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Sunrise Market Commentary

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Treasury rally going into payrolls. Buy the rumour sell the fact end of week reation?

Fri, Dec 5 2008, 10:26 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Thursday, global bonds traded mixed, as European bonds were hit by profit-taking, but US Treasuries extended its impressive rally on more MBS related demand. Weaker US equities failed to influence trading.

On the European bond market, longer-term yields rebounded after falling first to new all-time lows in the 10- and 30-year sector at respectively 2.94% and 3.09%. At the short end of the curve, 2-year yields rebounded too, despite the aggressive rate cuts in Sweden (-175 bps), UK (-100 bps) and the euro zone (-75 bps), the largest rate cut of the ECB ever. The rebound in 2-year yields followed on the ECB press conference, where ECB’s Trichet was very careful not to hint at any further interest rate cut, instead he warned ‘it is important to be aware not to become trapped at nominal levels that would be too low’. Comments of ECB’s Mersch later on suggested that the ECB won’t cut rates again in January. In a daily perspective, the European yield curve shifted around 5-6 bps higher.

In the US, yields fell new lows at all maturities as Bernanke hinted at more measures to prevent foreclosures in the housing market, including buying delinquent mortgages and providing bigger incentives for refinancing loans. A government official suggested the Treasury could step up the purchase of MBS to drive down mortgage interest rates to 4.5%. In a daily perspective, yields fell between 7 bps in the 2-year sector and 10 bps in the 10-year sector.

Treasury rally going into payrolls. Buy the rumour sell the fact end of week reation?

Today, all eyes will be on the November payrolls report. Last month, the payrolls surprised on the downside showing a drop of 240 000, while the September figure was sharply downwardly revised from -159 000 to -284 000. The weakness was broad-based as only local governments and health and education added jobs. For November, the consensus is looking for another sharp drop (-333 000) in payrolls, but an even weaker figure is not excluded after the ADP report showed a sharper than expected decline in employment. Assuming that government payrolls rise about 10 000 in November, the ADP report would point to a drop of 240 000 in payrolls, but last year, the correlation between the ADP report and payrolls loosened significantly. The average discrepancy between the ADP and payrolls report has been around 100 000 which might indicate a decline of about 340 000 in payrolls, which is broadly in line with the consensus estimate. After the limited reaction on the ISM, a weaker outcome might have only partial impact on markets as a lot of bad news is already priced in. The unemployment rate is expected to come out at 6.8% in November, after 6.5% in October.

In a speech on housing and housing financing, Bernanke underlined the link between housing markets and the overall financial and economic environment. He suggested that to improve the overall economic conditions, more should be done to avoid/reduce foreclosures. He explored three ways to help stem foreclosures that would once more require public funds. We won’t elaborate on these, but he also suggests that bringing down rates would be an interesting venue to help preventing more foreclosures and the Treasury might do it by buying securities. The Fed already announced buying $500 billion of Agency MBS, but more could be done. In the market, there is talk the Fed would like to bring 15-year mortgage rates (conventional) down to 4.5%. This would generate a huge re-financing of more than a trillion dollars of mortgages and trigger a hedging operation that would consist in amongst others the buying of Treasuries. So the quantitative measures might run via mortgage buying instead of Treasury buying, but with similar effects on Treasuries than direct buying of the latter. Chicago Fed Evans defended the Fed’s aggressive policy and referred explicitly to the next FOMC meeting where the FOMC will be “thinking broadly”.

Commercial paper outstanding continued to rise in the most recent week, especial in the sector of the financial issuers. Asset-backed CP contracted. It seems that the Fed’s CPFF facility is showing its positive effects, but there is also evidence private investors are returning.

Regarding trading, Treasuries remained very well bid. In recent days and also yesterday, there was some attempt to take profit, but it was easily reversed, as if investors were looking for these dips to buy. The main theme is unaltered: the prospect of quantitative easing leads to the buying of Treasuries. However, also at the short end, investors take corrections at buying opportunities and rightly so. We would think 2- year Note should trade closer to 0.50%.

