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Sunrise Market Commentary

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US Treasuries slightly higher on dismal eco reports and plunging equities

Thu, Nov 6 2008, 08:27 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Wednesday, global bonds gained further moderate ground, as business sentiment surveys in the services sector in Europe, UK and US fell to record lows and the US ADP report showed a much larger than expected drop in em-ployment. This brought the fears for a severe and long recession back to the fore-front of investor’s minds and sent equities substantially lower. As such, the end of the presidential elections in the US failed to boost investor’s optimism, although several risk premiums declined. In the US, the liquidity, swap and agency spreads all nar-rowed.

Bonds however traded quite volatile throughout the session. Bonds dropped first lower on the announcement of a German economic stimulus program, but erased the losses later on the back of the weak ADP employment report, although there was a slight dip following the US refunding announcement. The record low of the Non-manufacturing ISM index (series starts in 1997) nor the decline on the US equity markets however could push bonds much higher, which ended the day with only lim-ited gains. In the US, there was a slight bull steepening of the yield curve, which brought 2-year yields back to the recent lows. In the euro zone, the belly of the curve outperformed, as 5-year yields fell 5.9 bps lower compared to 1.8 bps in 2-year yields and 3.7 bps in 10-year yields. The intra-EMU government spreads narrowed for the second day in a row.

US Treasuries slightly higher on dismal eco reports and plunging equities

Today, the eco calendar is less interesting today. The Q3 Non farm productivity figures are largely deducted from GDP figures and the payrolls reports (hours worked) and thus contain little new info. The weekly initial claims might be looked at, especially one day before the payrolls, but its survey week is later than the payrolls survey week and thus shouldn’t impact expectations for these payrolls that will be published tomorrow. Of course, a very weak claims report might have a psychological impact. The speech of governor Warsh on financial markets is scheduled for after closure. The ECB and BoE rate decisions might have some impact on Treasuries. Expectations on these decisions have gone to aggressive 50+ basis points cuts. The risk for such a huge cut is bigger in the UK than in EMU. For the ECB, we stick to 50 basis points rate cut, but followed by another 50 basis points rate cut, probably already in December. In a special flash (read Flash ) we argue that the ECB will put its policy of cautious incremental policy steps aside, for an aggressive easing campaign that would in a short period of time push the repo-rate to 2% or even lower.

The Federal Reserve again changed its rules on interest rates paid on required and excess reserve balances of banks. The rate on required balances will be equal to the average target Fed funds rate over the maintenance period, while the rate on excess reserves will be the lowest target rate during the reserve period. Before, the rate on required reserves was target rate minus 10 basis points, while the rate on excess re-serves was the target rate minus 35 basis points. The objective of the change is to bring the effective FF rate, that trades now well below the target rate, closer to that rate. However, it won’t eliminate totally the spread between effective and target rate, because some players like the FHLB is excluded from the legislation allowing the Fed to pay interest on the reserves. The change allows the Fed, if needed, to lower the FF target rate to close to zero, whereas before it was difficult to lower the target rate below, let’s say 0.50%.

The Treasury announced significant changes to its coupon calendar. The Treasury re-introduces a 3-year Note that will be issued on a monthly basis with a mid-month maturity, adds a second reopening of the 10-year Note and starts with quarterly issu-ance of new 30-year bonds. Next week’s refunding operation consists of a 25 billion $ 3-year Note, a 20 billion $ 10-year Note and a 10 billion $ 30-year bond. The total of 55 billion $ makes it the biggest refunding operation ever, but is broadly in line with expectations.

Regarding trading, Treasury yields dropped between 3 and 2 basis points, the curve marginally steeper. The decline in yields was modest, but followed two sessions of more pronounced declines. So is the glass half full or half empty? Was yesterday’s decline a disappointment or was the three-day move down the evidence that yields should stage another substantial down-leg? We would take a middle position. For the longer end, the upside in yields was tested and rejected, but the charts show that the downside was tested too and rejected too. The 30-year yield (now at 4.17%) tested three times the lows at around 4% (all time lows) but couldn’t sustain and establishing a 4-to-4.40% range. The chart of the 10-year yield (now 3.70%) showed that in mid-September the yield tested the 3.28% (mid March low) level, but couldn’t break it. Since two up-legs in yields were reversed, but always resulting in a higher low, the last one at 3.50%. So, also here a more sideways pattern is developing. In both cases, we would play the range and consider profit taking around the lows. The out-look for the shorter end of the curve is more bullish. The 2-year (1.33%) is test-ing the cycle (closing) low at 1.34% and a break would open the way to levels closer to 1%, the all time lows reached in the mid of 2003 (deflation scare) when the Fed funds stood at 1% too. The recent decisions of the Fed (cf. higher) suggest that the Fed fund may fall even somewhat more than we expect. So we would keep long posi-tions and add on up-ticks in yields. The 5-year yield (2.50%) is closing in on recent lows around 2.37%, which if broken would set the yield for a re-test of cycle lows at 2.16%. Also here the recent low was tested twice without success, but the third time might be the good one. The all-time 2003 low stands at 2%. So while we prefer the shorter end of the curve, the downside in yields isn’t huge either.

