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Sunrise Market Commentary

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Italian spreads widen ahead of today's bond auctions

Thu, Oct 30 2008, 08:07 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Wednesday, global bonds traded broadly sideways with the short end outperforming. Central bankers across the globe cutting rates aggressively continues to support the short end, despite the improvement in investor’s risk appetite.

Yesterday evening, the Fed cut rates by 50 bps to 1% and kept the risks on the downside, which signals that it is highly likely that rates will be cut again at future FOMC meetings. The Fed Fund futures now discount another 25 bps rate cut at the December meeting. Earlier in the day, the Bank of China cut interest rates for the third time in six weeks and also Taiwan and Hong Kong followed the Fed in cutting rates. This makes it all the more likely that also the Bank of Japan will cut rates tomorrow. Earlier this week, comments of the ECB and Bank of England already signalled their readiness to cut rates at their policy meetings next week.

As such, both the US and European yield curves steepened further. Regarding the latter, the spread between 2- and 10-year yields is now at its highest level since the beginning of 2005 at 126 bps. In the US, 2-year yields declined by 3.7 bps compared to a rise of 4.6 bps in 30-year yields. Similar movements were also seen in the euro zone, where German 2-year yields fell 2.3 bps, while 30-year yield were up 5.4 bps. German government bonds however continued to outperform their European counterparts. Italian and Greek spreads on 10-year maturities trade now well above 100 bps.

US Treasury curve steepens slightly on Fed 50 basis points rate cut.

Today, the calendar contains the first estimate of third quarter GDP and the weekly initial claims. GDP is expected to show a contraction in the third quarter. After rising 2.8% Y/Y in the second quarter of 2008, the consensus is looking for a decline of 0.5% Y/Y in third quarter GDP, but the risks are still on the downside. In the previous quarter, household consumption was supported by the tax rebate checks, but they are already spent long ago and therefore consumer spending is expected to show a sharp decline (2.4%) and its first drop since 1991. Residential investment is expected to remain very weak and might even deteriorate further, and also non-residential investment is forecasted to decline. The net export deficit likely narrowed further in the third quarter. GDP is expected to decline also in the last quarter of 2008 and probably through the first half of 2009. Last week, both initial and continuing claims surprised on the upside, with initial claims rising to 478 000 and continuing claims coming out at 3 720 000. In the week ended October 25, the consensus is looking for a marginal improvement in initial claims (478 000). Continuing claims, reported with a one-week lag, are expected to show a rise of 10 000 to 3 730 000.

Today’s 24 billion $ 5-year Note auction will all raise new cash at settlement, like all recent 5-year Note auctions. The size is unchanged from last month’s, but is sharply up from previous auctions. Last month’s 5-year auction went not all too good. It stopped about 4.5 basis points above the bid in the WI and the 1.91 bid/cover was below average, while Indirect bid was in line with average. Overall though, 5-year auctions have been volatile in their results and also for today, it is difficult to gauge its reception. Yields are at comparable levels as when last month’s auction was held and Tuesday’s 2-year auction went well, but that didn’t avoid last month the 5-year auction was sluggish. The 50 basis points rate cut yesterday and the soft statement should be considered as a positive, we think.

The Fed’s 37.5 billion schedule 2 TSLF auction showed some further signs of easing. 53.1 billion $ was bid for a 1.42 bid/cover at a stop out rate of 38 basis points, still above the minimum 25 basis points, but well below last week’s 50 basis points and below the very high levels seen in the weeks before. 1 and 3 month Libors declined by respectively 6 and 4 basis points to 3.11% and 3.42%, but this didn’t result in a decline of the liquidity spread (Libor – OIS) that stabilized, even increased slightly. In a weekly perspective, the spread is about 10 basis points higher.

