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Sunrise Market Commentary

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US Treasuries got hit despite equities losing some more ground

Thu, Oct 9 2008, 08:47 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Wednesday, global bonds couldn’t gain on the coordinated rate cut by 50 bps from the Fed, ECB and other central banks. The belly and longer end of the curve even suffered huge losses, as the US Treasury announced 40 B USD in new supply to ease severe dislocations in the Treasury market. As such, the ongoing sell-off on the equity markets failed to support the bond market. In a special flash published yesterday, we provide some further insight into the implications of yesterday’s rate cut for ECB policy rates.

In a daily perspective, US 2-year yields rose 9.5 bps compared to 17.5 bps in 5-year yields and 2 bps in 30-year yields. The tap of the 7-year Treasury bond however pushed 7-year yields 55 bps higher. In the euro zone, there was a sharp steepening of the yield curve with 2-year yields falling 13.5 bps, but 10- and 30-year yields up respectively 5 and 4 bps.

US Treasuries got hit despite equities losing some more ground

Today, the calendar is again thin and only contains the weekly claims. Last week, both initial (497 000) and continuing (3 591 000) claims surprised on the upside and also the payrolls came out very weak falling 159 000. In the week ended October 4, initial claims are expected to show a decline of 22 000 to 475 000, but continuing claims are expected to rise further to 3 608 000. Initial claims are expected to ease somewhat after the effects of the hurricanes Gustav and Ike fade.

The FOMC, unanimously, cut its FF rate in an inter-meeting and co-ordinated action to 1.5% from 2% previously and in a related action also the discount rate was cut by a similar amount. In its statement, the FOMC said that the pace of growth had slowed markedly in recent months and as a result of the financial turmoil additional restraint on spending is expected. On inflation, the Committee stated that while inflation has been high, it believes that decline in commodity prices and weaker eco prospects have reduced upside inflation risks. The statement concludes that the Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable growth and price stability. The FF future had anticipated a rate cut, but following the decision revised expectations for further action. The January FF contract now trades at an implied 1.19%, discounting a further 25 basis points rate cut and a 20% chance on a 50 basis points cut. Given the carnage the recent period of financial stress, which is not over yet, has done to the real economy, we suspect that the Fed might be obliged to cut its rates to 1% later on.

The Treasury announced and conducted a series of special auctions as a response to ongoing dislocations in the repo-market for a total amount of 40 billion $. Yesterday, it auctioned the 4.125% May 2015 and 4.25% August 2015. Today, it continues with the 4% February 2018 and with the 3.5% February 2018. These off the runs were in the CTD basket. As a result of the auctions, these Treasuries cheapened sharply making the curve smoother. However, also the other issues and the benchmarks were affected, albeit to a slightly lesser extent. Like seen in previous periods of stress, the on-the-runs are especially looked for, making the difference with the offthe- runs much more pronounced than in calmer times. We saw recently also quite some dislocations at the large end in the European market, that gives some strange market-internal inspired moves. Both auctions saw thin and not aggressive bidding. The 10-year TIPS re-opening stopped above the WI bid side, but the bid/cover was okay and the indirect takedown solid. However, the TIPS auctions have little impact on the overall market.

Regarding trading, as explained above, especially supply issues and market internal items were behind yesterday’s strange moves. Of course, the market had expected a rate cut and so some buy-the-rumour-sell-the-fact reaction couldn’t be excluded. Nevertheless, the volatile, but after all disappointing reaction of equities makes the Treasury reaction disappointing. The turnaround intra-day may also have had a technical aspect. Indeed, both 2- and 5-year yields tested intra-day the sell off lows and approached the mid-March lows, when the tide turned and yields went north again. A similar picture was not yet apparent in the 10-year yield, but the Dec Note future did test the recovery high at 118-01+ before turning south. The 30-year yield exactly ticked the 3.8950% all-time low before moving up.