Aggressive rate cuts expected from the ECB and BoE

In the euro zone, all eyes will be focused on the ECB rate decision, where a rate cut of at least 50 bps is expected. The escalation of the credit crisis over the sum-mer has forced the ECB’s hand and has already resulted in a coordinated rate cut of 50 bps at the beginning of October. Since, it has become clear that the economy has come to a standstill, while upside inflation risks have further diminished. In this envi-ronment, Trichet already hinted at a rate cut last week and also other influential ECB governor council members like ECB’s Weber and Stark have indicated that rates will have to fall further and even hinted at an aggressive easing cycle. As such, there is still a significant risk the ECB will cut rates today by 75 bps to make a state-ment to the markets and bolster confidence. However, such a move could back-fire if it were interpreted as panic and that’s why we still favour a 50 basis points cut. Mr. Trichet’s statement should make it clear that the ECB won’t stop here. We expect an aggressive easing cycle that may include several 50 basis points rate cuts in a short span of time, with the next move probably coming as soon as De-cember. The easing cycle should bring the ECB repo-rate to at least 2%, the floor of the last easing cycle, but in all likelihood it will go even lower. The precise degree of official easing will depend on (1) the extent to which money market problems ease and (2) the extent to which fiscal policy is loosened. In this respect we will closely watch the ECB Trichet comments on the subject.

Given our aggressive ECB easing scenario, we strongly favour the short end of the curve and steepeners. If some disappointment would kick in after a 50 basis points rate cut (more is discounted), it might be an opportunity to step into the market. For extensive coverage of today’s ECB meeting, we refer to our ECB flash.

On the money market, the ECB will hold a pre-announced special longer-term refinancing tender for a maturity of the maintenance period of 33 days. As usual these days, the tender will carried out under full allotment and at a fixed rate. This was still set at the current policy rate of 3.75%, but given the expectations for a rate cut today, we expect demand to be very weak.

On the supply front, France and Spain will tap the market. France will tap four OATs with a maturity of 6, 10 and 30-year for an amount of EUR 4.5-6 B, while Spain will tap two bonds, a 3- and 7-year Bono (2.2-2.8 B). Yesterday, most intra-EMU gov-ernment bonds spreads narrowed for the second consecutive day, except for Finland that tapped its 4-year for an amount of 1 B. The narrowing of the Belgian spread was also very limited. Belgium yesterday announced a government guarantee for as much as 240 B EUR of interbank loans and bonds of Dexia and Fortis. Although there was no direct impact on the spread, the huge amount of the guarantee, which equals almost the total debt of Belgium (290 B), may limit the narrowing potential.

Regarding trading, the technical pictures are bullish for all maturities, but following the failed test of the 10-year yields to break below the year lows at 3.65% over the previous weeks, we are looking for some upward correction before adding to long po-sitions. From a technical point of view, rebounds towards 2.90% in 2-year yields, 3.50% in 5-year yields and 4% in 10-year yields offer good opportunities.

In the UK, the Bank of England is also expected to cut rates today. The more ac-tivist approach of the MPC and the recent dramatic worsening of the economic out-look has raised market’s rate cut expectations to 75 bps. We see no reason to go a-gainst the flow.

Currencies: big intra-day swings, but no clear trend

On Wednesday, EUR/USD showed again some marked swings. The announcement of the Obama victory in the US presidential caused a temporary rebound of the USD dollar, with EUR/USD testing bids in the 1.2800-area in Asian trading. However, this pocket of dollar strength was very short-lived and during the session the euro man-aged to stage quite a strong rebound, even if the market environment was not really euro supportive. The European data (Final services PMI) were again very weak and also the poor stock market performance recently used to be euro negative. The EUR/USD rebound even accelerated during the morning session in the US as the US data (ADP and ISM non-manufacturing) confirmed picture of the US economy sliding ever deeper into recessionary territory. Later in US trading, the EUR/USD cross rate pared part of the early gains due to the decline in the oil price (despite lower than expected US inventories) and the sell-off on the US stock markets. Never-theless, EUR/USD closed the session 1.2954, little changed from the 1.2981 close on Tuesday evening. The economic data yesterday might have played a role to ex-plain the intraday price action, but after all also for this currency pair this is still very much an order driven market. Overnight, EUR/USD lost some further ground. We tend to explain this move rather as being the result of global market factors (stocks, oil price) rather than speculation on the ECB interest rate decision scheduled for to-day.

Today, there are some second tier eco data on the agenda, but all eyes in the mar-ket today will be on the ECB and the BoE interest rate decision. In both cases, a 50 basis points rate cuts looks like a done thing. The question is: will they to more? De-spite recent dovish ECB talk we still consider the 50 basis point scenario as the most likely scenario with the Bank preparing additional steps in the near future (Decem-ber). If this scenario comes true, it should be fairly neutral for the single currency. In this case, EUR/USD trading will continue to be driven by the order-flow and the global financial environment. However, with markets desperately looking for meas-ures to kick-start economy, a larger than expected ECB interest rate cut shouldn’t in advance be considered as euro negative.

