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Sunrise Market Commentary

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US Treasuries extend their gains

Thu, Dec 4 2008, 08:10 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Wednesday, global bonds ended a volatile session again higher, as dire economic data out of the services sector and the US labour market raised fears for a deep and prolonged global recession. The declines in yields remained however limited, as equities proved resilient and gained for the second day in a row.

On the European bond market, it was again the longer end of the curve that outperformed, as German 30-year yields fell decisively below the all-time lows and closed at 3.33%. German 10-year tested the all-time lows too at 3%, but closed still above. At the shorter end of the European yield curve, 5-year yields rose 2.6 bps, while 2-year yields fell 1.8 bps ahead of today’s ECB rate decision. In the US, yields were unchanged at the 2-year sector, but fell 3.3 bps and 1.4 bps in the 5- and 10-year sector.

US Treasuries extend their gains

Today, the US calendar contains the weekly claims and October factory orders. In the week ended November 29, initial claims are expected to come out at 540 000, after 529 000 in the week before. For continuing claims, which are reported with a one-week lag, the consensus is seeking for an outcome of 4 030 000, after the unexpected drop (to 3 962 000) in the week before. The current level of initial claims is consistent with a payrolls decline of 300 000. Last month, factory orders showed a sharper than expected drop (-2.5% M/M) due to a steep decline in non-durable goods orders. In October, factory orders are forecasted to show a drop of 4.5% M/M due to the plunge in durables that were already reported in a separate report. Nevertheless, an even weaker figure is not excluded after the sharper than expected drop in durables that wasn’t yet completely discounted in the forecasts. The impact on markets might be limited ahead of the payrolls report released tomorrow.

Fed appearances include Dallas Fed Fisher at the Association of Energy economics, Chicago Fed Evans at a Bankers meeting in Michigan, Board member Kroszner in a panel on MBS and chairman Bernanke on housing and housing finance. We will closely looks for new info about the economy or policy, but chances that such new info will come available and move the markets are small, as Bernanke already spoke out his mind earlier this week, as did Fed Fisher and Kroszner.

The Beige Book painted a picture of a weakening economy. They were no districts that presented a more optimistic picture. Book after book the tone becomes grimmer. Weaker retail activity, declining manufacturing output, ongoing weakness in housing and decreasing commercial real estate were the main findings besides contraction in lending and tighter standards. Price pressures were called subdued. Concluding, the book suggested a deepening of the recession, which doesn’t differ from the picture we received from the eco reports. .

The results of Schedule 2 TSLF auction suggest a slight intensifying of funding strains. Indeed the bid/cover of 1.21 was more elevated compared to recent auctions and the 31 basis points stop-out rate was the first stop above the minimum stop since the October 29 auction. However, as it is the first auction to mature after the turn of the year, we suppose that’s the reason for the signs of increased strains.

Regarding trading, Treasuries ended yesterday moderately higher, yields down 1 to 3 basis points. Ongoing very weak eco data, now the ADP employment and the Nonmanufacturing ISM both for November, and volatile equities kept Treasuries well bid after an intra-day very modest profit taking. A rebound of equities in late session once more had no noticeable impact on Treasuries that ended the session at the highs. Overnight, Treasuries rose still a bit further.

Today, the calendar is not so exciting, but a surprise of the initial claims may still be good for a reaction, as traders are more and more looking forward to the payrolls, the most important eco report in any month, that will be published tomorrow. We have no clue about the way Treasuries will trade today. Will overextended conditions and upcoming payrolls inspire some to book profits, or will this iron-strong rally simply continue ultimately into the FOMC meeting on Dec15-16?

Re-iterating our view, 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?

ECB meets in Brussels under extreme pressure to slash interest rates

Today, the eco calendar contains only the preliminary figure of third quarter GDP growth. According to the flash estimate, euro zone Q3 GDP contracted by 0.2% Q/Q, which was in line with the consensus estimate and the preliminary figure is expected to confirm the flash estimate. Today, we will receive a first breakdown of third quarter GDP growth. The details of German GDP growth showed a large foreign trade deficit which is likely to be reflected in the euro zone figures. A negative contribution might also come from investment. Private consumption is expected to show a neutral or slightly positive contribution as retail sales held up rather well in the third quarter. However, the GDP figures will receive only limited attention as investors will be waiting for the ECB rate decision and the new ECB staff projections for inflation and growth.

