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Sunrise Market Commentary

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US Treasuries only moderately lower despite surge in equities

Wed, Oct 29 2008, 08:14 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Tuesday, global bonds had a rollercoaster session on the back of volatile trading conditions on the equity and currency markets, where the Asian and US equity markets staged an impressive rebound and the yen fell prey to some profit-taking. Market technical factors appear to be behind the moves, as hedge funds may have preferred to close their short positions after being hit by the Volkswagen saga and following a failed test of the recent lows in the S&P at around 840.

On a daily perspective, the movements on the bond markets were limited compared to the moves on the equity and currency markets. The short end outperformed both on the European bond and US Treasury market, which may indicate that markets doubt whether the rebound on the equity markets does point to a general improvement in the economic environment. As such, central bankers are still expected to cut rates further, but as there is more room to do so in the euro zone than in the US, the spreads between German and US yields narrowed further.

In the US, yield rose between 3.3 bps in 2-year yields and 14.6 bps in 10-year yields and compared to a decline of 5 and 0.8 bps in respectively German 2 and 10-year yields. As a result, German 10-year yields have fallen below US 10-year yields for the first time this year.

US Treasuries only moderately lower despite surge in equities

Today, the eco calendar contains the durable goods orders (September). In August, the durables dropped 4.8% M/M, while the consensus was seeking for a more modest decline (1.9% M/M). The underlying picture was very weak with transportation, machinery and primary metals all showing sharp declines. In September, durable goods orders are expected to fall 1.0% M/M and the less volatile durables ex transportation are forecasted to show a decline of 1.5% M/M. We have no clear view on the outcome, but a stronger figure should not surprise as orders for Boeing rose by 8%.

The 34 billion $ 2-year Note auction went well yesterday. The auction stopped at 1.65%, sharply below (5 bps) the bid price in the WI. The bid/cover was a strong 2.49 versus a 2.4 12 month average, despite the large size. Indirect bidders bid a record 23.5 billion $, for a strong 28% Indirect bid share (long term average 16.9%) and a lighter 59.6 hit ratio. So it seems that investors were still enticed by the safe haven Treasuries despite relatively low yields, even if they didn’t go aggressively behind the issue.

The FOMC meeting concludes late in the session. Since the October 8 rate cut, the financial and economic situation has further deteriorated and commodity prices fell even more, improving the inflation outlook. With the prospect of reaching the lower boundary of the Fed Funds target nearing, we think the Fed would prefer to cut rates at this meeting by “only” 25 basis points and keep some powder dry. However, we do expect in that case a very dovish statement. Downside growth risks should be called the predominant risk (should the Fed revert to using this way of modelling its view) or at least the inflation risks will be further downgraded. We don’t expect any dissenters. The November FF future trades at an implied 0.915%, or a more than 100% chance on a 50 basis points rate cut. This means that the risk is firmly for such an outcome. The Fed may consider that it is not the time to contradict the market, as this may cause some additional uncertainty.

Yesterday, the Fed’s Commercial Paper Funding Facility started to operate. It should help ease tensions in the money markets and we are eager to see whether indeed such effects become visible. The Facility works via a NY Fed supported and PIMCO managed Special Purpose Vehicle. The SPV will buy 90 day CP at 100 basis points over the 3 month OIS for unsecured paper and 300 basis points for ABCP.

Regarding trading, Treasuries lost modestly ground yesterday in another volatile meeting. Given the steep gains of equities we should qualify the performance of Treasuries as encouraging, even if the bulk of equity gains were registered close to and after the closure of regular trading. The curve bear steepened, a bit strange as equities were so strong. The 2-year Note auction went well though, showing that risk aversion is still a good support for the short end. Treasuries traded reasonable well in Asia overnight, despite some bourses doing fine (Nikkei up 7%). It seems that Treasuries are counting on a generous Fed when it announces its rate decision later today. Some are even counting on more than 50 basis points rate cut and the November FF rate trading at 0.90% doesn’t contradict these wishes. While a 50 basis points cut is probably the outcome, we think the risk is for a 25 basis points cut. See above for the reasons. Should this happen, there might be a negative reaction at the shorter end of the curve. Equities are another risk factor for Treasuries short term. Indeed, from a technical point of view, yesterday’s rally might be qualified as a trend reversal signal. We are a bit sceptical about the rally. It happened late in the session and without a clear-cut trigger. It would be healthier to see volatility decline and equities showing more gradual gains.

The MT technical pictures of the US yields are all outright bullish. Key supports stand at the all-time lows of 1.23/31% for the 2-year, at all-time lows of 2.32/16% for the 5-year. For the 10-year yield, 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 2-year, 3% for the 5-year and 3.90% for the 10-year.

