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Sunrise Market Commentary

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US Treasuries climb still moderately higher

Wed, Dec 3 2008, 08:04 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Tuesday, global bonds extended their rally higher on the back of Monday’s evenings’ comments of Bernanke, who suggested that the Fed would start buying longer-term Treasuries and Agencies. As such, it was again the longer end of the curve that outperformed. Hence, the slight, unconvincingly rebound in the equity markets following Monday’s sell-off couldn’t prevent yields from falling lower.

Following the break of US yields to new all-time lows across the curve, German yields are now also approaching the historic lows at 2.41% in the 5-year sector, 3% in the 10-year sector and 3.47% in the 30-year sector. 2-year yields are still somewhat further away from the all-time lows at 1.87%, as markets still doubt whether the ECB will cut rates aggressively given their recent comments in favour of a gradual approach. However, we expect the ECB to cut rates by 75 bps, which is more or less discounted by the market (see our ECB Flash).

In a daily perspective, US 5-year yields declined the most, 7.8 bps, compared to 1.6 bps in 2-year yields and 5.8 bps in 10-year yields. In the euro zone, the corrective bull flattening of the curve continued, as 2-year yields were barely lower, -0.8 bps, but 5- year yields fell 4 bps, 10-year yields 11.7 bps and 30-year yields 16.8 bps.

US Treasuries climb still moderately higher

Today, the calendar heats up with the ADP employment report (November), the nonmanufacturing ISM (November), weekly mortgage applications and third quarter unit productivity growth. Later today, the Fed will publish its Beige Book. Overnight, the weekly ABC Consumer Comfort index dropped another 2 points to -54, the lowest since the survey started in late 1985, showing that consumers remain downbeat and no stabilization in confidence has occurred yet.

Last year, the ADP employment report lost much of its previous strong correlation with the payrolls (released on Friday) as it constantly undercut the number of job losses. In October, the ADP report took a sharp plunge in employment (-157 000) and for November another very weak outcome is expected (-205 000). An ADP employment figure of -205 000 suggests a drop of 305 000 in payrolls. But a weaker outcome is not excluded. Last month, non-manufacturing ISM dropped to a record low (the series started only in 1997). The headline index declined from 50.2 to 44.4 and also the details showed a very weak picture of activity. In November, the consensus is looking for a modest drop (to 42.0), but after the sharper than expected decline in manufacturing ISM, the risks are on the downside of expectations.

The Beige Book is a preparatory document for the upcoming FOMC meeting that describes the economic situation via anecdotal evidence gathered by the various regional Reserve Banks. Usually it very closely reflects the message of the latest released economic reports. Therefore, the book is expected to show a grim picture of the economic situation that would be a basic input for deliberations at the FOMC meeting. However, the discussions at that meeting will focus on the Fed’s policy when rates will be at or close too the zero rate boundary. In other words, the discussions will focus on quantitative measures. Bernanke already prepared the market in a recent speech for such a change in policy orientation and the decision to meet for two instead of one day suggests that there may be some decisions taken on the subject.

Treasury Secretary Paulson elaborated on the recent yuan weakening (cf. FX parts) and said that US carmakers cannot be allowed to fail, given the current fragile conditions of the economy, suggesting that a solution might be found. However, in Congress the bickering continues as Congress wants the carmakers to come up with a reliable plan to make their firms viable longer term. According to WSJ, Paulson is debating whether to ask Congress for a second instalment of the $700B bailout package, which would contradict earlier indications that he would leave it to the next administration to decide on that. Does he need the funds for some new intervention? A report of a Congress Committee was highly critical about the Treasuries’ handling of TARP, suggesting that if Paulson asks for the second instalment, a lively debate will follow.

Philadelphia Fed president Plosser said the US economy is not facing a serious threat of deflation. The current decline in inflation is driven by tumbling energy prices that is by hypothesis a temporary effect that flattens out when energy prices stabilize. There is no reason to be scared as long as inflation expectations are anchored. Therefore, an explicit inflation target would have its merits. St-Louis Fed president Bullard made similar comments in a Bloomberg interview. He referred to the PCE deflator, which shows quite stable prices, as a better gauge of price trends. Bullard made clear that he was not convinced by arguments for further rate reductions. However, contrary to Plosser, Bullard has no vote at the 2008 FOMC meetings. President Plosser admitted that it was not unreasonable to describe the recent Fed’s balance sheet expansion as a form of quantitative easing. He added that in such policy, the Fed might not only buy Treasuries, but a range of securities. Today, Richmond Fed Lacker gets the opportunity to ventilate his views on the economy when he speaks at a seminar.