Concluding, supply issues and technical elements explain yesterday’s move. It is a wake-up call that even in a bond friendly climate, one should not count too much on a one-directional market. So, the risk is for some follow through selling today, as more auctions will be conducted. The initial claims should be no item. Equities hadn’t a convincing session yesterday and overnight Asian equities, following a promising first half of the session, were again downward oriented, even if they closed mixed. Very tentatively, we have the impression authorities are moving in the right direction regarding the credit crisis (re-capitalization both in UK- EMU and now also US considered, global rate action, more liquidity (Fed will buy CP, ECB opens liquidity spigot further)) and it wouldn't surprise if the intensity of the crisis may soften for now. Authorities start to cope with the size of the problems. From a technical point of view, the S&P shows a doji on the charts at high volume, meaning a potential trend reversal signal/end of downturn. To be validated, we need the S&P moving up and closing higher today. While we suggest more selling is possible, the picture of the Dec Note future shows that the contract is near the bottom of its sideways range. A further decline would have negative implications.

ECB takes further measures to ease strains in money market

Today, the focus will remain on the implications of recent policy actions to address the financial crisis. Yesterday, the ECB and the Bank of England joined other central banks in cutting interest rates by 50 bps in an effort to restore confidence in the markets and keep the fallout of recent financial stress on the real economy limited. In the evening, the ECB announced some further measures to ease the strains in the money market, as the governing council decided that from now on the weekly main refinancing operation will be carried out at a fixed rate tender procedure with full allotment at the official ECB policy rate, currently at 3.75%. At the same time, the council also decided to reduce the corridor of the standing facilities from 200 bps to 100 bps around the official ECB policy rate, which means that the marginal lending facility rate now stands at 4.25% instead of 4.75% and the deposit facility rate now stands at 3.25% instead of 2.75%. These measures should further improve liquidity in the European banking system and lower interest rates, as in the most recent weekly tenders the weighted average rate continued to rise and approached the 5% in comparison with the official rate of 4.25% at that time. Without these measures, there was indeed a clear risk that the interest rate cut wouldn’t filter through into the banking system and would remain impotent to ease the current stress.

Following yesterday’s moves, we have lowered our ECB target from 3% to 2.5% next year. For more details we refer to our flash (see link above). Today, the ECB will also publish its monthly bulletin. The articles included may provide further insight in the current thinking of the ECB. Further out, we also look for more government action to restore confidence in the banking sector. The ECB has done its job by cutting rates and opening the liquidity spigots still somewhat further, but more action is needed to improve the solvency of the banks. In this context, the UK government took some drastic steps, as it sought to recapitalize the major UK banks, offered a government guarantee on new short and medium term banking debt and increased the Bank of England Special Liquidity Scheme. Although more details will be needed, these measures go a long way to restore confidence in the UK banking sector. In the euro zone, there are no signs yet that governments are prepared to take similar measures and are still continuing on a national case-by-case approach.

Regarding trading, European bonds yesterday failed to gain on the ECB rate cut and equity turmoil. Especially at the longer end of the curve, the Bund fell sharply lower and put a bearish engulfing pattern on the screens, which is a potential trend reversal figure. Yesterday’s losses despite the extreme tensions and rate cut of the ECB indicate that the upward potential has become limited. In this context, some profit-taking at the longer end can be rewarding, the more as 10-year yields yesterday failed to break below important support levels at 3.65%, the neckline of a massive double top formation. Given the sustained stress in the banking system, we remain more positive at the short end of the curve.

Currencies: EUR/USD to enter calmer waters

As was the case in a lot of other markets, EUR/USD trading experienced a rollercoaster ride on Wednesday. It is very difficult to link the intraday movements to individual stories or events. However, the single currency recently felt severe headwinds from the financial turmoil (partly through EUR/JPY). In this respect there is some kind of logic in the pair receiving some support from the announcement of structural measures to support the UK banking sector and from the coordinated interest rate cut executed by a series of major central banks later in the session. On top of that, also the ECB announced series of (less high profile) technical measures to support liquidity in the money market. So, even if the gyrations on the stock markets (and also in a lot of other markets) showed an extremely high degree of uncertainty, the feeling that ‘something’ is done to address the problems in a semi-structural, semi coordinated way, which at last helped the single currency to move higher throughout the session, admittedly with often very erratic intraday swings. The poor closing of the US stock market caused EUR/USD to give back part of the early gains. Nevertheless, EUR/USD still closed the session with a decent gain at 1.3654, compared to 1.3588 on Tuesday.

Overnight, Asian (stock) markets still show an indecisive trading pattern. However, at least for now, the losses are limited (there are even some minor gains in some markets) and this apparently also tends to give some (albeit precarious) downside protection to EUR/USD.

