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Sunrise Market Commentary

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US Treasuries eke out some additional gains in quiet session

Tue, Nov 18 2008, 08:05 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Monday, global bonds eked out some moderate gains, continuing its multiday up-leg. For most of the day, equities were the driving force behind bond trading, with the eco data only having a very temporary impact at best.

In the EMU, the wings of the curve outperformed, as the 2 and 30-year yields dropped by 3 basis points, while the belly saw its yields down by 1 basis point. In the US on the contrary the belly outperformed, yields being down 6 to 8.7 basis points, while the wings saw their yield down by 3.5 basis points.

Regarding the economic news, French business confidence plunged to a 21-year low, according to the Bank of France survey. In the US, the New York Fed manufacturing survey was very weak, especially in its details, while the production data were quirky. August production output was revised sharply down (-3.7% M/M from -2.8% M/M), while September production output jumped unexpectedly by 1.3% M/M. Special factors like the hurricanes and the Boeing strike distorted the report. There was a small, though temporary negative reaction on both US data releases. Afterwards Treasuries/Bund followed closely the gyrations of equities.

In the US, Libors stabilized after two days of increases, while in EMU, Euribors slid another few basis points. ECB talk was bullish as ECB hawk Weber saw more room to cut rates, while in the US, Fed governor Hoenig was concerned about recent activist Fed policy. The respective height of official rates on both sides of the ocean explain the recent outperformance of the EMU short end of the curve.

US Treasuries eke out some additional gains in quiet session

Today, the calendar contains the October PPI figures and the NAHB housing market index (November). In October, PPI inflation is expected to decline sharply, after falling 0.4% M/M in September. The consensus is looking for a 1.8% M/M drop in producer prices due to lower energy prices. On a yearly basis, PPI is expected to come out at 6.2% Y/Y (versus 8.7% previously). Excluding food and energy, PPI is forecasted to show a modest increase (0.1% M/M). So overall, the PPI should confirm the rapid easing in inflationary pressures. The NAHB housing market index is expected to stay unchanged at the record low (14) reached in October, suggesting no signs of recovery yet. Fed chairman Bernanke and Treasury Secretary Paulson will testify before the House Financial Service Committee on the implementation of the TARP. This might be interesting as we suspect House members will grill Paulson on his flip-flopping on the TARP with Bernanke in an awkward position of giving his views on these change in attitude.

A Philly Fed survey of private (professional) forecasters revealed that private forecasters think the recession started in spring. They expect a sharp 2.9% crimp in Q4 with payrolls declining by an average 222 400 in the last three months of this year. In Q1, the economy would decline by 1.1%. The recession would last for 14 months, thus ending in June 2009.

Kansas Fed governor Hoenig joined some of its regional colleagues in his unease with the Fed activist policy to combat the credit crisis. Especially, the Fed lending to ever more non-bank firms got his concerns as it might be “mixing banking and commerce”. Some Fed steps have also raised questions about moral hazard, equitable treatment of different institutions and segments of the market and public interference in credit allocation. On monetary policy, he said the Fed had done what it can to buffer the economy, but a painful process of adjustment is likely ahead. The banks are unable to lend as aggressively, he said, as they are constrained by their own capital and a process of deleveraging is taking place. So, it shouldn’t surprise Hoenig sounded pessimistic on the economic outlook.

The Treasury announced that it will allow the Special Financing Program Bills to decline to preserve flexibility in the conduct of debt management. Public debt is nearing the public debt cap that currently stands at 11.315 trn.$ and with more TARP outlays likely in the next months, the Treasury wants to create room to implement TARP. The SFP bills were used to allow the Fed expand its balance sheet, but by introducing interest payments on excess reserves the Fed doesn’t need the STP balances, currently 510 bn. $, put by the Treasury at the Fed anymore. The STP balances (bills) will mature before the end of January 2009.

Regarding trading, Treasuries opened the week with a constructive, albeit it another low volume, session and moderately lower yields, the belly outperforming the wings. The price action was equity driven with the eco releases having only a temporary impact. We suspect that the eco releases won’t be important for trading today. PPI is interesting, but inflation is no longer an item, while the NAHB and TIC data are no market movers, even if the September TIC data may give us information about investors’ attitude towards Treasuries during the month that Lehman went bust. The testimony of Paulson & Bernanke might be interesting, while the debate in Congress on the support for the carmakers should be kept a close eye on. With equities near cycle lows, it is these elements that may decide the fate of equities and at the same time influence Treasury trading. Equities cannot linger on for too long at current levels. Or it breaks lower or it stages a rebound. So, Treasury investors might look for profit taking levels and in case of a selling wave for long entry positions.