German yields decline, despite equity rebound

Today, the euro zone data calendar contains the German CPI figures. After declining slightly less than expected in September, the German CPI (EU Harmonised) is expected to extend its recent downtrend in October (-0.2% M/M). Annual inflation is forecasted to fall from 3.0% Y/Y to 2.6% Y/Y. Yesterday, the first CPI figures out of North Rhine-Westphalia were in line with expectations, as inflation fell 0.2% M/M pushing the annual inflation rate down from 2.6% Y/Y to 2.3% Y/Y. Although the current inflation rates are still above the ECB inflation objective, recent comments have clearly indicated that inflation is no hindrance anymore towards lower policy rates, as the inflation outlook has improved materially due to the substantial decline in commodity prices together with the sharp weakening in demand. Against this backdrop, Trichet hinted on Monday that the ECB will cut rates again at the November meeting.

On the money markets, the Euribor fixings resumed their gradual downtrend following Trichet’s hint at lower policy rates. The 3-month Euribor declined 5 bps to 4.86%. This is however still way above the expected average policy rate over the coming 3 months. To restore the monetary transmission mechanism, the ECB has therefore decided to carry out its longer-term tenders also at a fixed rate and under full allotment. The first 3-month tender under these conditions will take place today at a fixed rate of 3.75%. Yesterday, the amount allocated in the weekly tender increased to a new recent high at 325 B, while the number of banks participated surged to 736. At the same time, banks continue to make use of the deposit and marginal lending facilities reflecting the persistent lack of confidence within the financial sector.

Regarding trading, the European bond market set down a strong performance yesterday, as the Bund recouped its early losses and even closed slightly higher. The rebound on the equity market couldn’t prevent a further bull steepening of the European yield curve, as investors bet on ever more ECB rate cuts to support the economy. The improved risk appetite on the equity market wasn’t reflected on the intra-EMU spreads, which continue to widen. As a result, the spread between German and Italian yields broke above the psychological level of 100 bps after Greek spreads broke above the same level last week.

The late rally on the US equity market and the positive performance of the Asian equity markets this morning do still increase the risk of some profit-taking on the European bond market. These should however be used to go long again. From a technical point of view, a rebound towards 2.90% in 2-year yields, 3.50% in 5-year yields and 4% in 10-year yields offers good opportunities.

In the UK, the calendar contains the September lending data. In August, net lending secured on dwellings declined sharply from 3.0B to 0.1B, while net consumer credit grew from 1.1B to 1.2B. Net lending secured on dwellings is expected to increase from 0.1B to 0.8B, but remains at very low levels due to the tightening in mortgage lending criteria and weak housing market. Net consumer credit is forecasted to decline to 1.0B. Yesterday evening, BoE’s Besley suggested that the current crisis indicates that asset prices will play a more important role in the setting of monetary policy in the future. Although, he said that rate cuts are ‘no magic bullet’ for the economy, he didn’t want to say that they won’t have any impact on the economy. Today, BoE’s Blanchflower will speak and can be expected to be very dovish.

Currencies: Return of risk appetite leads to correction in EUR/USD and USD/JPY

On Tuesday, EUR/USD tried to move again from the cycle lows set on Monday, but didn’t succeed until late in the session when a violent equity buying spree pushed equities to an outsized 10.8% (S&P) gain. The eco data didn’t impact trading: US data were awful, as both consumer confidence and the Richmond Fed manufacturing surveys showed record low values, emphasizing once more that confidence in the economic outlook is at rock-bottom levels for both households and firms. Housing prices declined further, but not more than expected. In EMU, the reports showed a similar picture with weakening French consumer and producer confidence. However, eco data aren’t the prime driver behind the market. The market doesn’t discriminate currently between countries on the basis of their relative growth performance. It reasons from the perspective of a global recession and a financial crisis and their impact on government reactions to these. However, the global recession and financial crisis causes also a sharp re-positioning which means in FX terms closing carry trades and repatriating the money towards the funding currencies like yen and to lesser extent the dollar.

Equities held up better than was recently the case and also the oil price more or less stabilized, given some sort of support to the euro and keeping EUR/USD close to the 1.25 mark for most of the day. It was a late session surge of equities that triggered a euro rally, as equities are the benchmark to gauge the risk appetite of investors and that temporary gave the green light. Crude oil similarly got a boost in late session. In a daily perspective, EUR/USD closed at 1.2682, up from the previous close of 1.2494. There was no specific trigger behind the late session surge. Of course, the market was hugely oversold. Some mention the hopes for a rate cut today, but as this was already well discounted, it isn’t a very good argument. However, we consider it as an internal market technical move. Did hedge funds need to cover shorts (to book profits) after being squeezed in shorting VW (and losing big)?

Overnight, equity trading was very volatile in Asia (cf. yen part), but at the time of writing, the bulls seems to trump the bears and as a consequence, EUR/USD is a little bit higher, trading just above 1.27 from an intra-day high of 1.2627. At the start of Asian trading, when equities surged on the back of Wall Streets’ gains, the pair hit a 1.2839 high. So, price action shows that the pair trades off equities and the risk aversion/appetite theme.