Regarding trading, Treasuries were pushed moderately higher yesterday, as follow through buying occurred on the themes of global recession, but especially on recent Fed speak about buying Treasuries. The imminent start of the Fed’s program to buy $500B Agency MBS and $100B Agency debt adds to the appetite for Treasuries via the need for hedging mortgage portfolios.

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 94 basis points to 178 basis points in a very short span of time. The technical pictures remain bullish. 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 busy with most data expected to be Treasury friendly. The ADP employment report will show a big decline in November private sector payrolls and the November non-manufacturing ISM should confirm that the sector is in recession. Traders will focus more on possible Fed policy on quantitative measures to support the markets and economy. Also the Fed intention to buy Agency MBS and Agency debt and its impact on mortgage portfolio hedging remains an item. The announcement of these measures pushed mortgage rates about 100 basis points lower (15-year conforming) (see graph below). Equities rebounded yesterday, but it was far from convincing and also in Asia, equities while in positive territory, don’t perform strongly. Our attitude hasn’t changed. Yields have dropped hugely in a short span of time. Fundamentals and technicals are still bullish, but thinning markets, overextended conditions and book closures suggest that profit taking on longs might be not such a bad idea, or will the bull run be prolonged until the December 15-16 FOMC meeting with some message on quantitative measures has passed?

German 10-year yields approach 3% mark

Today, the euro zone calendar contains the final figure of the November services PMI and the October Retail Sales. The final figure of euro zone services PMI is expected to confirm the first estimate of 43.3. But we see the risks on the downside of expectations after the downward revision in manufacturing PMI earlier this week. In September, retail sales came out stronger than expected; falling 0.2% M/M while a decline of 0.4% M/M was expected. For October, the consensus is looking for a drop of 0.4% M/M but a sharper drop should not surprise as labour market conditions are deteriorating.

On the supply front, the European Community yesterday sold €2B of its threeyear bond 3.25% Dec11. It was the first such issue from the European Community in 15 years. The amount raised will be used to finance the €6.5B rescue package the EU pledged for Hungary. As such, the bond is likely to be tapped twice next year for a similar amount. Given the recent dramatic widening of the intra-EMU spreads, the pricing of the issue was a hot item. At a spread of 113.1 bps above the German Bobl 149 and 15 bps above mid-swaps, the bond has been priced very cheap, as only Greece and Italy within the EMU do pay a higher spread above Germany. Although the height of the spread may be partly related to the low liquidity of the bond, the level of the spread is likely to cool the appetite to issue more under the European umbrella, which had been recently suggested to lower the general cost of capital for the EU member states.

Regarding trading, longer-term German yields extended their impressive decline yesterday and are now approaching the all-time lows at 2.41% in the 5-year sector and 3% in the 10-year sector. In the 30-year sector, the all-time lows at 2.47% are already under test. Given the proximity of these key support levels, we would become more cautious and consider some profit-taking, even while the technical picture is of course bullish and the fundamental picture also supports a bond positive view. A few weeks ago, 2-year yields also rebounded following the test of the eye-catching 2% level and haven’t yet fallen below, despite the favourable bond environment. Should a rebound in longer-term yields occur, these can be used to go long bonds again.

In the UK, yields dropped lower too, as the 2-, 5- and 10-year yields fell to new alltime lows. In contrast to the euro zone, it was a bull steepening of the UK yield curve, as investors were betting on more aggressive rates cuts from the Bank of England. The MPC will announce its rate decision on Thursday. Currently, a rate cut of at least 125 bps is discounted. Although the Bank of England has always pursued a more activist approach than the ECB, current aggressive market expectations do carry the risk for some disappointment after the rate decision.

Overnight, the Nationwide consumer confidence index and the NTC/REC labour market report both fell to a record low since the surveys started in respectively 2004 and 1997 highlighting the rapid deterioration of the UK economy.

Later on today, the data calendar only contains the November Services PMI. In the services sector, business confidence is expected to show a slight drop in November after the sharp plunge in the previous month. However, a weaker outcome is not excluded after the sharp deterioration in the Manufacturing PMI. Today, Queen Elizabeth II will also hold its annual opening speech in which PM Brown will outline its policy measures to confront the economic recession. However following last week’s prebudget report, we don’t expect this to move the market.