Today, the payrolls numbers will be used to gauge the extent and depth of the current downturn. The 333 000 drop expected would be one of the steepest post-war monthly declines. In past recessions, such high figures usually only occurred during one or two months. Recently, eco data have all surprised on the downside, suggesting that this might also happen with the payrolls. However, we are not sure that payrolls losses of 350 000 would be negative enough to push Treasuries to yet other record highs. We tend to think that the market is ready for profit taking unless the drop is way above estimates and even then the initial positive reaction may be reversed. Indeed, the 10-year is up 3 points and the 30-year even a full 6 points compared to the start of the week. However, should a correction occur, it might be nothing more than an end-of-week profit taking, if recent price is a good guide.

Failed test of the highs in the Bund points to profit-taking ahead

Today, the calendar is thin as it only contains the German factory orders (October) and Belgian unemployment rate (November). Factory orders are expected to drop 0.5% M/M in October after falling 8.0% M/M in September. Belgian unemployment might show a first rise from its cycle low of 6.6%. Ahead of the US Payrolls report this afternoon, the impact may remain limited.

On the ECB front, ECB’s Bonello of Malta will speak this evening, but following yesterday’s ECB rate decision and press conference we don’t expect him to move the market. By cutting interest rates by 75 bps to 2.5% yesterday, the ECB carried out its largest rate cut ever. The sharp downward revision to the growth and inflation projections also suggests rates may fall further to 1.5% or even 1% next year. Comments of ECB’s Mersch following the ECB press conference however sought to downplay expectations for more aggressive rate cuts in the months ahead. Although Mersch acknowledged the ECB had still ‘a little bit’ of room to cut rates, he warned that the 75 bps rate cut did not set a new ECB ‘rhythm’ and suggested the ECB was coming back into normal territory with rate cuts of 25 bps. His comments point to some important internal differences in thinking within the ECB. Ahead of yesterday’s meeting, several influential ECB governing council members, including Mersch and Bini-Smaghi, had pleaded for a continuation of the gradual easing cycle and as such had hinted at a 50 bps rate cut. It now appears that the consensus may have been to go for an aggressive rate cut of 75 bps and a wait-and-see stance afterwards. This leaves the question whether the ECB will cut rates again in January very much open. Currently, markets do however almost fully discount a 50 bps rate cut for the January meeting. This means that the short end of the curve is vulnerable to more profit-taking, although we still expect rates to fall lower in a longer-term perspective. For more details on the ECB rate decision and press conference, we refer to our flash ‘The ECB embraces an aggressive monetary policy stance’.

Regarding trading, yesterday we finally got a technical signal that the recent impressive rally may be running out of steam, as the Bund failed to break above the all-time highs at 124.60 in a sustainable manner and ended the session with a bearish engulfing pattern. As such, we currently favour profit-taking and wait on corrections lower before installing new long positions.

On the supply front, Spain yesterday raised €4B, as it sold €1.695B of its 5-year and €2.309B of its 3-year bond. Although the total amount was at the top of the preannounced range, demand was rather weak. Yesterday, Italy also announced that it will hold a mid-December BTP auction for the first time since 1996. In the previous years, the Italian treasury has typically cancelled mid-December auctions. This may put additional pressure on Italian bonds, as it will become increasingly difficult to sell bonds given the thinner liquidity conditions at around the end of the year. Yesterday, the intra-EMU spreads widened to new highs.

In the UK, the calendar is empty today.

Currencies: FX euro gains after ECB interest rate decision. EUR/GBP sets new life-time highs

On Thursday, EUR/USD trading developed in a very nervous environment. Uncertainty in the run-up to the ECB interest rate decision pushed the pair temporary below the 1.26 mark. However, the single currency already recouped part of the early losses before the ECB decision. The ECB delivered the 75 basis points rate cut that most markets had hoped for. EUR/USD reacted muted immediately after the announcement of the decision. However, we consider it a euro supportive factor that the ECB showed the flexibility to adapt its gradual approach to the extreme circumstance. We think that yesterday’s move reinforced the Bank’s credibility. It is difficult to say whether this was the major driver to explain the price action in EUR/USD yesterday afternoon, but EUR/USD was captured in a stop-loss buying move that began at the start of the ECB press conference. The US data were poor, too, but we think that the move was technically driven in the first place. Several intraday buying stops were hit and EUR/USD temporary jumped well above the 1.28 mark. Several Fed members spoke yesterday, including Fed’s Bernanke, and they again suggested that additional, ‘unconventional’ measures could be needed to support the economy. This debate could become a negative factor for the dollar over time. Whatever the reason, EUR/USD performed a decent rebound and the pair closed the session at 1.2777, compared to 1.27.17 on Wednesday. Also, interesting: the usual drivers for a EUR/USD rebound (higher oil prices and/or rising equities) this time played hardly any role or even pointed in the opposite direction (oil did set new lows at that time)!

