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Sunrise Market Commentary

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Bernanke's quantitative policy remarks flatten curve

Tue, Dec 2 2008, 08:37 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Monday, global bonds started the week like they ended the previous one, storming ahead. Sentiment in equity markets deteriorated again, following a more positive performance last week. Economic data again fell short of the already awful expectations. On top of that, Bernanke elaborated on financial markets, the economy and policy. We especially retain that the Fed currently has only one objective, notably to support financial markets and the economy. In this respect, Bernanke suggested interest rates might still be cut, but increasingly the Fed will switch to quantitative measures like it already took some recently. He explicitly spoke about the Fed buying longer-term Treasuries and Agencies. This was, of course, music in the ears of Treasury investors who upped their purchases of Treasuries.

At the end of trading, US yields had plunged by 9 to 22 basis points and EMU (German) yields by 6 to 13 basis points. In the US, the 2-year underperformed the remainder of the curve. In EMU, the belly, but especially the 5-year, outperformed the wings.

Regarding the data, the final EMU PMI for November was revised lower from the preliminary figure, suggesting the situation continued to weaken throughout the month, while in the US, the ISM fell short off already weak expectations. The NBER set the start of the US recession at December 2007.

Bernanke’s quantitative policy remarks flatten curve

Today, the eco calendar is very thin as it only contains the US vehicle sales (November) and weekly ABC consumer confidence. Last month, domestic vehicle sales showed a sharp plunge, coming out at their lowest level since February 1983. They are expected to slow even more in November (7.8M from 7.9M), even if lower gasoline prices and generous incentives suggest that a further decline may be avoided for now.

Treasury Secretary Paulson speaks on the US-China Strategic Economic Dialogue. Following speculation that the Chinese are allowing their currency to weaken against the dollar, Paulson’s comments may be interesting, as he may try to convince the Chinese that a weaker yuan is contrary to what the world needs right now. However, more likely, Paulson won’t touch this subject and if he does, it is unlikely the Chinese will take him very serious as Paulson represents the outgoing Bush administration and the Chinese will have to deal with the new Obama administration soon. Fed’s Plosser will speak on the economy. He is a hawk who is a bit concerned about the current aggressive monetary policy. He warned recently that the Fed should not make the error of 2003 and raise rates fast once the credit turmoil has subsided. However, following Bernanke’s comments yesterday, Plosser probably won’t get too much attention.

Bernanke at length discussed the situation in financial markets and elaborated on the multiple measures taken to support it. Thereafter, he painted a bleak picture of the economy, but cited some positive elements that may in due time help promote the return of solid gains in economic activity, like the monetary and possible fiscal stimulus, an eventual stabilization in housing markets as the correction runs its course, and the underlying strengths and recuperative powers of the economy. The most interesting part was however devoted to the outlook for policy. He said that “although further reductions from the current federal funds rate target of 1% are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited.” Indeed, the effective fed funds rate is already trading well below the 1% target rate. Bernanke insisted though that other means of policy, like the provision of liquidity, remained effective, via the use of its balance sheet. Firstly, he mentioned the purchase of longer-term Treasury or Agency securities in the open market in substantial quantities, driving rates lower. In this respect, he showed satisfaction that the announcement last week that the Fed would buy up to 500 bln. USD in Agency MBS and 100 bln. USD in Agency debt was met by falling mortgage rates. Secondly, Bernanke said the Fed can provide a backstop liquidity to certain financial markets (and not only to financial institutions) like they have done in the CP market (and more recently with the consumer credit facility) that provides liquidity directly to borrowers and investors. Bernanke also repeated that the Fed will preserve the viability of all key financial institutions. He concluded by saying that a normalization will have to take place at some point (in a timely way) to avoid inflation in the long run. However, that is an issue for the future; for now the goal of policy must be to support financial markets and the economy.

The NBER officially dated the end of the business cycle that started in November 2001 at December 2007, which at the same time marks the start of the recession. The Committee uses a broad set of data to determine start and end of a cycle, contrary to the popular criterion of two quarters of contraction in GDP, according to which the US economy wouldn’t yet be in recession.

