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Sunrise Market Commentary

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US Treasury trading resumes

Fri, Nov 28 2008, 08:28 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Thursday, European bonds traded broadly sideways in thin volume, as US markets were closed due to Thanksgiving. As such, bonds digested recent strong gains and ended the day slightly lower, except for the 30-year segment which outperformed the rest of the curve. There was little direct impact noted from the terrorist attacks on Mumbai on the financial markets, as equities were also up.

Intra-day, the more gradual than expected slowing in M3 money supply growth weighed on the European bond market at the beginning of the session, but the losses were recouped later on as the EU Commission confidence indicators showed that the euro zone economy has hit the wall. The Bund tested the highs in the aftermath but was unable to break decisively higher. Both 10- and 30-year yields have approached important support levels respectively at around 3.23% and 3.78% and these might have been a hurdle too high to break below for now. This couldn’t however prevent the 30-year segment to outperform and close at 3.77%.

US Treasury trading resumes

Today, the calendar is empty. The SIFMA recommends an early close of the bond market in observance of Thanksgiving. Most Americans will spend the day with their family and visit the malls as the Christmas spending season officially opens. December is traditionally the most important month for retailers and this will not be different this year. However, retailers are, correctly, pessimistic about their sales prospects and need to slash prices to attract buyers, something they are doing. However, it is unlikely this will be enough for a successful Christmas selling season. Indeed, the US economy is in a severe recession and the overburdened consumer is in the eye of the storm. His debt burden is higher than ever, his house is worth far less than a year ago and if he hasn’t lost his job like millions of Americans in the last 12 months (net job loss of about 1 million), he certainly will feel insecure about keeping its job. Lower gasoline prices are not enough of a counterweight. So retailers and markets will look closely, from today onwards, how bad sales are going to be in the Christmas selling season. It might tell us something about the depth of the recession.

On Tuesday and Wednesday, Treasuries staged a powerful rally that brought amongst others the 10-year yield to levels below 3%, record lows for at least about half a century. The Fed latest measures, notably the (future) purchase of 500 billion USD of Agency MBS and of 100 billion USD of Agency debt caused a sharp narrowing of the MBS spread and of mortgage rates. This will have various beneficial effects. It will support the housing market and it might lead to a wave of re-financings. Cash strapped households might use it to spend a bit more. While it is unlikely (and undesired) that households will again use their house as an ATM, it might offer some relief. Indeed, the decline in house prices means that households have far less equity in their house than a few years ago and banks will be more restrictive in their policy. The Fed measure had also some outright consequences for fixed income markets. All yields dropped, especially the longer-term ones. The hedging of mortgage books led to buying of Treasuries and swaps. To the extent that general risk aversion lessens it is on the contrary (slightly) negative for the shorter end.

Regarding trading, overnight in the Asian session Treasuries moved again modestly higher, but flows are thin. Equities are trading mostly higher, but modestly. The general theme of a deepening global recession is still at the forefront, but we discovered no new facts that might justify the overnight price action. Flows are very thin and this won’t change later on as US trading desks will be half empty and no eco reports are scheduled. However, those traders that are active will start looking forward to next week’s trading. The dataflow contains the key ISM and payrolls report and some central banks, but not the Fed will meet and decide on rates. Also many investors will start closing their books which means that trading will be ever thinner. Treasuries have done extremely well in the last months and the temptation to book profits will probably be irresistible for many, especially as in early 2009 new supply will hit the market. Therefore, we wouldn’t add to long Treasury positions at current levels and even consider profit taking.

The technical remained bullish during the correction of last Friday and Monday and in the case of the 10-year, the yield tested even an important resistance (3.25%) that held, a positive. The 1, 2 and 3% levels in the 2-, 5- and 10-year sectors at first played their role, but the rally that followed pushed the 10-year nicely below 3% and the 5-year testing the 2% again. So, there are no technical signs that the bull-run is over. However, the above mentioned factors and the overextended nature of the market make us take a neutral stance for now.

Awful eco data increase pressure on ECB to cut rates by more than 50 bps

Today, the euro zone data calendar contains the November flash CPI and the October unemployment rate.

Based on the sharper than expected declines in the German and Belgian CPI data earlier this week, the risk for the euro zone flash CPI is also on the downside of the market consensus for a decline from 3.2% to 2.4% Y/Y. Market impact may however remain limited, as the ECB has already pointed towards a substantial easing in inflation and has not even excluded that inflation may temporary fall into negative territory over the summer, due to the strong base effects related to the drop in oil and other commodity prices. In recent comments, several governing council members have stressed that such negative inflation figures should not be seen as a precursor of deflation.

The unemployment rate in the euro zone on the other hand is expected to rise slightly to 7.6% in October from 7.5% in September and compared to the 25-year lows registered at the beginning of the year at 7.2%. Over the coming months, a further deterioration can be expected, as the employment indices in yesterday’s monthly EU confidence survey all took a turn for the worse.