Regarding trading, Treasuries finished mixed yesterday with the curve steeper. The short end outperformed on expectation of a big rate cut that was indeed delivered late in the session, driving the curve slightly steeper. All in all, the reaction on the FOMC decision was modest, as a 50 basis points rate cut was discounted. Only the Fed funds futures showed some distinct reaction, implied rates down by 6 to 11 ticks. The Dec FF future trades now at an implied 74.5 basis points, the January one at 72 basis points effectively discounting an extra 25 basis points rate cut. While the Fed decision was positive for Treasuries, to the extent it stimulated a return in risk appetite, as evidenced by rising commodity prices and weakening dollar, it was a negative, especially for the longer end. Equities lost initial post-FOMC gains in another very late session move, but following a 10% gain on Tuesday, we wouldn’t draw too many conclusions from that. Overnight, Asian equities surged higher, keeping commodities well bid and the dollar on the defensive (versus euro). Today, the GDP report is intrinsically a Treasury positive, while the result of the 5-year Note auction is a wild card, it might weigh on the market ahead of the auction. Return of risk appetite, if sustained, is a negative. However, in recent sessions, yields have climbed higher, especially at the longer end of the curve. The 10-year yield re-approaches the 3.90% resistance that might stop the correction or it may extent to 4.10% which is another obvious resistance. So, investors might start to look out for levels to re-enter the longer end from the long side, even if we admit that the recent price action injects doubts into the near term positive outlook for especially longer-dated Treasuries. Signs of ever larger amounts of government money used to fight the financial crisis and recession is a cause of concern. The overnight measures in Asia (swap lines, rate cuts, fiscal packages) and the US rate cut and US plans for extra fiscal package offer hope that the oversold equity markets may be in for a longer-than-recently was the case recovery, another negative for Treasuries.

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. 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 3.90/4.10% for the 10-year, the latter levels are within reach.

Italian spreads widen ahead of today’s bond auctions

Today, the euro zone eco calendar heats up with German unemployment change (October), the European Commission confidence indicators (October) and the Spanish and Belgian CPI (October). In September, German unemployment declined (by 29 000) more than forecasted (15 000), but the labour market is expected to weaken in the coming months due to the recent rapid deterioration of the economy. This month, German unemployment is expected to decline 10 000, but the risk is on the upside. The European Commission economic confidence indicator extended its downtrend from 88.5 to 87.7 in September. Only consumer confidence stayed unchanged, while all other sub-indices deteriorated. In October, the consensus is looking for a headline figure of 86.0, with all components showing a decline. We see the risks on the downside of expectations due to increased turmoil in financial markets and the bleak outlook for the European economy. Yesterday, the German HICP fell more than expected, coming out at 2.5% M/M and today we will receive the Belgian CPI and a first estimate of the Spanish CPI. A larger decline will raise expectations that also the euro zone headline CPI will come out below the consensus of 3.2% Y/Y.

The substantial decline in commodity prices together with the sharp weakening in demand has diminished the upside inflation risks. Yesterday’s 50 bps rate cut from the Fed and other central banks signals that central bankers are prepared to cut rates aggressively. Earlier this week, Trichet already hinted that ECB is likely to cut rates next week and this view was confirmed yesterday by comments of ECB’s Provopoulos who stressed that the ECB hasn’t yet exhausted its ammunition. Today, ECB’s Ordonez, Weber and Wellink will speak.

On the supply front, Italy will issue a new 10-year benchmark (4.5% Mar 19 BTP) for an amount of between 3-3.5 B. At the same time, Italy will tap its 3-year BTP 4.25% Sep 11 (2-2.5 B) and its 7-year CCT (0.75-1 B). Today’s auction will be a good test for investor’s appetite for Italian bonds, which have been underperforming quite sharply over the previous weeks. Earlier this week, the spread between German and Italian 10-year yields surpassed the level of 100 bps, while the Italian Treasury cancelled its inflation-linked auction. The bonds will be placed through the uniform-price auction mechanism where the price and issuance amount are discretionally set by the Treasury. This mechanism was introduced at the previous auction in mid-October and will be used at least until year end due to the current high volatility in the financial markets.

