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Sunrise Market Commentary

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US Treasuries bolstered by ongoing equity crash

Tue, Oct 7 2008, 07:53 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Monday, global bonds rallied sharply higher, as the confidence crisis reached new highs with investors all over the world dumping equities. The panic came in the market as soon as Asian markets opened on Monday morning. The lukewarm response of US investors on the TARP approval on Friday eve and the spreading of problems in the European banking system, put into evidence by a number of individual accidents in the weekend, got the ball rolling. The absence, at least until now, of a coordinated response to the banking problems, especially in Europe, makes investors think the worst.

Indeed, the complete freezing of funding markets will very rapidly hit the already weakened global economy and could lead to a deep recession, some say depression. So yesterday, while financials lost again quite some ground, investors dumped all kind of stocks, without discrimination. Equity losses (indices) mounted to 6 to 9% in Europe, often registering the biggest daily losses in decades. In the US, equities ended well off the intra-day lows and lost around 3.5% to 4.35%.

The super safe government bond markets fared well and yields fell again sharply, between 11 and 20 basis points in the US and between 17 and 22 basis points in EMU (Germany).

Overnight, the Australian Reserve Bank took the unusual decision to cut rates by a full 100 basis points (India cut by 50 basis points), in an attempt to restore confidence. Asian bourses were already off the intra-day lows when the decision was announced. The Australian decision might be a precursor of a coordinated action by other central banks in the world that might lead to a relief rally. However, it will be a difficult decision, as its success is not guaranteed. Indeed, with the transmission mechanism impaired, it remains to be seen how a rate cut will affect market rates. Of course, the central banks may have little alternatives left. The liquidity-providing is needed, but is no measure that resolves the key problem of the solvency of part of the banking system and the loss of confidence in counterparties that resulted in a liquidity problem. There should be a comprehensive package focussed on the solvency problem, which is supported by sharp rate cuts.

US Treasuries bolstered by ongoing equity crash

The eco calendar is uneventful containing only the weekly retail sales and ABC consumer confidence and the August consumer credit. More interesting are the Minutes of the September 16 FOMC meeting, when the Fed kept rates unchanged, but hours later helped the AIG bailout put together. Government Fisher rejoined his colleagues instead of dissenting in favour of a tighter policy. However interesting the Minutes may be it is the speech of Fed chairman Bernanke in Washington that may be still more important.

The Fed is very in its attempts to keep liquidity flowing: It will double its auctions of cash to banks to as much as $ 900 bln, and said it will begin paying interest on the cash reserves banks hold at the central bank. As part of Monday's steps, the Fed will increase its auctions under the 28-day and 84-day Term Auction Facility operations to $150 bln each. The two forward TAF auctions in November will be increased to $150 bln each (Bloomberg). It is apparently also considering a still more drastic step, notably according unsecured lending to companies that are cash strapped, via the purchase of commercial paper.

Yesterday, Dallas Fed Fisher softened its tone, saying that he was less worried than before about inflation risks when the financial system would be repaired. St-Louis Fed Bullard on the other hand repeated his opposition against lower rates, as it may do more harm than good. Chicago Fed Evans didn’t address monetary policy.

Regarding trading, it was all fear that drove the action. However, US stocks staged a late session rally, halving its intra-day losses in the close. It is difficult to interpret yesterday’s intra-day equity rally. Technically, it doesn’t qualify as a trend reversal signal, but on the other hand it is obvious that the market is hugely oversold and the recovery from the lows intra-day is a positive. The VIX is above 50 (intra-day 58) extreme levels that in the past were always followed by some kind of government intervention and a rebound in equities that recently was very short-lived though. So this talk about a co-ordinated action fits very well this historical pattern. It might mean that the risks are today for a rally in equities and a move lower in Treasuries. Of course, this is all short term outlook. Longer term, equities aren’t out of the woods, eco growth will look ugly in a few months time and rates will be slashed. Technically, the outlook is positive for Treasuries, but the Dec Note future could not break above key resistance at 118 (which would have painted double bottom pattern). So, should we get some government action and/or equities would rise, there is room for profit taking in Treasuries. Regarding, rate cut expectations, the October FF rate closed at an implied 1.37 basis point yesterday, the January contract at 1.29%. While the liquidity conditions might have some impact of the October contract that isn’t linked to rate cut expectations, it looks that already quite aggressive action is discounted. So, overall, in a still very promising climate for Treasuries, we speculate on one of those recently frequent steep downward corrections to consider a buy-on-dips.

