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Sunrise Market Commentary

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US Treasuries: safe haven in turbulence

Mon, Sep 15 2008, 08:03 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Friday, global bonds traded mainly lower, as US equities showed some resilience in spite of the uncertainty on the fate of Lehman Brothers. Speculation about a take-over of the embattled investment bank supported the broad equity market and pushed bonds off the intra-day highs. The eco data played only a minor role in trading given the tensions in the financial markets. As a result, bonds reacted only slightly to the downward surprise in the PPI and retail sales as well as to the unexpected strong rebound in the Michigan consumer confidence. Both in the US and the euro zone, there was a steepening of the yield curve with short-term yields falling slightly compared to higher yields at the longer of the curve. In a daily perspective, US yields were down 1.7 bps in 2-year yields and up 9.4 bps in 30-year yields. In the euro zone, the benchmark change of the Schatz pushed 2-year yields down 3.8 bps compared to a rise of 9.2 bps in 30-year yields.

For comments on the week-end events, please see the bond and forex sections below.

US Treasuries: safe haven in turbulence

Today, all attention will go out to the events in the financial sector, while the economic data will be on the backburner. Nevertheless, there are a number of interesting releases like the September NY Fed survey on manufacturing and the August Industrial Production. In August, the headline figure of the NY Fed manufacturing survey surprised on the upside, coming out at 2.8, while the expectation was at -4.0, but the underlying picture remained very weak, as new orders and shipments deteriorated. In September, the consensus is looking for a marginally lower headline figure of 1.3, which would keep the index marginally above the growth/contraction threshold. Traditionally the indicator shows huge volatility and is often surprising analysts. Industrial production is expected to fall 0.3% M/M in August, after an upwardly surprise (0.2%) in July. Most of the decline will be due to a fall in car production, as domestic carmakers reduced their production sharply.

The financial crisis might now have reached its final phase, as systemic risk is at uncomfortable heights. The investment banking model is probably a thing of the past and other financials will once more have to confess that more toxic debt is on their books or that such debt is still worth less than thought until last Friday. Other financial players, like hedge funds, might have burnt their fingers too in the latest development. The unwinding of trades with the failed Lehman carries risks of some unforeseen developments. So, there are enough elements to drive bearishness to an extreme.

Asian equity markets, like Japan, China and Korea, are closed, but those that are open trade understandable sharply lower, with the financials hit the most. A similar reaction may be expected when Europe opens and later on as Wall Street enters trading. However, it will be interesting to see whether follow through selling occurs or whether the market rebounds later on. Indeed, this weekend’s events might also be the catalyst for a wash out that might be the precursor for a bottoming of the financial sector. The S&P is about 4% from its cycle bottom (1200) and it will be crucial to see whether this level holds. In the past, we often saw that in such circumstances, bottom fishers appeared and shorts covered positions. Should the index fall below 1180/60, we would think that the market is shifting from a soft growth, no inflation scenario to a deflation scenario, where a global recession is a possibility.

Longer term, it is clear that downside risks for the global economy have increased. The credit channel will remain crippled for longer and so firms/households will have more difficulties to secure funds for investing/consuming. The confidence channel will also affect both households and firms negatively. This means that central banks are again in the play. Inflation will fall sharply and so will inflation expectations (that have already done so in recent weeks). There is some talk about an emergency rate cut by the Fed today. One cannot exclude such a step, but we doubt it for several reasons. The Fed explicitly didn’t want to bail out Lehman for moral hazard reasons and to stop the bet some were playing in markets (selling short investment houses & banks/sometimes going long bonds). Cutting rates now would mitigate that message and put into question the measures taken yesterday. The FOMC will also meet tomorrow, making a move today looking pure panic. Even a rate cut tomorrow is rather unlikely, we think, for similar reasons. However, further out it is clear that rate cuts are likely, but probably framed in an inflation/growth story, not as an eye-catching rescue action for the financials. However, from an investment perspective, the difference is not so important right now: being at the short end of the curve looks appropriate.

ECB rate cut expectations gain momentum

Today, all attention will go out to the developments on the financial markets following the bankruptcy of Lehman Brothers. This will lead to additional tensions global financial markets with investors looking for shelter. This should favour government bonds, the principal safe haven place. The short end of the curve should profit most, which is already reflected in the sharp higher opening of the US Treasury and European bond markets this morning.

With regard to the ECB interest rate expectations, this suggests that markets are bringing ECB rate cut expectations forward in time. Until now, the ECB has always made a clear distinction between the developments in the banking sector and the monetary policy which remained focused on the outlook for price stability. In July, the ECB even hike rates to 4.25% despite the ongoing turmoil in the financial markets, as the inflation outlook had deteriorated. However, recently the outlook for price stability has improved and this may mean that the objective of price stability is less of an obstacle to cut rates compared to some time ago. This was highlighted by comments of ECB’s Weber, who is one of the most hawkish and influential members of the ECB governing council. He said that the outlook for inflation has brightened and called the recent fall in oil prices ‘reassuring’. As such, he concluded that ‘he is more confident now than a few weeks ago that the recent developments have contributed toward meeting our objective’ and didn’t exclude that inflation will fall below the 2% level in 2009. Some time ago, Weber still doubted whether inflation would fall on average below 2% in 2010. On Friday, ECB’s Wellink already suggested that things might change with regard to the outlook for monetary policy, as the drop in oil and commodity prices and a weaker real economy have a positive influence on the inflation outlook. Both however stressed that it is too early to give the all clear on the inflation front, as there are still some pipeline pressures from past increases in commodity prices and given the wage developments. In our view, it’s nevertheless clear that things are changing rapidly at the ECB and due to the recent developments with Lehman Brother rate cut expectations may gain momentum rapidly.

