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Sunrise Market Commentary

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US Treasuries continue to move ahead, curve flattens

Wed, Nov 19 2008, 08:13 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Tuesday, EMU bonds kept their positive bias, but couldn’t really build their gains out in the absence of strong drivers. EMU yields ended the day flat (2, 5, and 30-year) to very modestly lower (10-year). After the official closure, the Bund surged higher in sympathy with Treasuries that reacted to plunging equities. Treasuries were already better oriented in early US trading. Investors continued to book profits on steepeners for the third day in a row, the steepening trade was a favourite for most of the September-to-November period. Interestingly, equities, that shyly tested cycle lows, rebounded late in the session, but barely affected Treasuries. US yields fell by 5, 7, 12 and 12 basis points for respectively the 2-, 5-, 10- and 30-year sector.

Regarding the economic news, the US PPI report was mixed, headline PPI plunged lower, but core PPI unexpectedly increased to its highest level since 1989, but Treasuries barely moved, while the unexpectedly weak NHAB, released in late session, was ignored. The testimony of Bernanke, Paulson and Blair didn’t affect markets either.

US Treasuries continue to move ahead, curve flattens

The calendar contains the October CPI, Housing starts and Building permits. Later today, the Fed will release the minutes of the latest FOMC meeting, while Fed governors Kohn and Lacker speak on asset prices and subprime.

Last month, CPI declined from 5.4% Y/Y to 4.9% Y/Y and the consensus is seeking for another drop of 0.8% M/M to 4.0% Y/Y. Core inflation is expected to show a modest increase (0.1% M/M). After the PPI data, released yesterday, we put the risks on the downside of expectations for the headline figure, while core CPI might come out higher than the consensus expectation. Both housing starts and building permits showed a sharp drop in September. Housing starts dropped another 6.3% M/M to 817 000, while building permits plunged 8.25% M/M to 786 000. In October, housing starts are expected to show another decline to 780 000 and building permits are expected to come out at 774 000, while the previous figure was upwardly revised to 805 000. The housing market is expected to stay very weak in the coming months due to extreme tensions in financial markets and the global economic slowdown. This was emphasized once more yesterday, when the National Association of Homebuilders survey showed a stunning decline of its headline index to 9 in November from 14 in October. It is by far the lowest reading ever of this diffusion index that has its boom/bust level at 50.

Minneapolis Fed governor Stern, a team player inside the FOMC, said that he would support lowering rates again if the economic outlook dictates a cut, but repeated earlier comments that bringing the Fed Fund rate below 1% would involve institutional issues. In other comments, he admitted that inflation risks “clearly has diminished appreciably”, but that it was premature to worry about the prospect of deflation. It will be interesting to see whether the Minutes of the October 28-29 FOMC meeting contain discussions on the way the Fed will modulate its policy when reaching the zero rate constraint that may in practice been reached ahead of zero FF rate. Tentatively, we still count on a 50 basis points rate cut in December before alternative monetary policy steps might be introduced in 2009. However, we closely follow the debate that seems to have started in FOMC circles.

Minneapolis Fed governor Stern, a team player inside the FOMC, said that he would support lowering rates again if the economic outlook dictates a cut, but repeated earlier comments that bringing the Fed Fund rate below 1% would involve institutional issues. In other comments, he admitted that inflation risks “clearly has diminished appreciably”, but that it was premature to worry about the prospect of deflation. It will be interesting to see whether the Minutes of the October 28-29 FOMC meeting contain discussions on the way the Fed will modulate its policy when reaching the zero rate constraint that may in practice been reached ahead of zero FF rate. Tentatively, we still count on a 50 basis points rate cut in December before alternative monetary policy steps might be introduced in 2009. However, we closely follow the debate that seems to have started in FOMC circles.

In his testimony on TARP before a House Committee, Bernanke said that credit market remained strained, even if some stabilization has been occurred, due to the TARP and especially the capital injections in financial institutions. He defended the Fed actions towards the money market and commercial paper markets and endorsed the FDIC plan to stem foreclosures. More important, Treasury Secretary Paulson suggested he was reluctant to ask Congress for the second 350 billion $ tranche of the TARP, maybe to give Obama room to re-orient policy, and warned that the TARP was not a panacea for the ailing economy. TARP was intended to stabilize the financial sector, not to provide fiscal stimulus throughout the economy, a swipe to those who want a bail-out of the carmakers. Paulson said the Treasury would issue 1.5 trn. $ in Treasuries in the current fiscal year. The eventual bail-out of the carmakers remains a hot topic for markets and is currently heavily debated in Congress. House speaker Nancy Pelosi said that if no agreement is reached this week, she doesn’t see Congress meet in December, suggesting that the bail out would be off the table and bankruptcy might be inevitable. This is a main concern for markets now and positive for the safe haven Treasuries, but negative for equities.

