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US Treasuries sell off again despite crashing equities

Fri, Oct 10 2008, 07:39 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Thursday, global bonds couldn’t benefit from the ongoing turmoil on the financial markets and even lost ground in spite of the continuing sell-off on the US equity markets. Recent policymakers’ actions, including Wednesday’s coordinated rate cut by 50 bps, clearly failed to restore confidence, while fears for a global economic depression ride high. It seems the simultaneous sell off in equities and Treasuries, the two most liquid markets is due to forced selling of market players that are confronted customers withdrawing their money. In the US, the S&P 500 fell for the seventh consecutive session and closed more than 7% lower.

In yields, US 2-year yields reversed their early gains in the last trading hour, as equities collapsed, and closed 1.6 bps lower, but 10-year yields were still up 14.5 bps. Additional supply to ease dislocations in the US Treasury market still weighed on sentiment. In the euro zone, yields rose across the curve, as most maturities had fallen to important support levels over recent days, which proved to difficult to break below for now.

US Treasuries sell off again despite crashing equities

Today, the calendar heats up. It contains the August trade balance, the September import prices, the October IBD economic optimism index and the September budget results. Import prices will continue its decline driven by the plunge in commodity prices, including petroleum.

However, attention will be on equities, money market and the government. The credit crisis is taking another turn for the worse. Dislocation in markets is extreme amid signs that now other market players are engaged in de-leveraging, as their customers withdraw their money. This forced indiscriminate selling is scaring, but at some point selling should dry up. In this phase it doesn’t merit to look too much to underlying factors. This is best seen in the Treasury market that theoretically should do well, but saw a two day sell-off, especially at the longer end of the curve. Of course, the shorter end continues to profit from safe haven flows and from correct expectations that the fall-out of the crisis on the economy will oblige central bankers to very low rates, probably for longer. The government is correctly ever more aggressive in the funds it wants to spend to clean up the credit market mess. The bill will be translated in higher supply of government bonds. However, for the past two day sell-off, we suspect that it was mainly the result of forced selling and technical elements, as explained yesterday.

The stress is now reaching extreme levels and today’s session will be tense, as markets will be worried about the long weekend. The VIX at 62.9 is now at a historical high (at last as long as we have observations meaning the early nineties). This means that authorities will again come up with a kind of plan. The G-7 this weekend is the place where it should assembled, but other countries like the cash-rich China and the oil producers should participate. The S&P has now dropped 42% from the top and nears the 2002 lows at around 800/768. Being in a capitulation mode, we think the end-game may have reached its final stage. There is a good chance the capitulation might be near, but if the above levels wouldn’t hold, the risk would be for a genuine depression.

In such a context, we would be utmost cautious on Treasuries and wait for signs how the market looks to the after-capitulation environment. Will deflation be the driver, or will supply and the inflationary fears of the government interventions prevail?

European yield curve set to steepen further

Today, all eyes will shift to the G7 meeting, as recent actions from policymakers failed to restore confidence in the financial system. Yesterday evening, US equities dropped once again lower and Asian equities are also sharply lower this morning. The ongoing problems in the banking system were highlighted in the money market yesterday, as the one month Euribor fixing fell only 7 bps to 5.126%, while the three month Euribor fixing was unchanged at 5.393% despite Wednesday’s 50 bps ECB rate cut, the drastic changes in the weekly tender procedure and the narrowing of the standing facilities corridor. Besides the recapitalization of the banking sector, the discussion now more focuses on the government guaranteeing of the interbank lending, a measure already incorporated in the UK and Belgian rescue plan of the banking sector. The Netherlands yesterday announced it will make EUR 20 B available to support the banking sector.

On the ECB front, ECB’s Stark sounded very downbeat on the economic outlook, as he expected ‘very weak growth for at least several quarters’. Yesterday’s ECB monthly bulletin contained an interesting article on the informational value of M1 money supply growth on the economic outlook, which indicated that M1 money supply growth is a good indicator of turning points in the economy, but less so of the magnitude of economic growth. Nevertheless, the recent sharp slowing in M1 money supply growth does point to downside risks in the economic outlook. Today’s French and Italian industrial production data won’t move the market.

Regarding trading, despite the extreme tensions in the financial system, European bonds couldn’t gain yesterday. It may however be dangerous to draw too many conclusions out of yesterday’s trading session, as this may be partly due to forced selling from hedge funds. This morning, European bonds are off a strong start, with 2-year yields again testing the recent lows and important support zone at 2.92%. 10-year yields yesterday continued their rebound off the recent lows at 3.65% and neckline of a massive double top formation. Given the proximity of the major support levels, we don’t front-run on a break lower, especially not at the longer end of the curve, where the supply factor may become more of an issue and prevent yields from falling much lower for now. A further steepening of the European yield curve remains however likely, as this would support the economy and the banking sector.

