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Sunrise Market Commentary

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US Treasuries seem unstoppable

Mon, Dec 1 2008, 08:21 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Friday, in a very thinly traded session due to US traders and investors staying mostly at home, global bonds continued their bull-run and ended the session with nice gains. In EMU, yields fell between 3 and 5.5 basis points, the wings slightly outperforming the belly, while in the US, Treasuries dropped between 11 and 6 basis points, the curve ending steeper.

In EMU, the eco data were market friendly, HICP inflation dropped to 2.1% Y/Y, way below the 2.4% Y/Y expected and only a tad away from the 2% ECB target, that will be reached certainly in December. The unemployment rate on the other hand is trending higher, standing at 7.7% in October, higher than expected and up from a 7.2% bottom reached in March. The combination bolstered hopes for a 75 basis points rate cut at Thursday’s ECB meeting and supported especially the shorter end of the curve. However, late in the session the 2-year fell a prey to profit taking and had to surrender a large part of the intra-day gains. Weaker equities in the European morning session may have been a support too, even if they regained their losses later on, contributing to a decline in prices at the short end of the curve. In the US session, the technicals and month-end extension buying might have played a positive role, albeit as said in very thin dealings.

US Treasuries seem unstoppable

Today, the calendar contains November Manufacturing ISM and October construction spending. Last month, the ISM report showed another drop in manufacturing sentiment. The headline figure fell from 43.5 to 38.9, while the consensus was looking for a more modest decline. Manufacturing ISM is now at its lowest level since the double dip recession of 1980/82 and the consensus is expecting another worsening in November. The headline figure is forecasted to drop to 37.5, but the risks are on the downside of expectations, in line with the regional business confidence surveys. The Philadelphia, Richmond and Chicago Fed showed a sharper decline than expected and also the details were very weak, while the New York Fed showed only a marginal worsening in the headline index, but the details illustrated a very bleak picture. We don’t expect the ISM survey to bring any good new as it became clear in the previous month that the US economy has entered a severe and probably long recession.

Later on this week, markets will closely look to the November car sales, especially with the carmakers in a very difficult situation and as a reality check up on the health of consumers. The ADP employment report on Wednesday is a precursor for the Payrolls that are due for release on Friday. We do expect the data to be again very weak, but consider the consensus estimate for a drop in employment by 325 000 as reliable.

Fed appearances include chairman Bernanke and Dallas Fed governor Fisher today on the economy. These will be interesting, but we suspect little real new news. If Bernanke would speak about quantitative easing, that would be interesting, but most likely he will first discuss the issue at the December FOMC meeting. Other speeches include those of Philadelphia governor Plosser on Tuesday and Richmond Fed governor Lacker on Wednesday. Both are hawks and are a bit concerned about the current aggressive monetary policy. They warned recently that the Fed should not make the error of 2003 and raise rates fast once the credit turmoil has subsided. On Wednesday, the Beige Book, a preparatory document for the December FOMC meeting, will paint a picture of the economic situation via so-called anecdotal evidence from the various regional Federal banks. It is highly unlikely that the Beige Book will arrive to a different picture than the one painted by recent eco data.

Last week, in a shortened trading week, Treasuries fared extremely well. It recovered from a 2-day correction and rallied to new highs at the longer end of the curve. In yield terms, declines over the week amounted between 12 basis points (2-year) to 29 basis points for the 10-year. Interestingly, this happened at the same time equities had their best week since 1974, according to news wires. The catalyst doubtless was the Fed announcing a few more initiatives like buying Agency MBS and Agency debt and the new funding facility that focus on new securitized Consumer debt. The measures should push mortgage rates lower (which it did) and help restore the availability of consumer credit. Via hedging of MBS portfolio the decisions helped the longer end of the curve, but the shorter end did well too. It seems the move was interpreted as a signal the Fed would soon announce officially the start of a quantitative monetary policy that it already started via the expansion of its balance sheet. Including the most recent measures its balance sheet should top in a few weeks 3 trn dollars or a multiple of the 800 billion dollar size of its sheet before the Lehman demise in mid-September. There were little signs of thawing in the short-term funding markets. The 1-month Libor spiked 40 basis points higher, but due to the turn of the year now included in the maturity. However, there was no further drop in the 3-month Libor and the liquidity spreads widened modestly, as did the TED spread and 2-year swap spreads. Longer term swap spreads did narrow a few basis points and a similar movement was visible in the CDS market, both for investment grade and high yield.

