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Sunrise Market Commentary

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US Treasuries: failed to profit from global marker disarray

Wed, Oct 8 2008, 07:43 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Wednesday, global bonds traded mainly sideways, although US equities plunged lower for the fourth consecutive session. The Fed measure to start buying three-month unsecured and asset-backed commercial paper to ease frozen lending conditions could only temporarily support the equity markets, while hints from Fed’s Bernanke and ECB’s Quaden that a rate cut is becoming increasingly likely also failed to boost investor’s confidence. On the contrary, US equities sold off with the S&P closing down 5.74%. Despite the huge sell-off on the US equity markets, yields on US Treasuries were still slightly higher on the day (2-6 bps). In the euro zone, there was a huge flattening of the yield curve, as 2-year yields moved sharply higher by 11 bps and 30-year yields were again down 8.5 bps. 2-year bonds however reversed most of their losses after the official closing.

US Treasuries: failed to profit from global marker disarray

The eco calendar is thin today, as it only contains the August pending home sales, which are rather outdated. Pending home sales are expected to fall 1.1% M/M in August after declining a more-than-expected 3.2% M/M in July. We put the consensus on the downside of expectations as earlier released housing market data came out very weak in August.

Fed continues to expand its liquidity-providing into uncharted territory. It now lend unsecured via the creation of a Commercial Paper Financing Facility. This is a huge step that might ease pressures also in the interbank funding market.

The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants.

The SPV will buy CP based on a spread over 3 month OIS. (spread of 100 bps is whispered as a possibility). It would bring CP rates sharply down.

In his speech, Bernanke clearly paved the road for a rate cut. On inflation, he said (in the Q&A), that the outlook does look better and it will moderate pretty significantly over the next quarters. At the same time, he said that the downside risks to growth have increased and thus he concluded the Fed will need to consider whether the current stance of policy remains appropriate. So, it comes down to a timing issue. As we explained recently, it would be best that the Fed waits to cut rates until the tensions in the money markets diminishes somewhat and the transmission mechanism starts to function again. In this respect, we’ll look closely whether its most recent farreaching attempt, notably buying CP will be successful. If it starts to improve, a rate cut would make more impact and would prevent the potential loss of credibility that might occur when it cuts rates and market lending rates (eg. Libor) stay little changed. In this context the FOMC meeting of October 28/29 looks a good occasion to act. Of course, a coordinated rate action is also possible and with the G7-meeting at the end of the week, chances for a rate cut certainly increase, or even in case a coordinated action isn’t possible, a further seizure of markets may be enough to trigger an inter-meeting rate cut. Regarding the size, a cut by 50 basis points is nearly a certainty, but the risks for an additional 50 basis points rate cut later on increases by the day, even if there is still resistance for such a second step inside the Fed. The 1% FF rate is associated with the building of bubbles, but given the expected sharp fallout from the credit crunch on the economy we suspect that over time the Fed may decide it cannot do otherwise. The Minutes of the September FOMC stated that some members emphasized that if intensifying financial strains led to a significant worsening of the growth outlook a policy response could be required. Such an intensifying has of course occurred, probably to an extent even the governors couldn’t have thought about.

The 4 week T-bill auction showed once more how investors are scrambling for short-dated government paper. The auction stopped at 0.68%, 15 basis points below the WI bid. The bid/cover of 3.26 was very high and compares to last week’s 2.80. The first 150 billion $ 84 day TAF auction (up from 25 billion $) attracted 138 billion $ in bids (compared to 38.6 billion $ previously), for a bid cover of 0.92. As a result all bids were awarded at the minimum bid of 1.39%. The TAF offerings of the ECB and SNB auction were oversubscribed (covers of 4.43 and 2.23 respectively), suggesting once more that dollar liquidity problems are still bigger in overseas markets.