Recent awful economic data have increased pressure on the ECB to cut rates by more than 50 bps. Yesterday, the ECB shadow committee voted to cut rates by 100 bps to 2.25%. Eight of the fifteen members supported such a move, while four even preferred a 125 bps cut and only three a 50 bps rate cut. Although most governing council members appeared to support a gradual approach and implicitly hinted at a 50 bps rate cut, the abrupt slowing of the economy might still persuade the ECB to cut rates by 75 bps. A 75 bps rate cut was also discussed at the previous meeting, when the ECB ultimately decided to cut rates by 50 bps. Currently, markets have not yet fully discounted a 75 bps rate cut, even though the eonia futures at first sight suggest so. These however exaggerate current market expectations, as the eonia rates (2.95%) at present do trade way below the official policy rates (3.25%) (see graph below). The threat of a larger ECB rate cut next week will keep the upside in 2-year yields limited and again favours the short end of the curve.

According to Reuters, the ECB plans to delay the introduction of a rotation system in the governing council until the euro area has 19 members. Under the Maastricht Treaty, the rotation system should be implemented when membership reaches 16, but policymakers have the option to delay the introduction until 19 states have adopted the euro. This would mean that also following the introduction of the euro in Slovakia on January 1 2009, the ECB will stick to the current system of one country, one vote.

On the money market, the 1 month Eurobor fixings spiked 22 bps higher yesterday, the first rise in more than a month. This spike higher didn’t point to a deterioration of market conditions, but occurred as the one-month rate passed the year end, which have been usually times of heightened market stress. As a consequence, the three month Euribor continued their gradual decline and fell 2 bps yesterday to 3.88%, the lowest level since March 2007. Despite the sustained decline in the 3- month Euribor fixings, the liquidity spread has remained rather stable reflecting the still strained conditions. This is also reflected in the consistent large amounts deposited at the ECB overnight. In recent comments, the ECB has indicated that they will continue to pump as much liquidity into the market as needed, and only expected a slow improvement in the course of next year.

Regarding trading, yields were slightly up, except at the 30-year segment yesterday in a largely uneventful session. Both 10- and 30-year yields are still close to important intermediate support levels at respectively 3.23% and 3.78%, the January 2006 lows, ahead of the all-time lows at 3% and 3.47%. The proximity of these intermediate support levels suggests that the recent corrective flattening of the curve may be over for now and supports again a steepening of the European yield curve. Regarding the intra- EMU spreads, the Italian auction wasn’t a big success yesterday, and spreads are again widening at least at the longer maturities in the 10-year segment.

In the UK, the CBI distributive trades report is scheduled for release. Over the past days, there has been a remarkable flattening of the UK yield curve, which may not run that much further given the upcoming Bank of England meeting next week, where a rate cut of at least 50 bps is expected.

Currencies: Currencies trade sideways

On Thursday, EUR/USD lingered in a relative tight sideways range of 1.2860 to 1.2960 to take the extremes, closing at 1.2904, up 24 ticks from Wednesday’s close.

The absence of US traders was certainly responsible for the dullness of trading. There were a number of timid attempts by the euro bulls to push EUR/USD higher again following Wednesday’s downward correction, but they lacked dash, conviction and ultimately convinced traders it made no sense to insist further. So the pulse weakened throughout the session and the range became ever tighter. The European eco data, notably the EU Commission economic confidence data and the retail PMI’s echoed the message of deep recession that has become so common in recent days and weeks. However, it left currency markets unmoved.

Today, the US markets are open, but many trading desks will be near empty and real money investors probably won’t be active either. Overnight, trading in the EUR/USD pair remained lackluster, keeping the pair close to the 1.2915 where it is changing hands currently. No eco releases in the US today, while in EMU, the dataflow is light. The November HICP inflation is expected to have dropped to 2.4% from 3.2%, but following the release of the German and Belgian inflation, the risks are firmly on the downside of expectations. This might lead to more talk about the size of the ECB rate cut that will be decided next Thursday. At least, a majority inside the ECB Shadow Committee, voted in favour of a 100 basis points rate cut, but recently a number of ECB governors indicated that they should keep their minds cool and cut rates in a more “normal” way, insinuating that they prefer a 50 basis points rate cut. Nevertheless, the risks seem to be for a 75 basis points cut. While lower rates are often a negative for the currency, in the current environment this relationship carries less value.