Regarding trading, Treasuries posted another stellar performance at the start of the week. Renewed equity weakness, awful eco data & the official message that the US economy is in recession (for about 1 year) and a Bernanke speech bolstered Treasury investors’ bullish sentiment. Treasury yields fell between 8 and 22 basis points, the short end of the curve underperforming the belly and long end. Bernanke’s speech was very interesting. We retain that Bernanke will continue its aggressive policy and cut rates further, but increasingly will turn to quantitative measures like buying longer-term Treasuries and Agencies to ease financial conditions. In this context, it shouldn’t surprise that the 2-year T-Note yield has more difficulties to fall lower (given its current low level) than yields further out the curve. The market started to anticipate (or interpreted correctly the quantitative measures taken recently) some two weeks ago, flattening the curve. The 2-to-10-year yield spread narrowed a massive 80 basis points to 181 basis points in a very short span of time.

The technical pictures only improved further last week and yesterday’s price action confirms its bullishness. The 2- and 5-year yields are well below 1 and 2% respectively. The 10-year yield is way below the 3% and the 30-year yield fell convincingly to new lows, below 3.5%. Yields at all maturities are now at historical low levels.

Today, the calendar is less interesting (see higher) and probably not very influential on trading either. So, equities and the global situation might be decisive factors for Treasuries. We started the week with a cautious attitude and advised to contemplate profit taking on longs, especially in case thin conditions would lead to a further steep decline in yields. Our reasoning was based on overextended conditions, the disappearance of month end extension buying and maybe the easing of hedging pressures following the announcement of the latest Fed initiatives. Also the temptation to close books that is always an item in December was put forward together with the possibility of a bear market equity rally into next year, albeit after a temporary profit taking early this week. At least the profit taking occurred, but the jury is out on a bear market rally. Most of these arguments are still valuable or even more valuable, but we admit that the downtrend in yields is extremely strong and the fundamentals and Fed’s policy are also still positive, as are the technicals.

Risk aversion favours government bonds

The euro zone calendar is again very thin today, as it only contains the October PPI figures. In September, euro zone PPI plunged 0.2% M/M and is expected to show another drop (-0.3% M/M) in October. However, a larger decline is not excluded after the sharp plunge in the CPI last week.

Following the presentation of last week’s EU fiscal stimulus package, the Eurogroup Finance Ministers met yesterday. There was however little agreement, as the Finance Ministers clashed over how much they should increase public spending and how the rules of the Stability and Growth Pact should be implemented at times of economic crisis. These rifts may undercut confidence in the fiscal framework and push intra-EMU spreads still higher. Yesterday, the spreads between German and Greek, Italian and Belgian 10-year yields all set new highs. The moves were consistent with other markets, as the government CDS and Itrexx corporate credit spreads surged higher too.

At the annual conference of the CDU in Germany, Chancellor Merkel promised to ‘keep all options open’ and hinted that Germany might raise its efforts to support economic growth. This is a positive sign, as Germany has the most leeway within the euro zone to increase public spending.

At the money market, the ECB will hold its weekly refinancing tender. Over the past weeks, the ECB has flooded the money market with liquidity. Until now, this has failed to jumpstart the interbank lending market, as banks have continued to deposit large amounts at the ECB overnight instead of lending it out to each other.

Regarding trading, German yields fell substantially lower yesterday and set new cycle lows in the 5-, 10- and 30-year segment. Thereby, 10- and 30-year yields broke below intermediate support at the January and December 2006 lows at respectively 3.23% and 3.79%. As such, all yields are now approaching the all time lows at respectively 1.87%, 2.41%, 3%, 3.47% in 2-, 5-, 10- and 30-year yields. In the US, yields have already broken to new all time lows across the yield curve. Ahead of the ECB meeting on Thursday and given the sell-off on the equity markets, we expect German bonds to extend their recent gains.

Also in the UK, the calendar is very thin, but much attention will go out to the longerterm Gilt auction 4.25% Dec49. Following last week’s budget report, which included a substantial fiscal stimulus package, supply has become an increasingly important issue in the UK. In contrast to the European yield curve, the UK yields steepened quite substantially yesterday, which might be related to the upcoming supply and Bank of England meeting later this week.

