Markets: Fixed Income
Friday, global bonds had a very strong run, helped by a number of factors, driving US bonds sharply higher. The price action of European bonds was obviously also impacted by curve re-positioning in the aftermath of the surprisingly hawkish press conference of ECB Trichet on Thursday, leading to a pronounced flattening of the curve.
The US payrolls figures were weak and while the headline figure was close to expectations, it was a, partially suspect, jump in the unemployment rate that caught the eye. The initial reaction was fairly modest, but a drop in the dollar and sky-rocketing oil prices, due amongst others to increased geopolitical tensions between Israel and Iran blew equities off the cliff, generating a flight-to-safety bid for bonds. The May payrolls question the recent eco optimism of some market participants, which skyrocketing oil prices will only exacerbate. In EMU, German production fell again more than expected in April raising questions about the European eco outlook too. The Bund did react modestly positive following the release. The pronounced flattening occurred in the opening, after which the price action became more synchronized across the curve. The 2-to-10-year yield is now inverted to the tune of 21 basis points, versus a positive slope of 4 basis points just before the ECB meeting.
US Treasuries rebound on payrolls and equity sell-off
Previewing this week’s calendar, the eco data are back-loaded and include on Thursday the initial claims, the import prices and the retail sales, while on Friday the CPI and the Michigan consumer sentiment are scheduled for release. Today’s Pending Home sales and tomorrow’s trade balance shouldn’t be of utmost importance. Fed governors will be very active until Thursday with governors Geithner, Rosengren, and Bernanke active today. Especially Bernanke’s speech on inflation might be very important. Recently, also Bernanke showed some signs of discomfort about inflation and inflation expectations. He surprisingly pointed to the role of the weak dollar as source of inflation via its impact on commodity prices, which was seen as a first verbal attempt to support the dollar. After an initial rise of the dollar, the tide turned due to ECB hawkishness and payrolls’ weakness. While the losses aren’t yet very pronounced, it might put Bernanke’s credibility at stake at some point. So markets will eagerly listen whether Bernanke has more to say on the subject. Weaker dollar might eventually affect Treasuries negatively, but until now this wasn’t the case. The Treasury will re-open its 10-year Note issue on Thursday.
The various eco data, mostly from May, will be very much impacted by high energy prices. This will be behind the expected increase of the trade deficit in April.
The import prices (2.5% M/M) will sky-rocket because of the higher petroleum prices, but even core prices should continue to rise. Retail sales (May) are expected up 0.5% M/M (0.7% M/M for sales excluding car sales). Also here higher sales at gasoline stations should have been an important factor behind the expected increase, but it will be interesting to see whether tax rebates are playing some role. The unit car sales were reported slightly down and this might also be translated into declining car sales figures. The CPI is expected to have been up 0.4% M/M in May (and 0.2% M/M), once more on the back of higher energy and food prices, while the core should be up a trend-like 0.2% M/M. Given the focus on inflation, a deviation from consensus might lead to a sharp reaction. Initial claims is expected to rise again to 375 000, as last week’s drop might have been due to the Memorial Day holiday. Michigan consumer sentiment for early June is expected marginally lower at 59.5 (from 59.8, the lowest since June 1980). The ABC weekly consumer comfort index jumped higher in the most recent week, suggesting an upward surprise is possible, but the 0.5%-point jump in unemployment rate could have depressed household morale.
Regarding trading, last week, yields dropped quite substantially, while the curve steepened. The 2- and 5-year yield shed 25 and 23 basis points, while the 10- and 30-year yield dropped 13 and 9 basis points. It was a reaction to the rise in yields in the previous week. Yields fell on Monday/Tuesday (financial woes, equities), rose on Wednesday/Thursday, before plunging on Friday (payrolls, equities). Looking to the drivers, renewed financial strains were an important factor early in the week. Downgrades of banks, Lehman rumours and UK Bradford and Bingley difficulties to raise cash stood out. This was also reflected in a rise of swap spreads with 10-to-13 basis points to 93/94 for 2/5-year and 74 for 10 year. The Fed funds futures lost some ground and the March 2009 FF funds future now discounts a 2.46% rate, down about 20 basis points from the top reached on Thursday two weeks ago.