The technical pictures only improved further last week. The 2- and 5-year yields are below 1 and 2% respectively, key levels that are broken now on a sustainable basis. The 10-year yield is below the 3% and the 30-year fell convincingly to new lows, below 3.5%.

Looking ahead, the eco data will again be supportive for Treasuries and so are the technicals. Of course, the market is in overextended conditions and month end extension buying that might have played a positive role last week will disappear. Also the hedging that occurred in the Treasury and swap market following the announcement of the latest Fed initiatives (cf. above) might have run largely its course. To make it still more difficult, the market enters the final month of the year and the temptation to close books, that is always an item in December, will still be a bigger factor for trading this year, especially since liquidity has been decimated already beforehand. Equities are as usual a wild card. While profit taking on last week’s rally shouldn’t surprise, the odds for a bear market equity rally into next year aren’t so bad. On top of that, Treasury supply for 2009 should become an item and convince dealers and investors to make some room, cheapening the market. It this context, we take a cautious attitude and without becoming bearish Treasuries, profit taking on longs becomes more enticing, especially should thin conditions lead to further steep decline in yields in the next sessions.

German 30-year yields extend drop

The calendar is thin today as it only contains the final figure of the November manufacturing PMI which is expected to confirm the first estimate at 36.2. This was the lowest reading in more than a decade and highlighted the rapid deterioration of the euro zone economy. Later on this week, the main focus will be on the ECB rate decision and press conference, where we now expect the ECB to cut rates by 75 bps.

The diminishing of the upside inflation risks along with recent awful economic data have indeed increased the pressure on the ECB to cut rates more aggressively. The ECB shadow committee for instance voted last week to cut rates by 100 bps to 2.25%. Hence, although most governing council members recently appeared to support a gradual approach and implicitly hinted at a 50 bps rate cut, we expect the abrupt slowing of the economy and the plunge in the inflation rate to 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. Following last Friday’s fall in short-term interest rates, a 75 bps rate cut is now discounted by the market taking into account the current large spread between the eonia rate and the official policy rate, which tends to exaggerate market’s rate cut expectations. In the run up towards the ECB meeting on Thursday, we expect the short end of the curve to remain well bid.

On the supply front, the calendar is fairly thin too, as only Spain will tap the market this week. Spain will tap the 3- and 5-year segment, but no amount has been announced. Last week, demand has been mixed, as the Belgian auction enjoyed strong demand, but the Italian auction was weak. Overall, intra-EMU spreads remained very wide and even tended to widen again at the longer maturities, consistent with the rise in the government CDS market. On the money markets too, little improvement has been noted. On the contrary, the 1 month Euribor fixings spiked higher on Thursday due to the traditional end-of-year liquidity strains and also on Thursday the amount lent at the marginal lending rate increased substantially to around € 6 bln. from less than € 2 bln. the day before. This week, the ECB will only carry out a weekly refinancing tender. The next longer-term tenders will take place next week, for maturities of equal to the maintenance period, 3 months and 6 months.

Regarding trading, 2-yields fell again lower following the rebound from the 2% level towards 2.25% at the beginning of last week, but large part of the initial decline on Friday was undone later on. At the longer end of the curve, both 10- and 30-year yields tested the January 2006 lows at around respectively 3.23% and 3.78%. Vis-àvis the 10-year yields the test is still ongoing, but 30-year yields have broken lower, which has brought the all-time lows at 3.47% in the picture.

In the UK, the calendar is well-filled with the October lending data and November manufacturing PMI. In September, mortgage approvals showed a marginal improvement (33 000), but are expected to show a slight decline (32 000) in October while net consumer credit is expected to show a modest rebound (0.5 bln.), after reaching its lowest level since February 1994. Net lending secured on dwellings is forecasted to come out slightly lower (1.8 bln.). Regarding the manufacturing PMI, the consensus is looking for a modest decline (39.5) after a broadly unchanged figure in October, but we see the risks on the downside of expectations.

Currencies: FX Euro cedes ground

On Friday, EUR/USD was downwardly oriented for most of the session. The move was a bit strange as the broader market context developed in a euro supportive way. Stocks performed rather well and investors turned slightly less risk averse. The European CPI came out lower than expected, fuelling speculation for a bolder ECB rate cut this week. This might have weighed on the single currency. At the start of US trading, oil declined rather sharply and this has been an euro negative factor recently. However, the single currency didn’t follow the rebound in the oil price later in the session. US markets were open but with few traders at their desks and no US eco data on the agenda trading developed in a thin market and was mostly orderdriven. EUR/USD closed the session at 1.2691, compared to 1.2904 on Thursday.