Regarding trading, there is little new regarding the driver, financial sector angst and increasing risk of a severe recession. However, while equities dropped another 5%, again closing at the lows and painting another marubozu (exhaustion) signal on the charts, Treasuries held more to a sideways pattern. Overnight, Treasuries resumed its move higher, following a dismal equity session in Asia, where the Nikkei dropped 9.4%, the third biggest single day decline ever. Yields are down 6-to7 basis points across the curve. Also European bond markets opened sharply higher, probably in anticipation of more panic in equity markets. In such an atmosphere, Treasuries might once again be favoured and another “special” action of government possible (rate cut after all?). Of course, the government is running out of options. A massive re-capitalization might be needed, but it is difficult to decide one month before the presidential elections and a few plans after the TARP, that was hoped to calm the spirits. From a technical perspective, one would expect that the multiple steep declines had exhausted the down-move, but it ain’t normal circumstances, leaving all odds over regarding the end play. Interesting, but frightening, the 30-year yield is currently again testing the all time lows and a clean break would of course suggest that the markets are playing with the idea of depression and this seems to be the message of the equity markets too.

German 10-year yields approach key support levels amid deepening financial crisis

Today, the focus will remain on the policymaker’s response to the ever deepening financial crisis. In this context, the outcome of yesterday’s meeting of the EU Ministers of Finance was very disappointing, as they failed to agree on a common plan to tackle the current crisis. The only point of agreement was reached on a set of principles and an increase of the deposit guarantee to EUR 50 000, although some countries might raise the figure to 100 000. The current national case-by-case approach will therefore continue, but is unlikely to solve a global crisis. In this context, the UK and Spain already announced aggressive measures to safeguard their banking sector. Spain will set up a US like EUR 50 B fund to by bank assets and is thereby the first to copy the US strategy. In the UK, no specifics are known yet, but the government is likely to step in the capital of the banks.

On the central bankers front, the ECB yesterday injected a huge amount of liquidity in their weekly tender and will double the amount of its 6-month tender today from 25 to 50 B EUR. A coordinated rate cut today cannot be excluded following comments yesterday of Fed’s Bernanke and ECB’s Quaden, but the success of such a move is highly uncertain as long as the money markets are freezed and confidence between banks isn’t restored. Yesterday, the Euribor fixings continued to move up increasing the liquidity spread, which is a measure of the tensions in the money markets.

On the data front, the euro zone calendar contains only German industrial production (August) and the final figure of second quarter euro zone GDP. German industrial production is expected to show a decline of 0.3% M/M in August after falling a morethan- expected 1.8% M/M in July. In recent months, the German manufacturing sector showed a weakening and also manufacturing PMI fell clearly below the benchmark level of 50, which points to a contraction. However, factory orders came out surprisingly strong, but we think this is only an outlier as the trend is clearly down. The final Q2 GDP figures are expected to confirm the preliminary reading and no major movements are expected.

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. But also at the longer end of the curve, the picture is becoming more bullish, as 30-year yields dropped below the neckline of a multiple top formation and 10-year yields are approaching the neckline of a massive double top formation at 3.65%. A break below would bring the all time lows at 3% again in the picture.

In the UK, the NIESR institute estimated that the UK economy shrank 0.2% in the three months through September and called on the Bank of England to cut rates by 50 bps at its meeting tomorrow, which is in line with current market expectations.

Currencies: Global market panic hammers USD/JPY below 100- mark

On Tuesday, the financial meltdown continued with full force. Early in European trading it looked as if European stock markets (or at least some sectors within those markets) could enter calmer waters and this also to some extent eased the pressure on the battered euro (especially on EUR/JPY and on EUR/USD). The euro even rebounded further on the announcement of the Fed plans to support liquidity in the CP paper market. This may sound a bit strange at first sight. However, an easing of global stress in the current context usually tends to support the single currency. On top of that, in case these kinds of measures would lead to an easing in the tensions on the USD money markets, this often mentioned as potentially reducing the demand for dollars on the currency markets. We’re not really impressed by this liquidity argument, but especially as it helped for a (very brief) relief at the open of the US stock markets, it also supported EUR/USD at that time and the currency pair rebounded to set an intraday high in the 1.3740 area. However, the ‘relief’ on the US CP plan was very short-lived and as US stock markets dived later in the session, EUR/USD gave up the early gains. The US Fed president opening the way for a Fed rate cut (perspective of lower inflation) at that time even was seen (moderately) positive for the US dollar. EUR/USD closed the session at 1.3588 compared to 1.3499.