Regarding the ECB rate decision, we expect the ECB to cut rates by 75 bps to 2.5%, which is in line with current market expectations. Hence, although recent ECB comments have pointed in the direction of a continuation of the gradual easing cycle and a rate cut of 50 bps, we also think that the recent dramatic deterioration of the economic outlook and fall in inflation will leave the ECB with no other option than to take on a more aggressive stance on rates. In November, the ECB already discussed two options, a 50 and 75 bps rate cut, but ultimately decided to cut rates by 50 bps. Yesterday, the EU trade unions urged the ECB to cut rates by 100 bps today, as they said that ‘the pace of the slowdown in economic activity is alarming and is raising the prospect of strong disinflation rapidly turning into deflation’. Given the increased chances on a large ECB rate cut, we hold on to our positive view on the short end and even in case the ECB would decide to cut rates by only 50 bps and short-term yields rebound, we would consider this as a good opportunity to add to existing long positions. The ECB rate decision and tone of the press conference afterwards may also decide whether the recent flattening of the curve will continue or that some steepening will occur. For more details about the ECB monetary policy outlook, we refer to our flash ‘Will the ECB bow to widespread cries for sharply lower rates?’.

At the longer end of the curve, the breath-taking fall in yields continued yesterday, as 30-year yields plunged below the all-time lows. This morning, the 10-year yields set new record lows too below the 3% mark. The bund hasn’t however confirmed the break higher and is still below the record high at 124.60. A confirmation of the break higher today would be an additional bullish sign, but given the current overextended conditions we fear that first some profit-taking will occur and are looking for signs that some correction is nearing.

Outside the euro zone, the Swedish Riksbank has brought forward its interest rate decision and is also expected to slash interest rates today. A rate cut of 100 bps is expected, which would bring the key rate to 2.75%.

On the supply front, Spain will tap two bonds today in the 3- and 5-year segment for a total amount of €3-4B. Over the past days, intra-EMU spreads have been widening again, as general credit market conditions are again deteriorating. This was also reflected in the Itraxx Crossover index, which broke above 1000 bps yesterday for the first time ever. Earlier this week, Portugal could only sell €325M of the intended amount of €500M from its 15-year bond at an extraordinary auction, while the European Community had to pay a huge spread of 113.1 bps above the German Bobl to get its 3-year bond sold, despite its AAA status. On the money markets, conditions remain restrained too, as banks still deposit large amounts at the ECB overnight instead of lending it out to each other. The conditions in the credit and money markets are unlikely to improve soon, as the end of the year draws closer, which is typically a period of heightened stress and low liquidity.

In the UK, PM Brown yesterday announced dramatic measures to underpin the UK housing market, as he granted homeowners in financial difficulty the right to demand a two-year holiday on mortgage payments.

Today, the Bank of England will decide on interest rates and another large rate cut is widely expected. This week’s record lows in both the manufacturing and services PMI have heightened market’s rate cut expectations from about 50 towards 100 bps, but even a rate cut by again 150 bps cannot be excluded. Hence, the risk remains for a larger rate cut than currently expected.

Currencies: FX Sterling is again under pressure ahead of the BoE decision

On Wednesday, there were no new developments to report for EUR/USD trading. The pair continued to surf on the waves of global investor sentiment. A poor start on the European stock markets caused EUR/USD to test bids in the low 1.26 area early in Europe and this area was revisited at the start of the US trading session. However, US stock markets found a better tone after the open of the cash markets and EUR/USD trended higher to close the session in the 1.2717, little changed from the 1.2714 close on Tuesday. The macro data confirmed the deepening of the recession on both sides of the Atlantic with PMI/ISM data in the Europe, the UK and the US all coming out at distressed levels. However in line with recent market behaviour, those data had again a very limited impact on global market sentiment and thus also on EUR/USD trading.

