Markets: Fixed Income
On Thursday, global bonds most of the day traded sideways with a slightly negative bias. Equities didn’t crash further in the European session and a selling move in midmorning US session was reversed later on. This left European bonds moderate lower in the close with yields up 2 to 4 basis points, the longer end underperforming and rising 7 basis points.
In late US session, authorities came out with a plan to tackle the underlying problem of the credit crisis, the presence of illiquid and toxic assets on the banking balance sheets. This led to a relief rally on equities, pushing the S&P up 4.8%, the sharpest rise of equities in many years. As a consequence, Treasuries tumbled lower pushing yields up between 6 and 13 basis points.
US Treasuries tumble in late trading, as government mulls plan to solve the credit crisis
Today, the calendar is completely empty, with exception of a speech of Fed’s Evans on the economy in Switzerland, but this shouldn’t be of much interest for markets. The market will chew further on the government plan to tackle the credit crisis. According to the available information, the government would create a government (taxpayer) funded fund that would buy the distress, illiquid and toxic private-labelled mortgage related assets on the banks balance sheets. To finance it the Treasury will sell Treasuries. In a second part of the proposition, the fund will also buy government (SE) labelled MBS-linked debt. If we are right this was already in principle decided during the Freddie & Fannie rescue, two weeks ago. Regarding the timing, the plan should be finalized this week-end and the congressional approval should be done one week later. Another proposal would be the creation of federal insurance for in- vestors in money-market mutual funds. This should stem the outflow of funds from these usually considered very safe investments. In recent days, these outflows had contributed to the drying up of the liquidity and the massive injections of liquidity by the Fed (and other Central Banks). Also more measure to curb short-selling seem to be under consideration. There are still many details to be worked out, like the crucial one of the valuation of the toxic assets and thus about the losses the financials will have to book. According sources, the plan could be worth 500 billion $.
The initial reaction to the plan was of course very positive, with equities surging almost 5%, financials up more than 11%. In general, all more risky assets, credit products amongst them, should rebound. The timing of the measures was always critical. Indeed, the VIX index (and many other alert indicators) reached critical levels (just like in August 2007 and in January (Kerviel), March (Bear Stearn) and June 2007 (F&F)). The S&P showed twice (Monday and Wednesday) an exhaustion move and a critical support area was under severe test. So, while the plan doesn’t resolve everything and nasty things might still come out, in the context of forward looking markets, the downside in equities should now be better protected. We will now watch how markets react in a somewhat longer term. It is of course too early to be convinced that the bear market is over. For the super safe government bond markets, the easing of tensions and fears is a negative and we might see more losses in the days to come. For Treasuries, the question is how the plan will affect the economy (important for the short end due to the expected impact on monetary policy) and how it is funded and the costs of the plan. It will raise the already high deficit/debt and thus more supply of Treasuries is likely. This would be bad news for the longer end. The higher deficits might also have an inflationary impact, especially after the economic fortunes would improve.
We will look deeper in this matter in the next days and see how markets take it. Markets might also gradually look again more to economic developments. While the technical pictures are still bullish, we think that a more defensive posture regarding Treasuries is appropriate, as profit taking and reversal of safe haven flows will probably go on for longer. In a long perspective, given the fiscal impact of the plan, 10-year Treasury yields at 3.60% offer no value. All kind of spread products will do fine.
European bonds open sharply lower
Today, the euro zone data calendar is once again empty. As such, all attention continues to go out to the developments in the credit crisis. In this context, the plan announced by the US authorities overnight could mark an important step towards a longer-term solution of the crisis. At the centre of the plan is a the creation of a government-sponsored vehicle that would take bad assets off the balance sheets of financial companies and as such restore confidence between banks. Over the past days, banks had become extremely unwilling to lend to one another, which forced central banks to step up liquidity enhancing measures.
In the euro zone, the ECB joined forces with other central banks to address the continued elevated pressures in short-term US dollar funding markets and executed an overnight US tender for an amount of USD 40 B. As regards, the Term Auction Facility operations, the ECB also decided to increase the amount of US dollar liquidity provided to USD 25 B for the 28 days maturity operations and to USD 15 B for the 84 days maturity operations. In euro terms, the ECB also lent EUR 25 B in oneday money, the third liquidity providing overnight tender since the eruption of the crisis with Lehman Brothers, as liquidity spread spiked higher.
It will now be interesting to see whether Europe will copy the US plan, as the European banks face similar problems to the US. In this context, we have seen no comments yet. It however could prove much more difficult in Europe to execute such a plan given its fragmented political structure. In a market perspective, the US plan will however be welcomed and will ease financial stress, as was reflected in yesterday’s reaction on the US equity and the Treasury markets. This already led to a sharp lower opening of the European bond market with the Bund falling below its daily uptrend line. Given the extreme market tensions over the past days, a severe profit-taking move is likely. Although the reversal of recent safe haven flows will mostly hit the short end of the curve, we hold on to our positive view in a medium term perspective, as recent tensions in the financial markets have increased the downside risks to the economy and improved the outlook for inflation. In this context, there is a good chance that the 2010 ECB staff inflation projections will show inflation falling again in line with price stability, which would enable the ECB to start cutting rates in December. As such, a buy on dips approach at short end of the curve can be rewarding once the profit taking has run its course. The US plan should also put a cap on the recent widening of credit spreads in intra-EMU government bonds. Yesterday’s demand at the French and Spanish auctions was quite weak reinforcing the view that real demand for bonds remains tepid.
