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Sunrise Market Commentary

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US Treasuries flourish, as markets price in a global recession, sending equities sharply down

Thu, Oct 23 2008, 07:11 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Wednesday, global bonds rallied ebullient, as markets price in an ever bleaker view on the global recession. Interestingly, the longer end of the curve even outperforms the shorter end. Nevertheless, markets now fully discount a 1% FF target rate in January 2009 and an ECB rate of 2.70% in April 2009.

Plunging oil prices and other commodity prices, crumbling equities and blowing out credit spreads show that calm hasn’t been restored. The improvement in short term Interbank markets, as evidenced by Libors continued, but swap spreads more or less stabilized and T-bill rates even fell somewhat.

The deteriorating situation in Central Europe and LatAm were certainly a driving force too, especially in Europe, as they may point to another phase in the credit crisis. Economic data were few and without importance in yesterday’s trading.

In a daily perspective, German yields fell by 9 to 13.5 basis points, the belly slightly outperforming, while in the US, yields fell by 11.5 to 16 basis points, flattening the curve in a straight way.

US Treasuries flourish, as markets price in a global recession, sending equities sharply down

Today, the eco calendar contains the weekly claims and house price index (August). Last week, initial claims came out lower than expected due to the unwinding of the effect of the hurricanes which is now nearly completed. Continuing claims rose more than expected, coming out at the highest level since June 2003. For the week ended October 18, initial claims are expected to rise 4 000 from 461 000 to 465 000, while continuing claims, reported with a one-week lag, are forecasted to fall back slightly (3 700 000 from 3 711 000). The OFHEO House Price index is expected to show a decline of 0.5% M/M in August, after falling 0.6% M/M in July.

The New York Fed schedule 2 TSLF auction suggests that the dislocations have eased in the recent week. 47.25 B $ was bid in the 37.5 B $ auction, for a bid/cover of 1.26 (average 1.01). The stop-out rate at 50 basis points was sharply down from last week’s 322 basis points, but far above the min. 25 bps stop-out.

The Fed changed its rule on interest rates on bank excess reserves balances. The interest paid will now be 35 basis points below the lowest Fed Funds target rate during the 14 day maintenance period instead of 75 basis points before. Why this change? Recently the Fed funds traded below target and even below the 0.75% (1.50%-0.75%) paid on the reserves which was thought of as a floor. Under the new rule, the Fed funds should trade closer to the target with 1.15% the new, presumed floor.

Regarding trading, the market is in the grip of fear that flared once more up in recent trading. The S&P (Vix again near high) lost 6.10%, even with a late session bounce. Credit spreads widened further and are priced for an outright depression that would bring with it a historically never seen number of corporate defaults. We hope that distress selling is behind this (excessive?) widening that seems to be out of line, even when taking the equity weakness into account.

The technical pictures of the US yields are all outright bullish. 2-year yields (now 1.53%) find next resistance at the all-time lows of 1.23/31%, 5-year yields (now 2.55%) at all-time lows of 2.32/16%. For the 10-year yields, the recent low stands at 3.40% with 3.25% a major resistance level. The historical low (June 2003) stands at 3.07%. We would eye these levels as potential profit taking points for longs. To consider new long positions it might be preferable to wait for a rebound in yields to about 2% for the 2year, 3% for the 5 year and 3.90% for the 10-year. Any rebound in equities/return of risk appetite would trigger an upward correction in yields. A break of the lows mentioned above should be difficult, but should equities tumble decisively below the 2002 lows (S&P: 764), yields may mirror it by attacking those all-time lows. For today, the calendar is uneventful leaving it to general developments to drive the price action. Asian equities recouped part of the losses on a WSJ article the US is preparing a plan to help stem foreclosures. This is an important development that markets will notice and so might be a Treasurynegative.

German 2-year yields fall to new cycle lows

The eco calendar heats up today with the euro zone industrial new orders (August) and business confidence surveys for October in France and Belgium.

In July, industrial orders reported an unexpected rise (1.0% M/M), the first rise after eight consecutive declines due to a sharp rebound in transport equipment. For August, the consensus is looking for another modest increase (0.5% M/M). More attention will however go out to the Belgian and French October business confidence surveys, which will be seen as a good pointer for Friday’s influential PMI surveys. French business confidence is expected to decline from 92 to 89 and Belgian business sentiment is forecasted to fall from -14.4 to -16. The sharp falls in the German ZEW and several regional US surveys last week indicate the risks are clearly on the downside.

