to explain the move. The HBOS house prices were very close to expectations and also the BOE decision to leave rates unchanged at 5.00% was no surprise at all. On top of that, the move had already started before those two factors were published, so we see the move in the first place as a technical correction on the steep sterling losses recently. Overall euro weakness in other cross rates also played a role. EUR/GBP closed the session at 0.8100 compared to 0.8160 on Wednesday. However, overnight the sterling already gave up part of yesterday’s gains in Asian trading this morning.

Today, the UK calendar is empty. So, sterling traders will focus on cable and EUR/USD.

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, ongoing poor UK 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 weighed on the UK currency. Yesterday’s volatility/correction in EUR/GBP was remarkable, especially as it occurred in an environment of global market tensions, which until now most often was a negative factor for the sterling. Recently we advocated that a lot of bad news for the sterling should already be priced in at the current levels, but that technical indicators continued to be sterling negative. This remains the case especially as EUR/GBP is still above the previous range top (0.8100 area). We would be a bit surprised to see sterling making a powerful comeback in environment of global risk aversion and unwinding of carry trades. Nevertheless, we grow more cautious on EUR/GBP and wouldn’t be surprised if the EUR/GBP uptrend would gradually slow. That said, the technical picture remains EUR/GBP positive and there is no reason to already row against the tide. However, we turn more neutral short-term and are no in a hurry to aggressively buy the pair at the current levels.

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Published on  Fri, Sep 5 2008, 08:01 GMT