While the outlook for Treasuries is still reasonably bullish, especially at the shorter end, we would like to see a correction before entering the market. The technicals, which remain bullish, will guide us in the day-to-day tactics. The downtrend of the 2- year yield is intact and the 1.32/23% cycle lows are now broken, opening the way to yields around 1%. The 5-year (now 2.26%) is now below key resistance levels at around 2.35%, which if broken sustainable, would make the picture outright bullish. The pictures of the 10- and 30-year are more neutral. In a post-Lehman spike, the 10- year yield (now 3.65%) tested the 3.25% cycle low, but the test was rejected. Since, the yield moved a few times up and down, but setting always a higher low, a disappointment that wasn’t washed away last week. A short term positive for the 10-year picture would be a drop below 3.63%, but we are still a bit sceptical about the ability of the yield to drop much lower. We might see the yield testing support at 3.98% and even 4.10%, if risk aversion recedes.

Bund testing the 2005 highs on the continuation charts

Today, the euro zone eco calendar is empty, while the ECB speakers are unlikely to break new ground. On the supply front, Greece plans to tap its 3-year 3.8% Mar 2011 for an amount of EUR 1.3 B.

Yesterday, several ECB governing council members continued to paint a bleak picture of the euro zone economic outlook and hinted at further rate cuts to come. Especially the comments of the influential Bundesbank president Weber were interesting. Weber saw ‘a dramatic clouding of the economic outlook’ and expected ‘considerable weaker inflation rates towards 2009’ to give ‘room for monetary policy’. As such, he concluded that it isn’t ‘unrealistic’ that the ECB will cut rates further. Today, ECB’s Trichet, Stark, Tumpel-Gugerell and Liikanen are all scheduled to speak.

On the supply front, Greece is the first to tap the European bond market this week. Over the past month, the spread between Greek and German bonds has widened dramatically to peak at 165 bps in the 10-year sector. Since the spread has narrowed somewhat, but remained at levels not seen since the introduction of the euro. The recent narrowing has been in contradiction to what has been happening in the CDS market, where the CDS on Greece has continued to rise and even set new highs yesterday. Given the ongoing turmoil in the financial markets, we don’t expect a significant narrowing of the spreads yet. Yesterday, Belgium also detailed its plans with regard to next Monday’s bond auction. Belgian plans to tap four OLOs: two 3-year bonds, a 5-year bond and a 10-year bond. This afternoon at 2 pm local time, the Brussels commercial court will rule whether Fortis needed shareholders’ approval to sell most of its assets. If the asset sale to BNP Paribas is suspended, this could have negative consequences on the Belgian interbank and capital markets and may lead to an underperformance of Belgian government bonds.

On the money market, the Euribor fixings declined further, but the renewed rise in the overnight deposits at the ECB signals that there is still a lack of confidence. Yesterday, the ECB specified its plans to accept euro-denominated syndicated credit claims as collateral in another effort to ensure the liquidity provision to the financial sector. Today, the ECB will hold its weekly refinancing operation.

Regarding trading, the steepening of the European yield curve continued unabatedly yesterday, as 2-year yields fell to new cycle lows. First important support is seen at around the 2% level. 10-year yields however still fail to break below the year lows at 3.67% in a sustainable manner. In the Bund future, a new contract high has been set, but on the continuation charts the Bund has to break first above the December 2005 highs at 118.88 to improve the technical picture further (see graph below). Whether this will happen will mainly depend on the equity markets, where the test of the cycle lows in the S&P is still ongoing. For now, we however continue to prefer the short end and a further steepening of the yield curve.

In the UK, the short end once again outperformed the longer end of the curve, as disappointing demand for the 4.25% Dec 2055 Gilt auction weighed at the ultralong end. At the short end of the curve, PM Brown repeated that there is ‘scope for more rate cuts’ and called ‘monetary policy important to the restoration of growth’.

Today, BoE’s Besley will speak on monetary policy, while the calendar contains the October CPI figures. After reaching a cycle high (5.2% Y/Y) in September, inflation is expected to fall back in October. CPI is expected to come out at 4.8% Y/Y, while the month-on-month figure is forecasted to show a modest increase (0.1% M/M). Last week’s Bank of England’s inflation report however indicated that inflation will fall back quite sharply and risks undershooting the target in the medium term.

Currencies: major cross rates (temporary?) enter calmer waters

On Monday, the global context for EUR/USD trading was little changed. Global investor sentiment rather than country/region specific data continued to set the tone for trading in the major cross rates. Equities are still the most evident catalyst to asses this global investor sentiment. In Europe stocks opened reasonably well with some small gains despite the poor close in the US on Friday evening. This caused EUR/USD to go higher too and the pair tested offers in the 1.27 area during the European morning session. The US data (Empire manufacturing survey and production data) were mixed and had again no impact on trading. Equities failed to establish a clear directional move but another temporary improvement in global investor sentiment after the close of the European markets triggered some additional gains of the euro against the dollar. However, once again, market sentiment was very instable. Equities took a sharp hit at the end of the US trading session and this was enough a reason for EUR/USD to cede some of the early gains, too. EUR/USD closed the session at 1.2650 compared to 1.2605 on Friday. Given the ongoing high degree of financial and economic uncertainty, we consider this a decent performance of the single currency.

Today, the European calendar is again very light. In the US, the producer prices and the TIC data on US capital flows are on the agenda. Price data are not really a point of concern for currency trading. We are no big fan of the TIC data, but in the current environment of global market stress it will be interesting to see whether or not the US is able to take advantage of its presumed safe haven status. The appearance of Fed’s Bernanke and US Treasury secretary Paulson before the financial rescue house panel is a wild card.