Today, the calendar in Europe contains some second tier eco data and the ECB monthly bulletin. In the US, the weekly jobless claims are scheduled for release. Especially the latter might get some attention, as the developments in the labour market are important to assess how close the US economy is to a recession. However, global financial conditions will continue to set the tone for trading. The market reaction to yesterday’s coordinated action was far from euphoric. However, this shouldn’t come as a big surprise. Yesterday we already indicated that we feared the impact of these kinds of measures to be limited as long as no ‘structural’ solutions are put in place. Some steps have been set yesterday (UK), and probably some more might be in the pipeline. Visibility both on the content of additional measures and on the market reaction is still very low, but we have the impression that we could enter some calmer waters in the days to come. Yesterday, we already indicated that such an environment could be cautiously positive short term for the single currency in general and EUR/USD in particular. In a day-to day, we hold on to that view.

Longer-term, it is much too early to draw the conclusion that the environment that proved highly negative for EUR/USD will change in a lasting way. The lack/uncertainty on a credible, coordinated European approach remains a structural factor of weakness for the single currency.

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 1.4000 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. Obviously, we are not at that point yet. Over the previous two days the pair enjoyed a (temporary) consolidation. It will be interesting to see how solid the new reaction low (1.3444) will be.

On Wednesday, USD/JPY was again a good barometer of the global market stress. The heavy losses on the Asian and European stock markets caused the pair to set a new reaction low in the 98.60 area. However, the coordinated rate cuts by a group of major central bankers put an (intraday) floor for the pair. The pair rebounded to the 101-area immediately after the announcement, but the disappointing reaction of the US stock markets caused the pair to return close the lows at the end of the US trading session. USD/JPY closed the session at 99.14, compared to 101.47 on Tuesday.

This morning, the reaction on the Asian stock markets is still guarded. The Nikkei opened in positive territory, but at the moment of writing the initial gains already evaporated and index trades again close to the lows. However, also in this market the feeling is that the level of stress is no longer as high as was the case yesterday morning and this helps USD/JPY to trade off the lows in the 100- area.

Also this morning, Japanese machinery orders showed a disastrous decline (-14.5 % M/M; 13.0 Y/Y). The Japanese government indicated to prepare a new economic stimulus plan.

On the technical charts, 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, but earlier this week the global tensions have become severe enough for the yen to take advantage of the situation with the pair setting an a ST low at 98.60 yesterday. The ST picture in this pair remains negative as long as it holds below the 103.50 previous range bottom. There is still no reason to row against the yen positive tide. However, we hold on to our approach that it is dangerous buying 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’s market reaction to the coordinated rate cut is illustrative in this respect. So, we look out whether an easing in global market stress could give this pair some downside protection short-term with the 98.60 area the first point of reference.

Yesterday, EUR/GBP again made some very strange swings. The announcement of the UK plan to support the financial sector (which we consider a reasonably good approach to address the problem) supported the sterling only very temporary (against the euro). The pair set an intraday low in the 0.7720 area, but the Tuesday reaction low was not even tested. Later in the session, partially in line with EUR/USD, the pair returned to the 0.7800 area. The coordinated interest rate cut hardly left any traces on the EUR/GBP charts, but the pair staged an impressive rebound during the US trading session. EUR/GBP closed the session at 0.7890, more than one big figure higher compared to the 0.7786 close on Tuesday. We didn’t see a clear fundamental driver to explain this move at that time. The least one can say is that it is highly relevant from a technical point of view.

Today, the UK calendar contains the HBOS house prices and the trade balance. While interesting, we don’t expect those data to have a lasing impact on EUR/GBP trading. Recently a lot of assets/cross rates showed erratic swings in a market facing reduced liquidity conditions. This can still be the case in the days to come.

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, the global sell-off in the euro obviously was a dominant theme on the currency market and this caused EUR/GBP to extensively test the 0.7760 range bottom. It is still early days, but after yesterday’s sharp rebound we tend to conclude that the test of the downside is rejected. This also fits our long-standing assessment on the sterling. In a day-to-day perspective we put the risk for EUR/GBP to move further up in the (reinstalled), longstanding sideways trading range.

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Published on  Thu, Oct 9 2008, 08:58 GMT