Outside the euro zone, the Swedish Riksbank is expected to cut rates again today following the coordinated 50 bps rate cut early October. The market is split whether the bank will cut rates by 25 or 50 bps. Overnight, the Reserve Bank of New Zealand slashed its benchmark rate by 100 bps to 6.50%. The aggressive easing in policy rates around the globe is likely to continue, as the global economic outlook has deteriorated sharply and central bankers step up their fight to fend off a long and deep recession or even depression, which could lead to a deflationary spiral. Today, the ECB will also hold its non-monetary policy meeting. No rate change or statement is expected, but yesterday’s comments of ECB’s executive board member Gonzalez-Paramo suggest that the ECB may well cut rates again at the November meeting, as he indicated that the ECB could lower rates again ‘without adding to inflationary risks’. As such, there are no reasons to fight the current trend for lower interest rates, although market expectations for more ECB rate cuts have been rising quite sharply over the previous days and markets are currently thinking about another 50 bps rate cut at the November meeting, which is completely discounted by the December meeting. Given the heightened interest rate cut expectations in the short term, it may be rewarding to look further out on the curve, although a confirmation of the drop in 2-year yields below the year lows may signal that more downside is likely.

Already yesterday, 5- and 10-year yields declined even more compared to 2- year yields, with 10-year yields again approaching the year lows at around 3.65%. Although we wouldn’t front-run on such a break lower, it would materially improve the technical outlook and bring the all-time lows at 3% again in the picture. Yesterday, the tap of the German Bobl attracted strong demand, which contrasted with the sluggish demand for the Greek bond earlier this week. As such, there is no sign yet that intra-EMU spreads should narrow again, on the contrary rising risk aversion pushed the spreads back towards the recent highs.

In the UK, the calendar is interesting today with the September retail sales. In July and August, retail sales came out unexpectedly strong and in September the consensus is looking for a decline of -0.7% M/M. It is however important to note that retail sales showed wild swing in the previous months and therefore a large deviation from the consensus shouldn’t surprise. Following Tuesday evening’s downbeat comments of King, yields plunged lower in the UK and 2-year yields are now testing the 2003 lows. This high-profile level may be a hurdle too high to break below in a first attempt.

Yesterday, Barclays issued a first bond that carried a government guarantee. The EUR 3 B three-year bond was price at mid-swaps plus 25 bps, similar to agency debt and attracted good demand. In the total cost of the bond, one should also add the fee Barclays has to pay to the government which has been set at 50 bps plus the median five-year credit default swap of around 95 bps. As such, the government guarantee facilitates longer-term funding, but not at very cheap levels.

Currencies: the traditional crisis trading patterns again at work

On Wednesday, EUR/USD trading was still driven by the mounting fear that the financial crisis would lead to a protracted recession. This fear was the driver for trading on all markets, but at least for now the market perception is that Europe could be hit at least as hard or even harder compared to the US (or Japan). The financial crisis reaching Central and Eastern Europe only reinforces this feeling. However, yesterday’s price action in fact is nothing more than a continuation of a market trading pattern that is already in place for several months. In times of market stress the yen and the dollar are perceived as better safe havens compared to the single currency and at least for now there is no trigger available to change this widespread market feeling. So, yesterday morning in Asian trading EUR/USD fell in some kind of back hole, setting a new reaction low in the 1.2745 area. The pair regained some of the Asian losses early in European trading and returned to the 1.29 area around noon. However, even in a daily perspective, it would be an exaggeration to call this a rebound (EUR/USD started trading in Asia yesterday morning in the 1.3050 area) and a new batch of negative corporate news headlines from the US hammed investor sentiment again blocking any upside potential in EUR/USD. The pair closed the session at 1.2855, compared to 1.3063 on Tuesday. As was the case yesterday morning, EUR/USD again experienced a difficult time in Asia this morning as the EUR/USD cross rate set a new minor low in the 1.2730 area this morning.

Today, the calendar is better filled compared to the previous three days. In Europe, French and Belgium business confidence and the EMU industrial orders are on the agenda. In the US the claims and the House prices are scheduled for release. However, we doubt whether these series will contain any information to change the course of events. Should we expect anything from the ECB non-policy meeting?