Our standing view is that a prolonged period of sub par growth and a deflationary environment is more supportive to the dollar than to the single currency and this was an important factor behind the decline of EUR/USD from 1.60 to below 1.24. This is also the main reason for our EUR/USD negative view longer term, which re-mains intact. However, over the previous days, the single currency showed some-what more resilient, even at time times when the global market environment was not really euro supportive (oil, stock market decline yesterday). We don’t draw firm con-clusions from yesterday’s price action yet and look out for the market reaction on the ECB interest rate decision. For now, we hold on to our view that the pair entered a sideways trading/consolidation pattern within the boundaries of 1.231 and 1.3297. However, we stay open-minded as we feel that the downside in this pair might be-come better protected short-term.

From a technical point of view, EUR/USD since the last week of September tum-bled from the 1.4866 reaction high to levels below the 1.24 mark early last week. High profile intermediate supports like the longstanding daily uptrend line since 2002, 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 last week. EUR/USD needs to return above the 1.3259/94 (previous reaction low/reaction high) in a sustainable way to get a first indication that EUR/USD sentiment is improving. Recently, we favoured a sell-on-upticks approach in case of return action higher in the above mentioned trading range. From a technical point of view, there is no need to change tactics yet, but a break above the 1.33 area would be an indication that the EUR/USD rebound/correction could have some further to go (at least partial stop loss protection).

On Wednesday, USD/JPY started trading in Asia in the 99.50 area. The decline on the stock markets in Europe triggered a first selling wave with the pair testing bids in the 98.30 area. In the US, the dollar held up rather well against the yen despite the poor US eco data, but the steep losses on the US stock markets caused a new sell-ing wave. The pair closed the session at 97.97, compared to a 99.70 close on Tues-day. The daily loss is ‘logic’ but no really huge, given the negative stock market per-formance.

This morning, the BOJ minutes of the early October meeting showed that the gov-ernment incited the Bank to join international action to address the financial crisis, but at that time the bank apparently didn’t consider a rate cut yet. Growing market stress and a quick deterioration in the (global and Japanese) economic outlook later last month made the Bank to change his mind. Overnight, the pair shows some addi-tional losses, in step with the equity sell-off in Asia this morning.

On the charts, global market stress hammered the pair through the key 103.50 range bottom early October and the pair set a new reaction low at 90.93 two weeks ago. An easing in global market tension sparked an USD/JPY rebound with the pair reaching a reaction high in the 100.55 area early this week. Recently, we were neu-tral on USD/JPY. However, over the previous days, the 100.55 reaction high, proved a hard nut to crack short-term. With market nervousness still high and the global eco picture still awful, a sell-on-upticks approach for return action lower in the 101.55 to 90.93 range is favoured.

Yesterday, EUR/GBP showed again some rather wide intra-day swings but at the end of the day EUR/GBP was little changed. At first, the steep gains from Tuesday and the pair coming close to key resistance caused some short-term profit taking. The poor UK eco data (collapse in the services PMI and disappointing production data) at that time only had a very limited impact on sterling trading and EUR/GBP set an intraday low in the 0.8050 area early in US trading. Sharp, order-driven, swings in cable were behind this move. However, with the uncertainty on the BOE interest rate decision looming, sterling couldn’t hold on to its gains and later in US trading EUR/GBP recouped the early losses to close the session at 0.8146, little changed from the 0.8134 close on Tuesday.

Today, all eyes in the market will be on the ECB and probably even more on the BOE interest rate decision. As is the case for the ECB, a 50 basis point rate cuts looks like a done deal. However, even more than for the ECB the risk is for the BoE to take more bold action. In theory, a more aggressive BoE interest rate cut could be sterling negative. However, with markets/investors desperately looking for decisive action to stop the bleeding for the economy, we’re far from convinced that a 75 or even a 100 basis points rate cut would lead to a sharp sell-off of the sterling against the single currency.

Already for some time, we advocate that we don’t see the need for a sustained comeback of the sterling against the euro based on the eco (and financial) picture in both areas. Our view came under pressure two weeks ago with EUR/GBP exten-sively testing the key 0.77 support area. However, the range held and the pair in ex-tremely volatile trading even revisited the highs in the 0.8200 two weeks ago. The pair currently comes close to the top of this sideways trading range. To assess the market reaction on today’s BoE interest rate decision, we take a close look at the technical picture. An aggressive rate cut might be a good reason to extensively test the top of the sideways range in the 0.8200 area. For now, we still prefer a scenario of no sustained break above this key level. Our cut-off point is the 0.83 area. Sus-tained trading above this level would suggest that a new sterling selling could be in the making.

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Published on  Thu, Nov 6 2008, 08:44 GMT