In other news overnight, the ABC Consumer Comfort index fell in the most recent week (-2 points) to a fresh all-time-low, suggesting that the recent marginal up-tick in the Michigan consumer sentiment index might have been a blip. The retrenchment of the consumer is a key factor in the current recession that is deepening. According to the FT, Citigroup closed one of its supported flagship hedge funds after the fund lost 53% of its value in October.

Regarding trading, Treasuries continue to blossom and yields are sliding lower, The 2- and now also the 5-year yield set new cycle lows, but also the longer end, that we shunned a bit more recently, did well. The context for Treasuries remains constructive. Eco data are awful and equities are still at major (cycle low) levels. The sword of Damocles is still above the big 3 carmakers, which of course feed into the safe haven buying of government bonds. The technicals are bullish for the 2- and 5-year sectors and yesterday the picture for the 10-year improved too, but still only from a shorter term perspective.

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 broken (now 1.12%), opening the way to yields around 1%. The 5-year (now 2.17%) is below key resistance levels at around 2.35% and tests now the 2.15% (mid-March low) level, which if broken sustainable, would lead to the all time lows at around 2%. Levels of 1 and 2% for respectively 2- and 5-year yield look nice profit taking levels. 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. A short term positive for the 10-year picture was yesterday’s drop below 3.63%, which might open the way for a retest of the 3.25% level, but we remain still a bit sceptical about this happening soon.

ECB’s Stark warns for a crisis in public finances

Today, the euro zone eco calendar is empty.

Yesterday, ECB’s president Trichet hinted again at more interest rate cuts in the euro zone and called on the European governments to use the flexibility of the stability and growth pact to stimulate the economy, as he called the current crisis the worst since the World War Two. ECB’s Chief Economist Stark however stressed that ‘all monetary and fiscal policies need to remain committed to their respective mediumterm objectives’ and pleaded for a ‘global financial stability pact’. Stark said that he hoped that following the spreading of the financial crisis to the real economy, there won’t be a third step of the crisis, namely a crisis of public finances. This is indeed the biggest threat to the current bullish outlook for the European bond market and indicates why supply should be closely monitored.

Today, Germany will tap its 5-year Bobl 4% Oct13 for an amount of EUR 4 B. Although German bonds have been outperforming their European counterparts over the past weeks, demand at the German auctions has remained rather weak. This may also be the case today, as the issue will see competing supply from KfW, which plans to sell a new 3-year bond this week, and from France, which will tap two 5-year bonds tomorrow. But whether this will have an impact on the intra-EMU spreads is highly uncertain, as Greece could only sell its 3-year bond yesterday at a huge spread over Germany.

On the money market, the Euribor fixings extended their recent decline. The decline, however, has still been more related to the lower ECB interest rate expectations rather than to a real improvement in the money market conditions, as the liquidity spread has remained at elevated levels and banks have continued to deposit large amounts of money at the ECB instead of lending it out to each other. Yesterday, the amount allotted at the weekly refinancing tender rose to its highest level since last December, as a record number of banks participated in the tender. These issues indicated that there was still a lack of confidence within the financial sector and suggested that the ECB might have to lower interest rates even more than usual before the rate cuts will start to support the economy.

Regarding trading, the outlook for bonds improved following the break higher in the Bund above the December 2005 highs at 118.88. If confirmed today, this would bring the January 2006 highs at 122.65 in the picture ahead of the all-time highs at 124.60. Such a confirmation may also result in some correction on the recent sharp steepening of the European yield curve.

In the UK, the calendar is interesting with the CBI industrial trends report (November) and the Bank of England Minutes. Last month, the CBI report showed a sharp drop in total orders (-39 from -26). For this month, we expect a more modest drop after a slight improvement in the manufacturing PMI. In November, the BoE cut rates by an amazing 150 basis points, the largest rate cut in the MPC’s history. This indicated that the economy had deteriorated very sharply and that further rate cuts will be needed. We expect the Minutes to show a debate about the scale of the rate cut.