Looking forward, trading will be affected by a number of factors. After the payrolls, it is obvious that the economy remains weak and the two key activity data this week, the retail sales and the Michigan consumer sentiment survey won’t do anything to change that view. However, inflation moved higher on the market’s lists of concerns and also in this respect, we probably won’t see a change this week. Bernanke’s speech on inflation may be a highlight this week together with the oil price. We think Bernanke will have to walk a fine line between showing that the Fed will keep a close eye on inflation and prevent inflation expectations to get unmoored, but on the other hand, the Fed probably don’t want allow rate hike expectations to move up further. The economy doesn’t seem strong enough for the Fed to hike rates anytime soon. Equities tumbled lower on Friday and odds have now risen that they fall further, maybe to the January/March lows. This would give Treasuries scope to profit from safe haven inflows. All elements taken into consideration, we feel that the uptrend in yields might be over for the time being and some further gains of Treasuries might be expected. The technicals are still not yet fully convincing, but that may change soon. So we start the week with a modest Treasury positive bias.
Inversion European yield curve continues
Today, the euro zone data calendar is as good as empty. This morning, the German trade balance came out better than expected, as the surplus widened further from 16.6 B to 18.7 B in April. This was mainly due to rise in exports, while imports dropped.
On the ECB front, ECB’s Trichet will speak this evening in Paris. Last week’s warning at the ECB press conference that rates could go up in the euro zone as early as next month took the market by surprise and lead to a huge flattening of the European yield curve. We don’t expect Trichet to give much new info. Friday’s jump in the oil price has further deteriorated the inflation outlook in the euro zone and currently inflation concerns clearly outweigh economic worries. The inversion of the yield curve nevertheless highlights the increasing concerns about the economic outlook among markets’ participants. On Friday, the inversion continued and in swap terms the spread between 2- and 10-year German swap yields is currently at its lowest since 1992 at -60 bps compared to a record low of -121 bps in 1992, when the economy fell into a recession.
Following last week’s move, markets currently discount more than two rate hikes in the euro zone. A rate hike in July and by October is now fully anticipated. By December, there is a 50% probability on another rate hike to 4.75%. This looks very aggressive, given the deterioration of the growth outlook and the divisions within the ECB governing council, where not everyone pleaded for higher interest rates. We still think that the ECB is overly optimistic on the growth outlook, as it expects the through of the current economic cycle at the end of the year and the economy to recover afterwards. However as inflation could push higher through the summer months, concerns about higher interest rates may well persist. Therefore, we don’t feel much to go against the tide at the current moment. This view is reinforced by the bearish technical pictures, now that yields have broken above previous resistance levels and some even set new cycle highs.
In the UK, the calendar contains the PPI data. This is usually no market mover, but given the current focus on inflation an upward surprise may continue to push shortterm yields higher.
Currencies: Payrolls and oil kill dollar rebound
On Friday, EUR/USD extended the sharp rebound that started on Thursday after the ECB press conference. A disappointing US payrolls report (especially the high unemployment rate did catch the eye) and a sharp spike higher in oil prices hammered the US currency. EUR/USD was traded around 1.5600 going into the payrolls report, spiked higher to the 1.57 area upon the release and gradually trended higher to close the day at 1.5777 (compared to 1.5593 on Tuesday). The pair still trades in that area this morning.
Today, the calendar of eco data is rather thin with only the US pending home sales scheduled for release. We expect this indicator to be only of intraday importance for currency trading. Late in the US session Fed’s Rosengren and later also Chairman Bernanke will speak at a conference with the striking subject title:”Understanding inflation and the implications for monetary policy: A Philips Curve Retrospective”. This can yield some interesting headlines. From a currency point of view, it will be interesting to see whether Bernanke repeats last week’s warning on the impact of the weaker dollar for inflation. If so, it could be of some support for the US currency. On the other hand, after the poor payrolls report, giving specific indications on monetary policy will be a difficult balancing act for the Fed.