In the UK, the calendar is also empty today. Yesterday, the UK’s watchdog announced measures to ban short-selling of financial stocks in a move to ensure the stability of the financial sector. Also here it remains to be seen whether the UK authorities will create a similar plan to take the toxic assets off the bank’s balance sheets, given the precarious situation of the UK budget.
Currencies: dollar gains on US bail-out plan
On Thursday morning, EUR/USD extended its rebound after strong (mostly oil related) gains on Wednesday. At start of European trading, the major central bankers announced additional measures to support market liquidity and this caused some easing in global market tension (as mirrored in a cautiously positive open of the European stock markets). At first, EUR/USD showed no strong reaction but throughout the European morning session EUR/USD gained momentum and the pair tested offers well above the 1.45 big figure going into the US trading hours. The rebound in the oil price at that time again played a role, but the correlation was less obvious than on Wednesday. As is the case in almost all other markets, EUR/USD trading these days is very much order driven (by the way, the oil market is probably also driven by the unwinding of all kinds of correlation hedges). Later in the session, the rebound on the US stock markets on news headlines about a new plan/fund to address the credit crisis, supported the dollar and EUR/USD closed the session at 1.4348, not that much different from the 1.4326 close on Wednesday. Overnight, the dollar rebound continued and EUR/USD trades in the 1.4200 area at the moment of writing.
Today, the European and the US calendars are empty. So, currency markets can focus on the global credit stories.
Until a week ago, EUR/USD was caught in a forceful downtrend. The decline in the oil price and growing signs of deterioration in the European economy caused a sharp re-allocation in favour of the dollar. However, this trading paradigm changed last Friday. After the Lehman/AIG break-down, EUR/USD entered calmer waters. Currency markets apparently became indecisive on which side to choose in case of rising overall tensions and on which economy would be most vulnerable to the fallout (financially and economically) of the credit crisis. At the same time, oil remained the most important driver for EUR/USD trading intraday. The US taking to lead in addressing the credit problems by creating room to downsize the banking sector’s balance sheet currently puts the dollar in the pole position. So, in this context, it would be understandable for EUR/USD to drift lower in the ST consolidation range. In a longer term perspective we still look for evidence that the US economy will indeed avoid a major setback on the recent developments (and that over time the interest rate differential will go in favour of the dollar) before preparing for a new break higher in the dollar/lower in EUR/USD. Lingering uncertainty on how the problem will be tackled in Europe might be a short-term negative for the single currency, too.
From a technical point of view, EUR/USD gave a short-term trend reversal signal on Friday last week. The pair yesterday set a reaction above the 1.4500-mark, but the key 1.4570 area (Aug 26 low) was not challenged. We hold on to our view that EUR/USD entered a consolidation pattern between 1.3882 (reaction low) and the 1.4575/80 breakdown area. After the rejected test of the upside of this range, we now favour a sell-on-upticks approach in EUR/USD with a potential retest of the 1.3954 (longstanding uptrend line)/1.3882 (reaction low) area.
USD/JPY was again haunted by swings in investor sentiment caused by the unraveling of the credit crisis. So the pair jumped up and down in a 105.50/104.00 trading range, even testing the bottom of this range on intraday stock market weakness in the US, before the new headlines on the bail-out fund hit the screens. Since, USD/JPY staged a powerful rebound in step with the euphoria on the stock markets. USD/JPY closed the session at 105.44 (compared to 104.66 on Wednesday) and even trades in the 107.00 area at the moment of writing supported by strong gains on all Asian stock markets.
On the technical charts, USD/JPY staged a gradual rebound from the mid-July reaction low to set a new reaction high at 110.68 on August 15. Since then, the pair gradually slipped through a series of support levels and this move accelerated after this weekend’s ‘credit events’. USD/JPY on Tuesday set a new reaction low in the 103.55 and there was no follow through selling, which was already a bit disappointing from a yen point of view, given the high level of stress on global markets. As the US plans could be a milestone for this crisis (of course subject to a lot of specifications and approval) this also could be a trigger for a rebound in USD/JPY. We adopt a buy-on-dips approach in this pair. It is still early days, but if the plan is indeed able to mark a U-turn in investor sentiment, return action toward the MT range top (110.66) could be on the cards.
EUR/GBP initially staged a remarkable rebound yesterday. The move can only be explained as driven by a global repositioning in stretched overall market conditions and was in step with the rebound of the single currency after the announcement of (coordinated) central bank measures to address the liquidity in global financial system. In line with market behaviour of late, the eco data had no impact on EUR/GBP trading. On the contrary, the sterling continued to lose ground after the publication of stronger than expected UK retail sales. This is another indication of order-driven trading. The EUR/GBP rebound shifted into a lower gear in the afternoon (more or less in strep with EUR/USD) and the easing of market tensions later in US trading even helped sterling to recoup almost all its intraday losses. EUR/GBP closed the session at 0.7891, not that much different compared to the 0.7883 close on Wednesday.
Today, the UK calendar is empty
Two weeks ago, EUR/GBP tried to break out of the longstanding sideways 0.7760/0.8098 trading range, but the test was rejected and this triggered a significant correction sending the EUR/GBP pair again in the previous range. Recently, the sterling showed remarkable resilience vis-à-vis the euro (despite global market stress) and dropped below a series of intermediate support levels.
Medium term, we hold on to our view that it is too early for a major/sustained comeback of the sterling. However, with short-term market sentiment being sterling friendly, the chances for return action towards the key 0.7760 reaction low are rising.