On the money market, the Euribors resumed their gradual downtrend following Trichet’s hint that the ECB may cut rates again at next week’s policy meeting. Yesterday, the ECB held its first 3-month tender with a fixed rate and under full allotment. The ECB allotted 103 B in the tender more than double of the usual 50 B. The amount bid was however slightly less than in the previous tender indicating that some banks may have chosen to await the next longer-term tender given the expectations for interest rates to fall quite sharply over the coming months. The persistent usage of the deposit and marginal lending facilities nevertheless suggests that confidence isn’t yet restored within the banking sector.

Regarding trading, steepening remains the name of the game on the European bond market, as investors expect the ECB to cut rates ever more aggressively. Although this heightens the risk on a correction, we continue to trade the bond market from the long side. As such, rebounds in yields should 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 yield curve continued to steepen too, with the spread between 2- and 10-year yields reaching their highest levels in 13 years. This morning, the Nationwide house price index showed house prices falling 1.4% M/M and 14.6% Y/Y in October. Yesterday evening, BoE’s Blanchflower signalled that rates may need to fall substantially to counter the current strong deflationary pressures.

Currencies: Yen and Dollar lose more ground, as authorities try to get ahead of the curve

On Wednesday, EUR/USD continued to rebound and moved from opening levels at 1.2682 to a close at 1.2960 and overnight, the move was extended to 1.3297 before some profit taking occurred pushing the pair to 1.3172 at the time of writing.

The story of the recent turnaround is quite straightforward and linked to a return of risk appetite. That was very visible in the global equity markets that are doing fine, just like commodities and emerging market currencies, all considered as “risky” assets. Of course, technical reasons as the oversold character of those markets and the previous pronounced falls add to the cocktail that helped the euro gain 10 big figures in three trading sessions against the Greenback.

It seems that markets are considering that the most recent initiatives across the world to get ahead of the curve on the financial crisis and its dire consequences for the real economy might succeed. Indeed, China, Taiwan and Hong Kong cut rates, but especially in a far-reaching never seen action the Fed opened swap line to the tune of 120 billion $ to countries like Mexico, Brazil, Singapore and South Korea. This is a very important feature, as the shortage of dollar liquidity was a very negative development for these high growth countries which are counting on to support the global economy.

So, Aussi, Kiwi, emerging currencies, but also euro and pound could fight back following a two-month, historical unprecedented long and steep decline of these currencies against yen and dollar

Today, the calendar contains the US GDP that is expected to show a contraction in the third quarter. After rising 2.8% Y/Y in the second quarter of 2008, the consensus is looking for a decline of 0.5% Y/Y in third quarter GDP, but the risks are still on the downside. In EMU, the EU confidence survey, Spanish and Belgian CPI and German unemployment figures will be released. We think that the impact of the eco data should still be only temporary, as the global risk appetite/aversion theme is the driver that is currently not tightly linked with eco developments that are uniformly bad across the globe.

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. However, EUR/USD has now arrived at the first key resistance level around 1.3259, previous low, which we singled out as a potential entry point in a sell euro-on-upticks. It is worth a try, but given the steep correction, it might be safe to wait on the outcome of the current test.

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, but a powerful rebound occurred in recent days. EUR/USD needs to return above the 1.3259 reaction low to get a first indication that pressure is easing. However, Tuesday’s move constitutes an outside key reversal/bullish engulfing move, confirmed yesterday, that might be an indication of a medium term low in place.

On Wednesday, USD/JPY more or less kept a sideways trading pattern digesting Tuesday’s sharp rally. Of course, both currencies stand on the same side in the risk appetite/risk aversion play, but the yen is nevertheless the primus inter pares. However, the marginal yen gains should be seen against the recent USD/JPY rebound and the presence of important resistance. Overnight, the dollar did gain some ground, but only limited one. The steep gains of the Nikkei, more hope on a BOJ rate cut and a new fiscal package are all measures that are intrinsically yen negative. Therefore, we wouldn’t consider new yen long position, even as important resistance looms, but wait on the outcome of the test of that resistance. Indeed, the underlying yen support (risk aversion) might shift somewhat more to the background if the equities can prolong its rise for somewhat longer

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 the past three sessions show 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. The neckline of the configuration stands at 101.30 and should of course hold or its positive implications disappear. 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  Thu, Oct 30 2008, 08:50 GMT