Currencies: EUR/USD and USD/JPY continue to trade sideways, EUR/GBP correction slows

On Tuesday, the story of EUR/USD trading was very much straightforward. The pair mirrored almost perfectly the intraday gyrations of the major stock market indices. The pair sipped below the 1.2600 mark early in European trading on a poor stock market performance in Asia and during the first hours of European trading. Global sentiment improved going into the US trading session and EUR/USD tested offers in the 1.2700 area just after the close of the European stock markets. The US data (PPI and TIC data) had again no lasting impact on trading and this was also the case for the appearance of Mr. Bernanke and Mr. Paulson before the House Financial services Committee. However, sentiment on the US stock markets remained highly instable and at some point it even looked as if a test of the key 818-support area was in the cards. This also caused EUR/USD to return to the intraday lows. A real test of the lows (in equities) was avoided and both stocks and EUR/USD closed the session off the lows. EUR/USD finished the day at 1.2618, compared to 1.2650 on Monday. Despite the intraday volatility, the EUR/USD trading pattern is losing dynamics and tends to settle in a boring sideways trading pattern.

Today, European eco calendar is again very thin. In the US the CPI, the housing starts and building permits are scheduled for release and the Fed will publish the Minutes of the previous FOMC meeting. We don’t expect these events to have a lasting influence on trading. The Housing data have probably the best chance to have some, albeit limited, intraday impact.

For quite some time, negative eco news and risk avers investor behavior have supported the dollar (and the yen) and have weighed on the single currency. This theme was an important factor behind the decline of EUR/USD from highs above 1.60 to the correction low in the 1.2330 area. We are going to hold onto our EUR/USD negative bias longer term. However, since end October the single currency has 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. We expect EUR/USD to continue to develop within the barriers of this 1.2330/1.3297 consolidation pattern short-term. Whether the bottom of this range will continue to hold will be highly dependent on whether or not the major stock market indices will be able to avoid another down-leg below the recent lows (818 area for the S&P). The jury is still out on this item. However after the relative EUR/USD resilience of late, we have the impression that a forceful down-leg on the stock markets will be needed for EUR/USD to break below the 1.2330 area.

From a technical point of view, since the last week of September EUR/USD has 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 has established a sideways trading pattern. Recently, we favoured a sell-on-upticks approach in case of return action higher in the above mentioned trading range. We are holding on to that tactics. We do not yet front run on a break of the downside of the range. In this respect, we are still inclined to reduce/take profit on EUR/USD short exposure in case of dips towards to range bottom and are looking to re-sell in a case of return action higher in the mentioned trading range.

On Tuesday, the drivers for USD/JPY trading were very much the same as the ones that set the tone for EUR/USD trading: global investor/stock market sentiment. Early stock market weakness brought the pair close the 96.00 barrier around noon in Europe. There were again some stock market-driven gyrations later in the session. USD/JPY closed the session at 97.03, compared to 96.43 on Monday.

This morning, Japanese stock markets (contrary the Chinese stock markets) are not able to take any advantage from the positive close in the US yesterday evening. This supports the yen (slightly) this morning. The Japanese all industry activity index came out as expected (-0.1%M/M). Vice finance Minister Shinohara at a conference in Sydney said that he didn’t want the key currency country to continue running a huge current account deficit and that he wanted the key currency to be strong. It is not the time to execute high profile, unilateral currency interventions, but the declaration is illustrating the underlying unease in Japan with the current strength of the yen.

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. A temporary easing of global market tensions sparked a 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 are preferring 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. In a day-to-day perspective, USD/JPY is developing a ST triangle pattern suggesting that there is no strong momentum in one way or another.

Yesterday, the EUR/GBP correction that started at the end of last week lost power. At the start in Europe, the pair extended its decline and set a correction low in the 0.8360 area. However, the pair found a better bit at that level and the softer than expected UK CPI data helped the cross rate to change course. This release apparently faced investors with the possibility of additional BoE interest rate cuts in the near future. Throughout the session, the pair regained the earlier intraday losses and closed the session at 0.8435, little changed compared to the 0.8437 close on Monday.

Today, CBI industrial trends order balance and the BoE Minutes are scheduled for release. It would be highly surprising to see the CBI survey bringing any positive news. The BoE minutes are interesting, but the after last week’s inflation report, the framework for the BoE interest rate policy going forward has more or less been set out.

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 have caused sterling losing all its attractiveness. The break 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 of last week, some consolidation/correction kicked in on Friday and at the start of this week. Longer-term we continue to put the risk for additional sterling losses, even from the current levels. The pair must return below the 0.8215 area (uptrend line) to call off the red alert for the sterling. We are watching out how far this correction has to go. Yesterday’s intraday U-turn might be a first indication that the ST correction is losing momentum. We are not yet in a hurry, but we are still looking to buy/add to EUR/GBP long exposure in case of addition signals that the correction has run its course.

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Published on  Wed, Nov 19 2008, 08:32 GMT