Negative eco news and risk avers investor behavior have supported the dollar (and the yen) at the expense of the euro during several weeks, even months. This theme was the main factor behind the decline of EUR/USD from highs above 1.60 to the correction low in the 1.2330 area. Since end October, the EUR/USD pair has developed a consolidation pattern between 1.2330 and 1.3294. Until recently, the correlation between EUR/USD and indicators of risk aversion and economic had remained relatively high, but the euro gradually showed more resilience. Over the previous days, we suggested that markets may start looking out for another trading theme, which by hypothesis would be less USD supportive. Therefore alertness for a change in trading theme remains warranted. Do the aggressive measures of monetary easing become a negative factor for the dollar or will EUR/USD continue to trade in line with the swings in global risk aversion?

From a technical point of view, during the last three weeks, EUR/USD has established a sideways trading pattern. The charts suggest the EUR/USD trend is negative longer term. However, over the past week; we indicated to take partial profit in case of return action towards the bottom of the range as chances were rising for a more pronounced EUR/USD rebound. After Wednesday’s EUR/USD correction, the jury is still out as EUR/USD is now again in the middle of its sideways range. Shortterm players may still look to sell EUR/USD on a return action towards the top of the range (1.31/32 area). A sustained break above the 1.3294 area would be an important technical signal of a change in the USD constructive market sentiment. (Stop/loss on EUR/USD shorts).

Yesterday, also USD/JPY traded essentially sideways, closing down about half a yen at 95.19. Intra-day, the pair slid during the Asian session, only to slow move higher again in the European session. It is tempting to offer well supported equities and thus a return of risk appetite as an explanation for the slight dollar gains, but that looks stretched.

Overnight, the price action remained sideways oriented with USD/JPY currently quoted at 95.34. Equities are moving moderately higher, while eco news remained gloomy. Especially weakness in industrial production, down 7.1% Y/Y, falling car production (-6.8% Y/Y) and negative retail sales (-0.6% Y/Y) caught the eye and confirm that the economy will remain in recession. Tokyo Inflation data were close to expectations, but the core measure (excl. food and energy) fell to 0.2% Y/Y while the measure excluding only fresh food fell to 1.1% from 1.5% Y/Y previously, suggesting that deflation may once again a fact of life for Japanese policymakers. The unemployment rate dropped unexpected to 3.7% from 4% previously, but our favourite indicator, the job-to-applicants ratio fell further to 0.80 from 0.82, suggesting that labour conditions are worsening. In the face of these grim data, Fin Min. Nakagawa said that he wants the BOJ to consider more steps to help the economy, stimulating a return to a zero rate. However, as the yen thrives by bad eco news and risk aversion, neither bad eco data nor the speculation on zero rates is a yen negative. We expect more sideways trading today.

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 four weeks ago. A temporary easing of global market tensions sparked a USD/JPY rebound. The pair set a reaction high in the 100.55 (Nov. 04), but the rebound ran into resistance. Longer-term, the scenario of a well supported yen on the idea that prospects for a sustained improvement in the global economic picture remain very downbeat is intact. We are holding to a sell-on-upticks approach as long as the pair holds below 100.55. The USD/JPY downtrend remains very well in place, despite some improvement in equity markets. .

On Thursday, EUR/GBP fell for the third consecutive session, as the pair tested the neckline of a potential double top at 0.83.34. However, the level held and the pair moved slightly higher, but without regaining Wednesday’s closing level. The losses were contained though. There were no indications that the weak EMU eco data were behind the slight fall of the pair. It looked technically driven. In this respect, the inability of the pair to recapture the medium term moving average at 0.8445 (today) makes us think that the upside is capped in the very short term.

Overnight, UK consumer confidence was reported unexpectedly up to a still very low -35 from -36 in October, but the rise is insignificant and doesn’t change the outlook for household spending. Later today, the distributive trade survey will give us an update about the development of retail sales. The omen isn’t good. The weekly John Lewis retail sales figures showed another weekly decline in sales, the eleventh in a row, while the Woolworth and Kingfisher news was downbeat too. We will look closely to the reaction of sterling following the release.

The aggressive BoE rate cut three weeks ago and their negative assessment of the UK economy triggered an aggressive sterling selling wave. The quick loss of interest rate support and the very negative outlook for the UK economy have caused sterling to lose a lot 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 two weeks ago some correction/consolidation has kicked in. Longer-term the risk is for additional sterling losses. The tentative signs of bottoming out at the end of last week were confirmed earlier this week. The price action on Tuesday and Wednesday was disappointing though. Nonetheless, we hold on to our cautious buy-on-dips approach for EUR/GBP. A drop below 0.8334 would be a warning signal for our ST EUR/GBP positive bias, but at least yesterday the test failed. So we will be curious whether this will be enough of a signal for euro bulls to try the upside again. A break above the MTMA (see above) is needed to open the upside though. Longer term, the pair must return below the 0.8215/53 area (Breakup/ uptrend line) to call off the sterling red alert.

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Published on  Fri, Nov 28 2008, 08:37 GMT