Already for quite some time, negative eco news and risk avers investor behavior has supported the dollar (and the yen) and has weighed on the single currency. This theme was an important factor behind the decline of EUR/USD from highs above 1.60 to current correction low in the 1.2330 area. We hold on to our EUR/USD negative bias longer term. However, since end October, the single currency has showed more resilient and has since developed a short-term consolidation pattern. The correlation between EUR/USD and the stock markets is not one-for-one, but (the degree of) risk aversion remains an important factor for EUR/USD trading. For now, we continue hold on to our view that the pair might continue trading within the barriers of this 1.2330/1.3297 consolidation pattern. Whether the bottom of this range will hold is highly dependent on whether or not the major stock market indices will be able to avoid another down leg below the recent lows (840/818 area for the S&P). The jury is still out on this item.

From a technical point of view, EUR/USD since the last week of September tumbled from the 1.4866 reaction high to 1.2330 on October 28. High profile intermediate supports have all been taken out with remarkable ease. Over the last three weeks the EUR/USD decline shifted into a lower gear but the pair failed to regain the first important resistance area (1.3259/94) in a sustainable way and gradually returned south. Recently, we favoured a sell-on-upticks approach in case of return action higher in the above mentioned trading range. We hold on to that tactics but we do not yet front run on a break of the downside of the range. In this respect, we still tended to reduce/take profit on EUR/USD short exposure in case of dips towards to range bottom and look to re-sell in a case of return action higher.

On Monday, the trading in USD/JPY continued to develop within the same framework that is already in place for quite some time. The high degree of uncertainty and the ongoing elevated level of market stress (the VIX index has continued its uptrend over the previous days) are supportive factors for the yen. However, yesterday’s intraday swings in the stock markets were apparently not enough a reason to spark any directional trend in USD/JPY. The pair hovered up and down in a 96.00/97.50 trading range and closed the session at 96.43, compared to 97.14 on Friday.

This morning, the Japanese department store sales showed a further steep decline. The report confirms the quick deterioration in the Japanese eco picture. Yesterday’s GDP data showed that the Japanese economy has entered recession in Q3 and there is no reason to expect an improvement anytime soon. The Nikkei and most other Asian stock markets are again in negative territory. However, for now those stock market losses hardly have any impact on USD/JPY trading

Looking at the charts, global market stress hammered the USD/JPY cross rate through the key 103.50 range bottom early October and the pair set a new reaction low at 90.93 three weeks ago. An easing in global market tensions sparked a temporary USD/JPY rebound. The pair set a reaction high in the 100.55 on November 04, but the rebound ran into resistance. Longer-term, we prefer a scenario of the yen remaining well supported as there is still very little prospect for a sustained improvement in the global economic picture anytime soon. Recently, we indicated that gains beyond the 100.55 reaction high wouldn’t be easy short-term. A sell-on-upticks approach remains favoured as long as the pair holds below the 100.55 mark.

On Monday, EUR/GBP extended the correction on steep gains recorded after last week’s break above the previous range top in the 0.8200 area. The news flow on the UK economy remained negative (Rightmove house prices and CBI forecast) but contrary to what was the case last week, this news didn’t cause any additional damage for the sterling. Quite the opposite, sterling regained some ground against the dollar and euro. For now, we consider this move as nothing more than a technically inspired unwinding of heavily overbought conditions (in EUR/GBP) after the recent sterling sell-off. EUR/GBP fell from intraday highs in the 0.8570 area early in the session to an intraday low in the 0.8410 in US trading. The pair closed the session at 0.8437, a decent loss compared to the 0.8541 close on Friday.

Today, the UK inflation data are on the agenda. Inflation is expected the come down from the 5.2% cycle high to 4.8 %. This is still well above the BoE target, but last week markets already received the BoE’s assessment on the inflation/deflation problematic, with the bank clearly putting the risk for inflation to fall below the BoE target within the Bank’s policy horizon. So, today’s inflation figure will have no big relevance for the BoE interest rate policy in the (near) future.

The aggressive BoE rate cut two weeks ago and the negative assessment from the BoE on the UK economy after the publication of the inflation report pulled the trigger for an aggressive sterling selling wave last week. The quick loss of interest rate support and the very negative outlook for the UK economy going forward made sterling lose all its attractiveness. Wednesday’s brake above the high profile 0.8200 resistance area has made the technical picture outright negative for sterling/positive for EUR/GBP. After the sterling crash last week, some consolidation/correction shouldn’t come as a big surprise. Longer-term we continue to put the risk for additional sterling losses, even from the current levels. The pair needs to return below the 0.8215 area (uptrend line) to call off the red alert for the sterling. The pair currently tests the first important support area (0.8412 previous high). We watch out how far this correction has to go. We prepare to buy/add to EUR/GBP long exposure in case of signs that the correction has run its course.

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Published on  Tue, Nov 18 2008, 10:22 GMT