Currencies: The yen remains in the driver’s seat

Yesterday, initially it looked as if global markets, and especially the European equity markets, could enter calmer waters and this supported the single currency during the morning session in Europe. However, US markets were not really able to build on the relative calm in Europe and throughout the day stock market sentiment deteriorated further with US stocks declining at an accelerated pace at the end of the session. Even if the source of panic this time came from the US, The euro was again more sensitive to the high level of risk aversion/panic and EUR/USD gradually drifted lower throughout the session. The pair set intra-day highs in the 1.3785 area before noon in Europe, but closed the session near the intra-day lows at 1.3604, compared to 1.3654 on Wednesday. Oil also declined further, recently a dollar positive factor. However, in the current environment we wouldn’t give too much weight to this factor. Panic yen buying through EUR/JPY probably is the most obvious explanation for the current move in EUR/USD.

Overnight, the panic move was only reinforced in Asian trading, pushing EUR/USD down to the 1.3549 area. This is a decent loss compared to yesterday’s intra-day high, but after all, the moves in EUR/USD still are relatively contained compared to the sharp swings seen in other, minor cross rates.

Today, US trade balance and French and Italian production data are on the calendar. However, they will hardly get any attention from the investment community. Oil continues to decline, reaching USD 82 (WTI), not a supportive factor for EUR/USD. However, the global meltdown will continue to be the only driver for trading in all markets, including the currency markets. Yesterday, we hoped for some stabilization in global market tension (supported by the recent measures) to provide EUR/USD some short-term support. However, this hoped for stability was very short lived and EUR/USD is again one of the (albeit minor) victims of the financial rout. If the pressure persists, which looks very likely for the start of the European trading session, the risk obviously is again on the downside in EUR/USD. Markets will look for some kind of wonder out of the G7 meeting, to be held during the weekend. However, we don’t feel the need to make any bet on the potential results from this meeting and on what this will mean for EUR/USD trading. Until further notice we hold on to the view that elevated levels of stress favour the dollar more than the euro. At this stage, it doesn’t make any sense anymore to try to make any assessment on relative economic performance between Europe and the US and to draw conclusion for EUR/USD longer term. In this market one can only try to make an assessment on the development of crisis on a day-to-day basis.

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. This temporary calm apparently was short-lived. The reaction low (1.3444) is the first point of reference. A break below this level could indicate another downleg in this pair.

On Wednesday, USD/JPY again mirrored the swing in investor sentiment on the stock markets. Some calm returning to the market in Europe helped USD/JPY to regain the 100 barrier, with the cross rate setting an intraday high in the 101.50 area early in US trading. However, the sell-off on the US stock markets hammered the pair again below the 100 mark and investor panic at the open of the Asian markets even caused the pair to test bids in the 98 area the start of Asian trading.

This morning, the news on a Japanese life insurer failing only illustrates that the crisis will also hit this region. However, with Japan being an excess country and probably still some (last) carry trade unwinding to do to generate cash, this currently doesn’t weigh on the yen.

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 97.92 this morning. 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. Recently, we advocated that it is dangerous buying a safe haven asset (like the yen) 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. Of course the least one can say is that the scenario of easing global tension is not really viable at the current juncture. Once again, looking at the G7 is the only think one can do at the current juncture. The pair set a new reaction low this morning and the 95.77 area (year low) now becomes the next point of reference.

EUR/GBP had again a rollercoaster ride yesterday. In line with the price action on Wednesday, the pair initially moved cautiously higher to set an intermediate high in the 0.7955. The sterling tried to fight back going into the US trading session (despite very negative UK trade balance figures), but as soon as the global market panic resurfaced and as US stocks dived south, the sterling was sold, too. EUR/GBP closed the session at 0.7957 compared to 0.7890 on Wednesday and the sterling losses continued unabated in Asia this morning.

Today, the UK calendar is empty. As is the case for all assets (and currencies), everyone is scrambling for cash from whatever source. This leads to forced liquidation of all kinds of assets and apparently in this context there is also still some kind of sterling carry-trade unwinding to do.

Until the start of this week, sterling showed remarkable resilience vis-à-vis the euro (despite global market stress and ongoing poor UK eco data) and temporarily dropped below the key 0.7760 area n 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. However, after the sharp rebound over the previous three sessions, one can conclude that the test of the downside is rejected. This also fits our long-standing (negative) assessment on the sterling. In a day-to-day perspective we continue to put the risk for EUR/GBP to move further up in the (reinstalled) longstanding sideways trading range. As is the case for all other markets/assets; forced selling will also be the driver for trading in this pair. This kind of trading ‘strategies’ apparently turn out to be sterling negative at the current juncture.

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Published on  Fri, Oct 10 2008, 08:12 GMT