As such, the release of the euro zone Q2 labour costs won’t be a strong driver for today’s markets and should be considered as a backward looking inflation indicator, which won’t have a large impact on monetary policy anymore, despite recent ECB warnings about second round effects and the fears for a wage price spiral.

Regarding trading, we don’t go against the flow today and take on a bullish view on the bond markets, especially at the short end of the curve, as the comments of the ECB indicate that they are becoming more comfortable with the inflation outlook. This may mean that rate cuts are not the far distant prospect anymore they were even a month ago. As such, we clearly favour the short end of the curve and look for a bullish steepening of the European yield curve. At the same time, risk aversion will increase further, which will mean that the swap spread will become ever wider, as well as the intra-EMU government bond spreads.

Currencies: The new episode in the (US) credit crisis slows the USD rebound

Friday’s trading session marked the end of a week-long decline in EUR/USD. During the morning session in Europe, EUR/USD already moved higher, at that time support by a better stock market sentiment. However, later in the session the uncertainty on the fate of US investment bank Lehman brothers gradually changed the recent trading paradigm. Recently, rising uncertainty supported the yen and the dollar and was a negative for the euro. However, the lack of visibility on the US policy approach with respect to Lehman and a growing number of indications that the US authorities were no longer prepared to bail out the ailing investment bank at any price gradually changed investors’ positive attitude towards the dollar. EUR/USD throughout the US trading session and over the weekend staged quite an impressive rebound. The pair reached an intraday/correction high in Asia in the 1.4475/81 area this morning. However, EUR/USD already gave up part of its gains after the announcement Lehman filling for bankruptcy.

Of course, the Lehman story is not the only part of this weekend’s story. A group of major banks forming a pool to support market liquidity and Bank of America taking over Merrill Lynch could be considered as factors that could limit the spreading of the damage of the crisis. Today, there are some less important eco data on the calendar in the US, but the escalation of the credit crisis will be the most dominant theme for trading today.

Over the previous weeks, EUR/USD was caught in a forceful downtrend. The decline in the oil price and growing signs of a deterioration in the European economy (and elsewhere outside the US) caused a sharp re-allocation in favour of the dollar. The dollar even became favoured over the euro in case of global investor uncertainty, even if the source of that uncertainty came from the US. However, as indicated, this paradigm as been overthrown last Friday. Markets will now try to assess the next policy steps. After this weekend’s turbulence, the markets will probably speculate on additional US interest rate cuts. However, we are not sure of the Fed making such a step already today or even at this week’s Fed meeting. The Fed will probably focus on the effect of the technical measures to support market liquidity and any additional rate cuts will probably in the first place depend on the economic impact from the crisis. On top of that, the fall-out of this crisis on the European economy (and the European financial system) will also raise speculation on ECB interest rate cuts sooner than anticipated until now. So, the impact on EUR/USD could be more balanced than one might assume at first sight. Recently oil was also an important driver for EUR/USD and the oil price extends its decline this morning. However, we don’t think that oil will be a key factor for EUR/USD trading in the current environment.

From a technical point of view, on Friday we already indicated a first potential sign that the downtrend was losing momentum and the price action on Friday and over the weekend indeed suggests a halt to the standing EUR/USD decline. The pair currently testing the MTMA is another indication. The picture is still far from cleared out and one should expect more wild swings in the days to come. However, for now we assume EUR/USD to have entered a consolidation pattern between 1.3882 (reaction low) and the 1.4575/80 breakdown area. A re-break above the latter would indicate a further loss of momentum in the dollar. While this is not our preferred scenario, in the current environment of elevated market stress, stop-loss protection on EUR/USD shorts is warranted.

On Friday, USD/JPY trended gradually higher throughout the session. Especially the pair holding up rather well during the US trading hours (given the Lehman uncertainty) was remarkable. The sharp rebound in EUR/JPY at that time through the cross rates might have played a role. Nevertheless, over the weekend, the logical market reaction was again re-established and USD/JPY dropped rather sharply on the Leman crisis with the pair testing bids in the 105.30 area this morning. Japanese markets are closed this morning for local holiday. Of course, also for yen trading the developments on global (credit) markets will be key today.

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. There were some tentative signs that the correction was slowing last week, but the developments over the weekend again caused USD/JPY testing the recent lows in the 105.55 area. Our call for range trading in the 105.53/110.67 sideways range is under heavy pressure. Stop-loss protection to defend a break is warranted in the current environment. The yen should remain well supported as long as current market tension persists.

On Friday, EUR/GBP extended its correction lower and tested bids in the 0.7915 area late in the session on Friday. The move was again mostly technically inspired as there were no important UK eco data on the calendar. Over the weekend, the sterling also became a victim of the global financial uncertainty and EUR/GBP even temporary returned to the 0.80 area and trades in the 0.7965 area at the moment of writing.

Today, the UK eco calendar is empty. As for all other major cross rates, global market developments will also set the tone for sterling trading. Recently, sentiment turned somewhat less negative on the sterling, but we would be surprised the see sterling gaining further ground in an environment of heightened financial stress and risk aversion (unwinding of carry trades).

Two weeks ago, EUR/GBP tried to break out of the longstanding sideways 0.7760/0.8098 trading range, but the test was rejected and this triggered a correction sending the pair lower in the previous range. In line with EUR/USD, we indicated on Friday that the EUR/GBP correction could lose momentum. We hold on to that view, even if the losses for sterling/rebound in EUR/GBP over the weekend are far from spectacular. We hold on to our view that it is too early for a major/sustained comeback of the sterling. For now we stay neutral on EUR/GBP.

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Published on  Mon, Sep 15 2008, 08:17 GMT