Recently, sentiment on the single currency was already very negative and, among other things, the developments in central Europe only reinforce the feeling that the European economy is heading for a strong setback. Markets also came to the conclusion that the sharp deterioration in financial and economic conditions will force the ECB to cut interest rates in an aggressive way much sooner than expected, reducing the euro interest rate support. Already for quite some time we advocate that a prolonged period of sub par growth and/or some kind of deflationary environment is more supportive to the dollar than to the single currency and this is also the main reason why we are EUR/USD negative longer term. However, as we already indicated yesterday, we didn’t expect the decline to accelerate at the aggressive pace as seen this week. Earlier this week, we hoped that an easing in global market tensions could at least cause some kind of consolidation in EUR/USD, creating an opportunity to add/step in for dollar longs. This hope obviously is in vain. EUR/USD currently is a falling knife and there is no reason to try to catch it.

From a technical point of view, EUR/USD over the previous month tumbled from the 1.4866 reaction high to levels below 1.28 at the moment of writing. High profile intermediate supports the longstanding daily uptrend line since 2002 (today in the 1.4025 area; the previous low in the 1.3882 area and the 1.3259 10 Oct reaction low) were taken out with remarkable ease. 1.2481 (the Oct 2006 low) is now the first high profile support on the charts. EUR/USD needs to return above to 1.3259 reaction low to get a first indication that the pressure is easing.

Over the previous days/week, USD/JPY often held up rather well despite the ongoing period of elevated market stress. The yen gains against the dollar, even at days of steep stock market losses, often were not that spectacular. To some extent, one was tended to draw the conclusion that dollar was catching up with the yen and preferred safe haven. However, over the previous two days, the panic was again strong enough to cause a run on the yen. USD/JPY yesterday moved continuously lower from the 100 area early in Asian trading to close the session at 97.66, with only a very brief interruption in the run-up the open of the US market. The pair thus also dropped below the 97.91 previous reaction low.

This morning, Japanese export data only confirmed that the impact of the world-wide economic crisis also hits Japan through its exports. The Nikkei took an awful start to the new trading session setting a 5 ½ year low intraday, but regained some of the earlier losses at the moment of writing. Of course, a 3.0% loss for sure still can’t be considered as a success.

On the charts, global market stress hammered the pair through the 103.50 range bottom two weeks ago and the pair set a new reaction low at 97.92. Since, the pair rebounded and set a reaction high in the 103.05-area but a test of the key 103.55/85 resistance area (previous lows) didn’t occur. Recently, we advocated that it is dangerous to buy a safe haven asset (like the yen) at the top of market stress and suggested a buy-on-dips approach in case global market stress would ease. We are still not very fond of going yen long against the dollar at the current market levels. However, at least over the last 48 hours the market didn’t walk our way. From a technical point of view, the break below 97.91 is a serious warning signal. A sustained drop below the 95.77 year low would be the red alert in this currency pair. At that point, a disciplined stop loss strategy would be highly warranted. In line with EUR/USD, EUR/JPY extends its steep decline without any hesitation.

On Wednesday EUR/GBP trading was still driven by the speech from Mr. King on Tuesday evening. The BOE Governor warned that the UK economy probably entered its first recession in 16 years and that the outlook has not worsened as rapidly as it has been in the past month for a very long time. He also warned that this might mean that the adjustment in the trade deficit and the exchange rate will need to be larger and faster than otherwise would have occurred. The pond already faced a material setback on Tuesday evening, but there was additional follow-through sterling selling yesterday morning with the EUR/GBP pair reaching an intraday high in the 0.7900 area. Some temporary easing occurred during the morning session in Europe, but a new sterling selling wave kicked in early in US trading. A negative assessment from the UK Prime Minister on the UK economy going forward might have added to the sterling negative sentiment. The Minutes of the previous BOE meeting also showed the MPC to take into account a sharp deterioration in the prospects for the economy and also the risks to the inflation outlook have shifted to the downside. EUR/GBP closed the session at 0.7906 and at 0.78165 on Tuesday.

Today, UK calendar contains the retail sales release. We would be surprised if this release would bring any positive news;

Already for some time, we advocated that we don’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. In this respect, the 2-year UK government bond yield coming close to the 2002 lows is quite illustrative. However, this view came under pressure recently with EUR/GBP extensively testing the key 0.77 support area early this week. However, our view/strategy was saved by Mr. King on Tuesday evening. Despite the overall euro negative sentiment, EUR/GBP is now again in the longstanding sideways trading range. In a day-to-day perspective, after the sharp rebound of the previous two sessions, we think that the short-term upside in this pair may become more difficult short-term. Longer-term we think that the established sideways trading pattern between 0.7700 and 0.8100 can hold in the foreseeable future.

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Published on  Thu, Oct 23 2008, 07:22 GMT