Currencies: USD/JPY tests key support level, sterling records heavy losses

On Monday, the global crisis feeling flooded global financial markets again. This had also some impact on the currency markets, but the effect on most major cross rates was far less pronounced compared to the wild swings seen in the bond or equity markets. Yesterday’s price action in EUR/USD was a good example. The pair started trading in Europe in the 1.27 area and in nervous trading drifted lower to reach intraday lows in the 1.2585 area early in US trading. The eco data (poor European PMI’s) might have played a minor role, but global risk averse investor behaviour was the dominant factor for trading. The continuous decline of the oil price was also no help for the single currency. The steeper than expected decline in the US manufacturing ISM had no lasting impact on EUR/USD trading. Later in the session, EUR/USD basically traded sideways despite the deepening losses on the US stock markets. Bernanke in a speech indicated that the Fed had alternative, unconventional tools it could use as its official policy rate was coming closer to zero. We didn’t see a direct link between the EUR/USD price action and the content of his speech, but we think that unconventional measures (buying Treasuries to bring long term rates lower) are no help for the dollar either. EUR/USD closed the session at 1.2611 compared to 1.2691 on Friday. Given the high degree of global market stress and the steep decline in the oil price, we consider this loss of EUR/USD as not really excessive.

Today, the calendar in the US only contains the vehicle sales which usually are no market mover. The same applies to the European PPI data. So, the usual global drivers (stocks and oil) will continue to set the tone for EUR/USD trading. The debate on the ‘optimal’ size of the ECB rate cut on Thursday will also continue. This lingering uncertainty might continue to be a slightly negative factor for the single currency in the run-up to the ECB decision.

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. The correlation between EUR/USD and indicators of risk aversion has continued to play a role, but the euro has gradually shown 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 four weeks, EUR/USD has established a sideways trading pattern. The charts suggest the EUR/USD trend is negative longer term. However, recently 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 drifted again lower 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 the downside, we expect the 1.2330 support area to hold, at least short-term.

On Monday, USD/JPY was traded as could have been expected in an environment of global market stress. The ongoing slide on the European stock markets caused a first selling wave during the morning session in Europe. (USD/JPY dropped from the 95.25 to the 93.60 area). A brief consolidation period kicked in at the start of trading in the US, but later in the session, a second selling wave occurred and caused the pair to close the session at 93.19, compared to 95.52 on Friday. USD/JPY closed the session below the key 93.55 support (neckline), which is important from a technical point of view.

Overnight, Japanese/Asian stocks did build on yesterday’s steep losses in the US and Europe (except for the Chinese market). However, at least for now this hasn’t caused any additional losses for the USD/JPY cross rate. At an emergency meeting, the BoJ left its policy rate unchanged at 0.30% but announced it would accept a wider range of collateral to improve Japanese companies’ access to funding at the end of the year.

The Chinese central bank set is reference rate for the yuan against the dollar marginally lower again. The yuan is losing slightly further ground after yesterday’s selloff. The RBA cut its official interest rate by a steeper than expected 1.00% (from 5.25% to 4.25%). The reaction of the Aussie dollar to the decision was rather muted; losing slightly ground against the US dollar.

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 stays below 100.55. The USD/JPY downtrend remains very well in place. Yesterday’s jump down below the 93.55 support opens the way for a retest of the year lows. Stocks markets will decide whether/when this pattern will be completed.

On Monday, sterling continued its rollercoaster ride. At the end of last week, the UK currency ignored the negative UK eco data and EUR/GBP even dropped below a first important support level (0.8334 neckline). However, the tide turned at the start of the new trading week. Global investors became again more risk averse and this weighed on the UK currency from the start of trading in Europe yesterday morning. On top of that, the UK eco data were again awful. Mortgage approvals stayed at the cycle low, UK house price dropped 8.1% Y/Y (according to Hometrack) and last but not least, the UK PMI survey for the manufacturing sector dropped to its lowest level since the start of the series in 1992. So, EUR/GBP started trading in Europe in the 0.8275 area but rallied to reach an intermediate high in the 0.8440 area around noon. A second selling wave kicked in at the start of trading on the US stock markets. EUR/GBP set an intraday high in the 0.8525/30 area and closed the session at 0.8467. This was still a loss of more than two big figures for sterling compared to the close on Friday (0.8252).

Today, the UK calendar only contains the PMI survey on the construction sector.

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 long term 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. On Friday, the pair temporary dropped below a first important support level (0.8334 area), but this test of the downside has been rejected by yesterday’s sharp rebound. The key 0.8215 area has not been challenged. There is lot of uncertainty on the outcome of the ECB interest rate decision, but we have the impression that sterling is even more vulnerable going into Thursday’s BoE interest rate decision. An additional loss of interest rate support contains the risk for more sterling losses against the euro. Especially if global market stress were to stay high, a retest of the highs in EUR/GBP over the next days shouldn’t come as a big surprise.

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Published on  Tue, Dec 2 2008, 08:48 GMT