Calls for more European coordinated action increase, as markets crash

Today, the euro zone eco calendar will once again be overshadowed by the developments in the global financial markets. The sharp falls in the equity markets yesterday increased the need for further action from the policymakers to restore confidence in the financial markets. In this context, the EU issued a statement that ‘it will take whatever measures are necessary to maintain the stability of the financial system’. There is however no agreement whatsoever on a European plan to help the banking system. Yesterday, Italian PM Berlusconi and EU Monetary Affairs Commissioner Almunia called for governments to take more coordinated action and to avoid unilateral decisions. Today, the EU Finance Ministers will meet again in Luxembourg.

In the UK, Chancellor of the Exchequer Darling is considering a partnationalization of the banking system by taking an equity stake in those banks that requested it in exchange for generous dividends and capital gains. Today, the government will also publish a banking bill giving the Bank of England statutory powers to intervene in failing banks and to provide for an element of pre-funding by banks of the depositor compensation scheme. The UK may also extend the guarantee on retail deposits from the current level of £ 50 000. Following last week’s move in Ireland to guarantee all deposits of the sixth largest banks, Germany, Sweden, Denmark, France and Italy have taken already similar measures.

Overnight, the decision of the Australian central bank to cut rates by 100 bps may increase speculation in the market that other central bankers may follow suit soon. Yesterday, the BCC and CBI called the Bank of England to cut interest rates by 50 bps on Thursday. Although several ECB governing council members (Tumpel-Gugerell and Bonello) called for a ‘prudent approach’ and to ‘avoid hasty steps’, a coordinated rate cut by 50 bps cannot be excluded. The main problem however remains the monetary transmission mechanism, as the Euribor and Libor fixings continue to move higher, despite the speculation on lower interest rates. As a result, the liquidity spread continues to widen. Hence, a rate cut may fail to lower inter-bank lending rates and may therefore backlash as long as there is no plan to improve the solvency of the banks. Therefore, the ECB may still want to wait on a solvency plan before cutting rates. Today, the ECB will hold its weekly refinancing operation.

In the current crisis, we continue to prefer the short end of the curve, as the rapid worsening of the economic outlook will persuade the ECB to cut rates aggressively in the months to come. Today, German factory orders for August will be released and are likely to confirm the weakening of the economy, although orders are expected to rise for the first time in nine months. Yesterday, the technical picture of the Bund improved following the break higher above 116.13. A sustained break higher would suggest that a new up-leg is in the making.

In the UK, the calendar is attractive today, with the releases of August industrial and manufacturing production. Both are expected to show a decline with industrial production falling 0.1% M/M and manufacturing production declining 0.2% M/M. We put the risks on the downside of expectations after the sharp declines in the manufacturing PMI.

Currencies: Euro sell-off continues.

On Monday, trading in EUR/USD developed along the same lines that were already set out at the end of last week. The European banking sector remains in the eye of the storm and this continues to weigh on the single currency. Through the cross rates, the sharp sell-off in EUR/JPY due to global risk aversion added to the downward pressure in the EUR/USD headline pair and, last but not least, the (deflationary) decline in the oil price is also a negative for EUR/USD. So, EUR/USD opened the week with steep losses in Asia after European governments ad to take (separate, non-coordinated) actions to try to shore up the financial system and EUR/USD extended its decline throughout the session, close the day at 1.3499, compared to 1.3772 on Friday last week. There were hardly any eco data on the agenda and if any they were completely ignored for currency trading.

Overnight, ,the RBA surprisingly cut rates by 1% (from 7.00 % to 6.00 %) and this fuelled market speculation that other central bankers might consider a similar (coordinated?) action in the hours/days to come. This helped Asian stock markets to recoup part of the earlier losses and (supported by a cautious rebound in EUR/JPY) also helped EUR/USD to regain around one figure with the pair trading in the 1.36 area at the moment of writing.

Today, the calendar only contains some second tier economic data in the US and Europe. Markets will again focus on the developments in the credit markets and on the stock markets and the debate on potential interest rate cuts by other major central bankers will probably also intensify. With respect to the latter, an (coordinated) emergency rate cut might bring some short-term relief for stocks and other assets that were recently hit by rising global risk aversion. However, one might doubt whether this will contribute much to a structural solution for the problem of undercapitalization and the lack of money market liquidity that needs to be addressed to help the banking sector to gradually resume its function of financial intermediary for the economy. So, such a move could, if it were to occur, temporary ease the pressure on the stock markets and on the cross rates that were hard-hit recently (as was the case for EUR/USD and EUR/JPY). However, we’re far from convinced that this will be enough to cause a lasting U-turn. So, in a day-to-day perspective a slowing in the steep EUR/USD downtrend is very well possible. However, in a long-term perspective, it is much too early to draw the conclusion that the environment that proved to by highly negative for EUR/USD will change in a lasting way, even in case of coordinated interest rate cuts.