Today, the calendar contains the US durable orders. We expect the durables to be weaker than the 1.1% M/M fall consensus expectation, but that shouldn’t have much impact. It is well known that the economy is in dire straits and whatever the durable report reveals, it wouldn’t change that assessment. The FOMC decision is more important. The market firmly discounts a 50 basis points cut and that is completely discounted. There are some stories in the media that markets are looking for something more substantial. We doubt whether the Fed will deliver that. The Fed seems convinced that currently interest rate policy is less important than other policy levies, like fiscal policy, liquidity policy, and should be conscience that by cutting rates big, it rapidly nears the zero bound for rates which would make monetary policy making much more difficult. Therefore, we think they go by 50 basis points, but with the risk that they choose for 25 basis points combined with a very soft statement. Why that may look to be negative for equities and thus positive for the dollar, we are not convinced that it would hit equities sharply. The 25 billion $ rescue package for Hungary, released overnight, is a dollar negative.

We advocated that a prolonged period of sub par growth and a deflationary environment is more supportive to the dollar than to the single currency. This is also the main reason for our EUR/USD negative view longer term, which remains intact. Shorter term, there might be reasons for the euro to get some respite. The steep decline of the single currency in recent weeks, the re-assessment of the ECB rate outlook (markets now discount a 2.5%-2.25% official rate in mid-2009) and tentatively the return of more normal conditions in the equity markets might be dollar negative. Very short term, the focus is on the FOMC meeting, might have offered dollar bulls a pretext to book profits, but didn’t they do it yesterday? A 50 basis points rate cut may still be somewhat dollar negative and the IMF package for Hungary is another negative, but we don’t think it will change the longer term (positive) outlook for the dollar. In this context, we still favour a sell euro-on-up-ticks, preferable when EUR/USD is closer to 1.3259.

From a technical point of view, EUR/USD over the previous month tumbled from the 1.4866 reaction high to levels below the 1.24 mark early this week. High profile intermediate supports like the longstanding daily uptrend line since 2002 (today in the 1.4050 area), the previous low at 1.3882 and the 1.3259 10 Oct reaction low were all taken out with remarkable ease. 1.2481 (the Oct 2006 low), under test in recent days, remains the first high profile support on the charts. EUR/USD needs to return above the 1.3259 reaction low to get a first indication that pressure is easing. However, yesterday’s move constitutes an outside key reversal/bullish engulfing move that might be an indication of a medium term low in place. Confirmation is needed though and we shouldn’t forget that the markets are not functioning normally.

On Tuesday, USD/JPY rallied higher, following two very nasty sessions in which the pair plunged 7 yen lower. Indeed, USD/JPY opened the session somewhat below 93, but moved higher when the Nikkei rallied in the second half of Asian trading session. The pair took a breather in the European and early US session, but staged a powerful follow through rally later on when US equities found the way up. Better equities coupled with yen overbought conditions and some “wild?” rumours on a BoJ rate cut were a nice pretext to book profits. USD/JPY closed at 98.03, up from 92.78.

Overnight, Japanese equities traded very volatile. At first they rallied more than 7% higher (Nikkei), losing nearly at their gains at mid-session, only to stage a late session rally, ending the day up 7.7%. However, USD/JPY reacted less outspoken. The pair gained modestly on the initial move higher of equities, but rapidly lost ground again, even before equities hit the skids. Of course, yesterday’s huge yen losses and the volatility in equity trading convinced many that the risk aversion trade that benefited the yen in the past shouldn’t be buried yet. There is no reason to expect the yen negative carry trade to resume anytime soon. There were also messages that Japanese exporters stepped in to sell dollars to lock in USD/JPY levels of closer to 100. The rumours of a BOJ rate cut are probably only that, rumours. Indeed, we think it wouldn’t at all restore optimism in the economy. It took the BOJ so long to get away of its zero rate policy that is closely associated with the deflation decade. Going back to zero could have a devastating impact on confidence. The current problem of a strong yen isn’t a problem of too high rates and we doubt it would help weaken the yen.

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 90.93 last Friday. Longer term, the break below the March 2008 USD/JPY low means that little key support is seen before the all-time (April 1995) low at 79.75. Recently, we were not fond of buying yen on the argument of extreme stress, as the yen may rapidly lose ground if the financial markets stabilize and yesterday’s move shows the argument isn’t totally unfunded, even if we admit that in a longer term perspective, the yen did very fine and was the world outperforming currency. Therefore, we still don’t want to run after the yen and don’t feel eager to buy into the yen. From a technical point of view, the picture is however clearly bullish with a triple top on the charts with targets that stand below the 79.75 all-time low. Short term, USD/JPY may correct higher with a sustained move above 98.98, the medium term moving average needed to bring the pair in more neutral territory.

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Published on  Wed, Oct 29 2008, 08:37 GMT