Recently, we got the impression that the topside in EUR/USD gradually became better protected and last week’s warning from Mr. Bernanke that the weak dollar contributed to an unwelcome rise in inflation gave the US currency some additional support. However, the combination of a very hawkish ECB (almost pre-announcing a July interest rate hike), a disappointing payrolls report and sharply higher oil prices were a powerful poison to kill any dollar rebound and sent EUR/USD sharply higher on Thursday/Friday of last week. The dollar faces again an uphill battle and even if European eco data continue to give growing evidence of a slowdown in activity, the prospect of additional interest support put the euro in driver’s seat again.
In a medium term perspective, we have a neutral bias on EUR/USD and assume the pair to stay in the 1.5285/1.6020 range as long as visibility on the economic picture in the US and Europe remains low. Over the previous two weeks, we turned somewhat more dollar positive short term and even thought that the downside of the range could come in the picture. However, that move was blocked on Thursday and on Friday, our short-term defense area (1.5670) was blown away after the payrolls. We’re not convinced that the current developments (higher European interest rates in a context of slowing growth) will be euro positive in a longer term perspective. However, we don’t row a against the very aggressive price action seen at the end of last week. So, we amend our short-term bias for EUR/USD to neutral. The 1.5819 reaction low is the last protection on the upside. If broken, it would even open the way for a retest of the highs. Bernanke and oil remain the wild cards for today’s trading.
On Friday, the combination of a disappointing US payrolls report, sharply higher oil prices and a sell-off on the US stock market also triggered a correction in USD/JPY. USD/JPY last week tried to break above some key resistance levels and traded above the 106 barrier going into the payrolls report but also this attempt was rejected after the report and the pair had to make a step backward later in the session. USD/JPY closed the session at 104.92 (compared to 105.94 on Thursday.
This morning, there were some second tier eco data in Japan (Money supply, bank lending and leading indicators), but as usual they had hardly any impact on currency trading. The losses on the Japanese stock markets are substantial, but not extraordinary given the price action in the US on Friday. After some additional losses at the open in Asia, USD/JPY now tries to fight back and again trades above the 105 mark.
After a rebound from mid March to early May, USD/JPY settled in a narrow 102.55/105.87 trading range throughout the month of May. The topside of this range was tested several times and at the end of last week it looked as if a break would succeed. However, the events on Friday decided otherwise. Nevertheless, we still consider the losses in USD/JPY rather moderate given the market context (sharp equity losses, negative US data, record oil prices).We wouldn’t add to USD/JPY long exposure now, but we still have the impression that the downside in this pair remains rather well protected. Recently the correlation between the yen and the stock markets was not as tight as it used to be some time ago. However, this can change again if the (negative) correction on the equity markets reaccelerates. However, even in this scenario we think that the 102.55 area should continue to give decent support. A break below would change the long-term picture (stop-loss) but for now this is not our favourite scenario.
On Friday, there were no important eco data in the UK and the price action in EUR/GBP was mostly driven by what happened in EUR/USD. Follow-through price action after the hawkish ECB comments and the spike higher in EUR/USD after the payrolls also pushed EUR/GBP again towards the psychological barrier of 0.80.
Today, the UK calendar contains the UK PPI data. We don’t have a strong view on the outcome of the series. It will be interesting to see the market reaction on a higher than expected figure. Would higher UK interest rates (rate hike speculation) be a support for the sterling?
Since mid April, EUR/GBP develops a consolidation pattern after the steep sterling losses of the previous months. We turned neutral on EUR/GBP recently as a new attempt to move higher ran into resistance, mostly due to a loss of momentum in the euro overall. However, this euro correction obviously is blocked after the hawkish ECB press conference last week. We were sterling negative longer term and hold on to that view. The pair trades again in the upper part of the 0.7766/0.8098 consolidation range. A break above the 0.8034 reaction high would further improve the technical picture in this pair. In a day-to-day approach we continue to prefer a buy-on-dips approach. The 0.8098 all-time highs come again in the picture.