From a technical point of view, EUR/USD rebounded from the 1.3885-area and set a new reaction high in the 1.4865 area. This was a significant correction, but the key 1.4900/10-area (reaction highs) was not challenged and last week EUR/USD turned again south. The pair fell below the previous low (1.3882) and the longstanding daily uptrend line since 2002 (today in the 1.3980 area) making the MT picture outright negative for the pair. Sustained return action above the previous low (1.3882) would be a first indication of an easing in the euro sell-off. The pair regaining the 1.4310/1.4225 area (breakdown/MTMA) is needed to really call of the alert. Obviously, we are not at that point yet. So, this remains EUR/USD sell-on upticks environment medium term. The pair is now heavily oversold and some short-term consolidation might be on the cards.

It has been different sometimes in the past, but ever mounting tension in the financial system and the investor risk aversion indicators going through the roof, this time created a perfect environment for the yen to capitalize on its save haven characteristics. USD/JPY started trading in Asia in the 105 area but was already hammered to the 103-area at the start of European trading. After a temporary consolidation, the pair got another battering as global stocks were in free-fall after the opening of the US stock markets. The pair tested bid in the 100.30 area and closed the session at 101.82, compared to 105.32 on Friday. For EUR/JPY, the sell-off was even more spectacular as the down-move in USD/JPY was reinforced by steep EUR/USD losses. At some point, the pair even traded 10 yen lower compared to the close of Friday. EUR/JPY closed the session at 137.50 compared to 145.11.

This morning, the BOJ left rates unchanged at 0.50 %. For now, a rate cut is apparently not yet considered. The BOJ acknowledged that growth has been sluggish and that this condition may persist for some time given the slowdown in overseas economies is becoming clearer. Asian/Japanese stocks regaining some of the early losses (partially triggered by the RBA rate cut) helped USD/JPY to recoup part of yesterday’s steep losses with the pair trading in the 103 area at the moment of writing.

On the technical charts, USD/JPY set a reaction low in the 103.55 area after the Lehman crisis. The hope on a US bail-out plan propelled the pair again higher in the 103.55/110.68 trading range. However, the gains could not be extended and renewed global market stress caused the pair to fall below the 103.50 range bottom yesterday morning. Recently, we were not always impressed by the yen performance. However, the global tensions apparently have now become sever enough for the yen to take advantage of the situation. The ST picture in this pair remains negative as long as it holds below the 103.50 previous range. For now there is no reason to row against the yen positive tide. However, we are reluctant to buy into the yen at the current juncture. It is dangerous to buy a safe haven asset at the top of market stress. If the global stress eases, even if it is only in a marginal way, this kind of safe haven positions might yield steep losses, too.

Yesterday, the steep overall euro losses at the start of trading in Europe were also mirrored in EUR/GBP and the pair opened well below the 0.7760 support (at around 0.EUR/GBP 0.7720). However, contrary to some other major euro cross rates, the losses in EUR/GBP were not extended. On the contrary, EUR/GBP even rebounded as global stocks were hammered by a new selling wave on the stock markets after the open of US trading. So, at that time, the sterling even lost ground even against the battered euro. So EUR/GBP closed the session at 0.7742 compared to 0.7778 on Friday.

Today, the UK calendar contains the UK industrial production data. Markets will also take a look at the domestic debate on the guarantee of deposits and on a plan to inject capital to shore up the capital basis of the banks. Looking at the performance of the (UK) banking stocks yesterday, the effect of this kind of measure at least looks ambiguous from a market point of view.

Recently, the sterling showed remarkable resilience vis-à-vis the euro (despite global market stress and ongoing poor UK eco data) and dropped below a series of intermediate support levels and yesterday morning the pair attacked the key 0.7760 area, the bottom of the longstanding sideways trading range. Already for some time, we advocated that we didn’t see the need for a major/sustained comeback of the sterling against the euro based on the eco (and financial) picture in both areas. However, over the previous the global sell-off in the euro obviously was the dominant theme on the currency market and the break below the 0.7766 range low is a high profile technical alert that shouldn’t be ignored. We stand aside for now. Longer term, we are not convinced that the UK eco and financial fundamentals call for a strong sterling rebound against the euro, but as long as the hyper euro-negative sentiment on markets persists, this is not a good argument to fight the current EUR/GBP sell-off. In will be interesting to see how EUR/GBP reacts in case of an easing in global market tensions (Which currency will profit the most in such a scenario?).

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Published on  Tue, Oct 7 2008, 08:04 GMT