Today, the calendar contains the US ISM manufacturing and construction data. In Europe the Final PMI data are scheduled for release. The ISM will again paint a very gloomy picture of the US economy, but this shouldn’t come as a big surprise anymore. The same is true for the European data. So, trading will again be driven by the reaction on the stock markets. Investors will also continue to focus on the ECB interest rate decision on Thursday. There is a lot of debate in the market as to whether the Bank will shift to an audacious approach and cut rates by more than 50 basis points. The uncertainty on the ECB approach is apparently a slightly negative for the single currency at this juncture.

Negative eco news and risk averse investor behavior have supported the dollar (and the yen) at the expense of the euro for several weeks, even months. It was the main theme 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 remained relatively high, but the euro gradually showed more resilience. Early last week the euro tried to leave the lower end of the trading range behind, but the gains could not be sustained. Last week, we suggested that markets may start looking out for another trading theme, which by hypothesis would be less USD supportive. This idea was not really confirmed by the price action at the end of last week. The uncertainty on the outcome of the ECB meeting is too high. Nevertheless, alertness for a change in the trading theme remains warranted.

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 EUR/USD drifting lower again at the end of last week, the jury is still out. Going into the ECB interest rate decision, short-term players may still look to sell EUR/USD on a return action higher in the established trading range. 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).However, we’re not that far yet.

On Friday, USD/JPY showed rather wild intra-day swings. However, at the end of the day the established market logic was more or less respected. A decent stock market performance helped the pair to some, albeit limited, gains at the end of the day. Intraday trading in the pair was also very much order driven and swings in other yen cross rates (EUR/JPY) played a role too. USD/JPY closed the session at 95.52 compared to 95.19 on Thursday. In a longer term perspective, the result of Friday’s price action was in fact not that relevant.

Overnight, Japanese/Asian stocks trade with limited losses. This is slightly supportive for the yen. On top of that, a series of central banks including the RBNZ and the RBA will decide on interest rates. Uncertainty on the outcome of those meetings and the fact that the carry currencies are at risk to lose a lot of interest rate support in the near future might be a supportive factor for the yen ahead of those interest rate decisions.

This morning, the price action in the yuan also did catch the eye. The Chinese central bank decided to lower the mid-point of the yuan against the dollar. This is fuelling speculation that China might consider to use its currency to support exports as a way to help support the slowing growth in the country. From a global point of view, one of the biggest surplus countries pursuing a weaker currency to revive its economic would be very strange and unwarranted. However, the move at least deserves close monitoring.

Looking at the USD/JPY charts, global market stress hammered the USD/JPY cross rate and the pair set a new reaction low at 90.93 at the end of October. 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. In a day-to daily perspective the USD/JPY showed a very dull trading pattern over the last trading sessions.

On Friday, EUR/GBP extended its downward correction. The UK eco data (Consumer confidence and even more the CBI distributive trades) again pained a very bleak picture on the UK economy. However, this was apparently no item anymore for sterling trading. The pair drifted towards the first support area (08334) earlier last week and on Friday, the break of this level triggered some additional repositioning in favour of sterling. EUR/GBP closed the session at 0.8252 compared to 0.8377 on Thursday.

Overnight, the newswires gave some attention to an interview of EU Commission president Barroso as he indicated that some British politicians had indicated that they would have been better off if they had the euro. This kind of talk of course sparks some popular headlines, but we don’t expect this item to become an important driver for sterling trading in the near future.

Today, the UK calendar contains the Final money supply data, some lending data and the manufacturing PMI. The data will probably confirm the beak picture of the UK economy. However, this was less off an item for currency trading recently. Trading in the UK currency was mostly driven by global market sentiment. This week’s BoE interest rate decision is a factor of uncertainty, but the outcome of the ECB meeting is far from clear, too. So, for EUR/GBP trading this looks like an undecided game.

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. Last week, it looked as if the 0.8334 area would be able to give to support. However, this hypothesis was rejected on Friday. The drop below 0.8334 is warning signal for our ST EUR/GBP positive bias. The pair currently tests the key 0.8270/15 area. A sustained drop below the 0.8215 break-up would be important from a technical point of view and would make us force to take a more neutral approach for trading in this pair. (Stop-loss for short-term longs).

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Published on  Mon, Dec 1 2008, 08:31 GMT