Today, the US payrolls are on the calendar. The market already expects a loss of 333 000 jobs in November. We don’t have strong arguments to distance ourselves from the consensus. Recently, the reaction on currency markets to economic data mostly occurred indirectly via the reaction on the stock markets. This could also be the case today. Later, the data on the US mortgage delinquencies also deserve some attention.

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. The jury is still out on this, but yesterday’s price action in the wake of the ECB interest rate decision and press conference might have been a cautious indication that the downside in EUR/USD becomes better protected. 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. Of course, as soon as the payrolls are out of the way, markets might gradually enter end of year trading conditions. Over the previous two years, markets already showed some ‘strange’ moves due to less favourable liquidity conditions. One can expect that this will be even more the case today. So, trading might become highly ‘at random’, with little or no reference to the economic picture. In such a context, the technical picture should prevail as a guide from trading rather than the eco data or any underlying market view.

From a technical point of view, during the last four weeks, EUR/USD has established a sideways trading pattern. Longer term, the charts haven’t given any clear sign that the EUR/USD downtrend has been aborted. For this to happen, a sustained rebound above the 1.3294 range top is needed. Nevertheless, recently we advocated taking partial profit in case of return action towards the bottom of the 1.2330/1.3294 trading range. In a day-to-day perspective we tend to prefer a buy-ondips approach.

On Thursday, USD/JPY extended its gradual decline that is already in place for several days. The ongoing flow of negative eco data and the hesitant investor behavior on equity markets continue to support the yen. The late session sell-off on the US equity markets only reinforced this move. USD/JPY closed the session at 92.23 compared to 93.30 on Wednesday.

Overnight, Japanese/Asian stock markets show a mixed picture. The Nikkei close the session almost unchanged. USD/JPY is little changed compared to yesterday’s close in the US.

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. 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. We don’t try to fight the wellestablished downtrend in this pair. However, the nearing of a key support (year low at 90.87) warrants some caution. One can also expect Japanese officials to come out to warn on excessive yen strength/volatility in case of a break below the 90 mark. So, partial profit taking/Stop loss protection on USD/JPY shorts might be considered.

On Thursday, sterling was hammered again. Uncertainty in the run-up to the ECB and BoE interest rate decision weighed on the UK currency and EUR/GBP already set new life-time highs during the morning session. The EUR/GBP rally halted just ahead of the 0.87 big figure. Sterling found some temporary relief after the announcement of the BoE decision, but this rebound was very short-lived. Later in the session, EUR/GBP joined the rebound in EUR/USD and the pair closed the session at 0.8706, compared to 0.8601 on Wednesday. So, the pair closed the session well above the previous life-time high which, if confirmed, could be important from a technical point of view. From a fundamental point of view, we continue to think the out come of yesterday’s combined ECB and BOE decision remains a structural negative factor for the sterling.

Today, the UK calendar is empty.

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 and yesterday’s break above the previous short-term high only reinforces this picture. After the recent steep sterling losses, some short-term consolidation might occur. However, we hold on to our view that a negative interest rate differential vis-à-vis the euro, combined with ongoing negative eco news contains the risk for additional sterling losses over time. On top of that, the BoE looks still pleased with the support the weaker currency is providing to the UK economy. So, we consider a more pronounced correction (e.g. towards the 0.8568 hourly neckline) as an opportunity to extend our buy-on-dips approach. In a (very) long term perspective, 08824 is the target of Multi year double bottom formation (neckline 0.7253). A sustained drop below the 0.8330/0.8215 area would question the MT positive picture in this pair.

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Published on  Fri, Dec 5 2008, 10:41 GMT