Currencies: calm trading session, sterling remains under pressure

On Tuesday, EUR/USD reversed Monday’s losses, but in a longer term perspective, it didn’t bring any change in the global picture. The pair set an intraday low at the start of European trading in the 1.2565 area as global markets still felt the fall-out from the sell-off on the US stock markets on Monday evening. However, the pressure gradually eased and EUR/USD found a better bid. A series of intraday buy stops were hit and the pair reached an intraday high in the 1.2765 area after the positive open of the US stock market. Later, the pair settled in a sideways trading pattern in the 1.2700 area and closed the session at 1.2714, compared to 1.2611 on Monday. De eco data in the US and Europe were second tier and had no impact on trading. Early in the session, the pair had again a rather tight correlation with the price of oil, but this link become less tight later in US trading as EUR/USD ignored another down-leg in the oil price.

Today, the US calendar contains the Challenger Job cuts, ADP labour market report and the Non-manufacturing ISM. Later in the session, the Fed’s Beige Book will be published; In Europe the final services PMI are scheduled for release. The services data in Europe and the US might bring some interesting headlines on the depth of the crisis, but from a currency point of view the ADP report and the Beige book are more important for trading. However, the day-to-day swings on global equity markets and the upcoming ECB meeting will continue to be the key drivers for trading.

Negative eco news and risk adverse 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 the end of 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 might have started looking out for another trading theme, which by hypothesis would be less USD supportive. This didn’t happen, at least not for now. The uncertainty on the outcome of the ECB meeting is too high. A 75 basis points ECB rate cut shouldn’t come as a big surprise for the currency market anymore. In a longer term perspective, we stay alert for a potential change in the trading theme. We still look out whether the ‘more gradual’ ECB approach compared to the Fed (which is moving ever closer to quantitative easing) at some point won’t become a negative factor for the US currency.

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 suggested 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). On the downside, we still expect the 1.2330 support area to hold, at least short-term.

On Tuesday, USD/JPY experienced a remarkably quiet trading session. The pair set an intraday low in the 92.65 area at the start of trading in Europe. Receding global market tensions also caused some limited scaling down on yen long positions and USD/JPY temporary returned to the 93.75/80 area. However, the gains could not be sustained and the pair closed the session at 93.18 almost unchanged from the 93.19 close on Monday. Of course, yesterday’s stock market rebound was not that impressive if compared to the steep losses on Monday. In this context, the yen resilience shouldn’t come as a surprise.

Overnight, Japanese/Asian stocks trade mostly higher, but the gains are not really impressive. USD/JPY is trading rather stable just above the 93.00 mark.

The Chinese central bank set its reference rate for the yuan against the dollar marginally strong compared yesterday’s fixing. So, this might be an indication that the Bank doesn’t want a rapid depreciation of the yuan. However, the Yuan continues to trade at the bottom of its daily band against the dollar. Yesterday, US Treasury Secretary Paulson also addressed the problem. Paulson said that it was important that China continued to boost domestic demand. The appreciation of the yuan since 2005 (over 20 %) is important and significant but Paulson stressed that this process should continue.

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 yen might continue to trade strongly as long as the global economic and financial picture remains downbeat. We are holding to a sell-on-upticks approach as long as the pair stays below 100.55. The USD/JPY downtrend remains well in place. On Monday, the pair fell below the 93.55 support and this has opened the way for a retest of the year lows. Stocks markets will decide whether/when this pattern will be completed.

On Tuesday, sterling failed to regain the steep losses recorded on Monday. So, the temporary easing in global market stress didn’t give the UK currency any relieve. The ongoing flow of negative eco headlines and the uncertainty ahead of tomorrow’s BoE interest rate decision continued to weigh on sterling. The EUR/GBP showed some intra-day volatility but at the end of the day, EUR/GBP closed the session at 85.24 compared to 0.8467 on Tuesday. So, the pair continues to trade with striking distance of the recent highs (0.8549/68), which is the last area of defense ahead of the high at 0.8662.

This morning, the nationwide consumer confidence came out at 50 (from 56), the lowest level since the start of the series in 2004. Later today, the UK Services PMI will be published. The consensus expects the index to decline to 41.2 (from 42.4). So, a negative outcome shouldn’t come as a surprise, but it might still fuel speculation that the BoE will have all the room to take another bold step at tomorrow’s policy meeting.

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 of 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 a sharp rebound over the past to days. 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  Wed, Dec 3 2008, 08:26 GMT