Today, the US calendar contains the initial jobless claims and the factory orders. However, all eyes will be on the ECB (and BoE) interest rate decisions and on the ECB press conference. Also interesting, later in the session, Fed chairman Bernanke will speak on housing and housing finance.

From a currency point of view, the reaction on the ECB decision will be far from evident. The ECB rate cut early last month had no lasting impact on EUR/USD trading and this could again be the case today. Markets assume that almost all major central banks will be forced to reduce interest rates to extremely low levels in the near future. In this context a 75 basis point rate cut should be no surprise for the currency markets and have no lasting impact on EUR/USD trading. A surprise (50 or 100 basis points) could be a temporary negative for the euro (ECB is expected to respect some kind of predictability). However, markets will soon come to the conclusion that those surprises are only a temporary deviation from the obligatory path to absolute lows levels in Europe, too.

Negative eco news and risk averse investor behavior have supported the dollar (and the yen) at the expense of the euro. 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. 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. We don’t expect the outcome of today’s ECB interest rate decision to have a lasting impact on EUR/USD trading. 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. At this point, there are indications yet for such a change in market thinking. However, we stay alert.

From a technical point of view, during the last four weeks, EUR/USD has established a sideways trading pattern. The charts suggest that the EUR/USD trend is negative longer term. However, recently we advocated taking partial profit in case of return action towards the bottom of the range. In a day-to-day perspective, we stay neutral. The 1.2330/1.3294 range is well in place. Short-term players can continue to play this range.

On Tuesday, USD/JPY was as usual driven by the swings in global investor/stock market sentiment. A poor start of the stock markets in Europe sent the pair to an intraday low in the 92.55 area early in the US session. However, in nervous trading, the pair trended higher roughly in step with the stock markets and closed the session at 93.30, again little changed from the 93.18 close on Tuesday.

Overnight, Japanese/Asian stocks failed to build on the ‘rebound‘ in the US yesterday evening. Japanese Q3 capital spending data came out that expected (-13.0% Y/Y).

The RBNZ cut its official interest rate by 150 basis points to 5%. The reaction of the kiwi dollar was muted.

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 Wednesday, sterling remained under pressure. The UK eco data and global environment were again sterling unfriendly. Consumer confidence tumbled and the UK services PMI declined more than expected from 42.4 to 40.1. On top of that, the overall market sentiment remained very risk-avers, especially early in the sessions. Last but not least, the uncertainty on the outcome of today’s BoE meeting made investors cautious to hold sterling long exposure. Sterling came already under pressure at the start of European trading and the PMI release caused EUR/GBP to test offers in the 0.8600 area. Later in the session, sterling temporary regained ground, but the pair closed the session at 0.8601 compared to 0.8523 on Tuesday. So, sterling simply extended its recent decline of against the euro.

Today, all eyes in the market will be on the BoE and ECB interest rate decisions. With respect to the BoE decision, markets will be more or less ‘shocked’ if the Bank would cut rates by less than 100 basis points. On the ECB interest rate decision, markets are divided between a 50 or a 75 basis points rate cut. We favour the scenario of a 75 bp rata cut. At the current juncture, the potential impact of monetary policy actions on the currency markets is a bit ambiguous. Will markets focus on the ‘absolute’ level of interest rates (the classic interest rate differential) or on the potential supportive impact from lower interest rates on the economy going forward? With respect to sterling, we think that in the current environment, a wider negative interest rate differential is a negative for sterling. So, we don’t expect the world to look more sterling friendly after the combined BoE and ECB decisions. Recall that last month’s surprise BoE rate cut and the BoE’s economic assessment after the Publication of the inflation report pulled the trigger for the massive sterling sell-off.

On the technical charts, 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 three weeks ago some correction/consolidation has kicked in. Longer-term the risk is for additional sterling losses. Last week, 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 days. The key 0.8215 area has not been challenged. 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. In a (very) long term perspective, 08824 is the target of Multi year double bottom formation (Neckline 0.7253).

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Published on  Thu, Dec 4 2008, 08:25 GMT