Overnight, Asian markets show no sign at all of an easing in the level of global investor panic, but at least for now, this causes no additional losses for EUR/USD.

Today, the calendar again only contains some second tier economic data in the US and Europe. However, currency markets will continue to be driven by the developments on the global markets and by the initiatives to address the fall-out from the credit crisis. Over the previous 24 hours there were some tentative signs that both the Fed and the ECB gradually move closer to an (coordinated?) emergency rate cut. With global stress still mounting, the chances on such a move are rising, but we stick to our view that the impact of these kinds of measures might again be limited as long as no ‘structural’ solutions are put in place. So, we remain skeptical on this item. Nevertheless, if it occurs, we tend to think that easing tensions (if they were to occur on such a move) could be cautiously positive short term for the single currency in general and EUR/USD in particular. 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. The lack of a credible, coordinated European approach remains negative for the single currency. In these erratic trading conditions, we tend to give more attention than usual to the technical picture.

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 and the pair fell below the previous low (1.3882) and the longstanding daily uptrend line since 2002 (today in the 1.3985 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 area (breakdown) is needed to really call off the alert. Obviously, we are not at that point yet. Yesterday, the pair enjoyed a (temporary) consolidation, but with also EUR/JPY still under quite some pressure, we see no reason to turn less negative on EUR/USD for now.

During Tuesday’s trading session, the gyrations in the stock markets were still the main driver for USD/JPY trading. The reaction on the US CP support program was very limited and very short lived (USD/JPY only gained a few ticks). Later in the session, US stock markets were again sold off in an aggressive way. This kept USD/JPY under downward pressure too, but the losses at that time were still rather contained if compared to the ravage on the stock markets. USD/JPY closed the session at 101.47, little changed compared to the 101.82 close on Monday.

However, overnight Asian stocks showed ever more panic selling with the Nikkei losing almost 10% at the moment of writing and this triggered a new wave of safe haven yen buying with the pair breaking below the high profile 100 barrier this morning.

On the technical charts, USD/JPY global market stress hammered the pair through the 103.50 range bottom on Monday. Until the end of last week, we were not always impressed by the yen performance. However, the global tensions have now again become severe 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 bottom. 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. In this respect, coordinated actions by central bankers, if they would occur, could cause a sharp U-turn to the current uni-directional yen long market. So, yen longs should consider trailing stops to protect their positions. Of course in the current market conditions one could raise the question whether it is technically possible to execute such a strategy.

Yesterday, some easing in the overall downward pressure on the single currency and the high degree of uncertainty with respect the UK banking sector (debate on whether or not major UK banks had asked for government support to shore up their capital) caused EUR/GBP to perform quite a significant rebound early in European trading with the pair returning to the 0.78 barrier at that time. However, the pressure on the sterling gradually eased later in the session. The pair hovered up and down during the US trading session and closed the session at 0.7787, compared to 0.7742 on Monday.

This morning, the nationwide consumer confidence (50 from 52) and the NIESR GDP estimate (-0.2) were as bad as expected. However, in the current environment, this is no news for the currency markets. The key factor for the sterling trading today will be the UK plan for the financial sector. At the moment of writing, the plan is not yet available. Recently, officials indicated that an important part of the plan could be measures to support the capital basis of the UK banks. However, with no details available, the impact on markets in general and on sterling in particular is difficult to asses. The UK banking stocks at least were not really happy on the idea. In normal circumstances, one would consider a plan better than no plan (sterling positive), but in the current environment this is far from an evident call.

Recently, the sterling showed remarkable resilience vis-à-vis the euro (despite global market stress and ongoing poor UK eco data) and dropped below the key 0.7760 area on Monday morning, 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, recently 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 hold on to our view that we’re not convinced that the UK eco and financial fundamentals call for a sustained rebound of the UK currency against the euro. However 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. The UK bank plan is a wild card today.

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Published on  Wed, Oct 8 2008, 07:56 GMT