Markets: Fixed Income
On Thursday, the bull steepening of the US and European yield curves continued, as the ECB signalled that it could soon start cutting interest rates and US equities sold off. Increasing fears for a global recession dominated trading and eased previous concerns about inflation. Given the rapid worsening of the global economic outlook and the ongoing freezing of the money markets, bond markets do increasingly speculate on the possibility of a coordinated rate cut by the main central banks around the globe. For a complete review of yesterday’s ECB press conference we refer to our flash 'ECB Trichet hints at early rate cut'.
As such, the short end outperformed with US 2-year yields falling 20 bps compared to 6.5 bps in 30-year yields. In the euro zone, 2-year yields fell 12.7 bps to new recent lows, while 10-year yields declined only 6.5 bps. 30-year yields also underperformed with a decline of 10.7 bps. Ongoing weak demand at the EMU government bond auctions don’t prevent yields from falling lower, but does lead to a further widening of the spreads with Germany.
US Treasury curve bull steepens as equities hit the skids
Today, the eco calendar contains the very important payrolls report (September) and the non-manufacturing ISM (September). After the extremely weak manufacturing ISM the markets are looking forward to see whether this figure can be confirmed by a weak payrolls report. If confirmed, this might have a bigger impact on Treasuries than the ISM had on Wednesday. After a disappointing payrolls report in August, the September report is expected to show another sharp decline (-105 000), which is in line with both initial and continuing claims reaching recession high levels. Also the manufacturing ISM painted a bleak picture of labour market conditions dropping from 49.7 to 41.8 in September. The ADP labour report surprised on the other side though, showing only a drop of 8 000 in private employment. Assuming that government payrolls rise about 15 000 in September, the payrolls report would report a rise of about 7 000, but since the fall of 2007, the correlation between the ADP and payrolls survey loosened significantly, with the ADP reporting materially stronger figures than the BLS Payrolls report and therefore we have no reasons to distance ourselves for a consensus-like figure, but with many some risks on the downside. The Nonmanufacturing ISM is expected to show only a modest decline in September, coming out at 50.0 against 50.6 in August. After the plunge in manufacturing ISM such an outcome looks too optimistic to us, even if they measure different sectors of the economy.
The Commercial Paper statistics showed that outstanding paper plunged by a record 94.9 billion $ in the latest week, of which 64.9 billion $ in financial CP. While part may be linked to the failure of Lehman, it probably is also evidence of the more general problems at the hearth of the financial system, the interbank funding market. ABCP plunged by 44.2 billion $ despite the new ABCP facility at the Fed.
The 25 billion $ TSLF auction was again well bid, a bid/cover of 1.96 and a stop out of 42 basis points, which compares to a minimum stop out of 10 basis points. So, there remain ongoing signs of strains. The Fed’s discount window loans for October 1 amounted to 49.5 billion $, the highest one-day record.
Overnight, Fed governors Hoenig (Kansas) and Bullard (St-Louis) took the stage and both showed very little (none) eagerness to ease monetary policy further. Hoenig remained concerned about headline and core inflation and noted that the monetary policy stance was very accommodative. The credit crisis had blunted the effectiveness of monetary policy, but its impact would be felt once confidence returned to markets. He supported the Fed policy to make a distinction between liquidity measures aimed at restoring confidence and monetary policy that is focussed on the broader picture. Similar picture from Bullard who said it straightforward: I think lowering interest rates right now, maybe, is not the right response and further out said he was concerned about the 1% number that was associated with the creation of a lot of problems. Both governors are non-voting FOMC members.
Regarding trading, yesterday, the dataflow was once more positive with higher than expected claims and weaker-than-expected factory orders. However, just like in previous days, it is the general theme of the financial markets tensions that is the main driver. This is reflected in bull steepening of the curve and an increase in rate cut expectations. The Fed fund future rates discounts a 1.50% rate for October and broadly a similar level further out. Deducing rate cut expectations from the FF future is a bit more uncertain and unreliable currently, as unusual conditions reign in money markets. The ongoing critical state of the situation in funding markets is further illustrated by the CP and TSLF data (see above) and by the euribors that rose further to respectively 4.04% (1 month) and 4.20% (3 months). Looking to trading today, the main items are the September payrolls and the vote in the House on the TARP (after trading?). Uncertainty on the fate of the TARP is still high. Overnight, two regional governors talked though on rates, but its effect in Asian trading is small (bear flattening), but visible.
So the event-driven trading will continue also today. The climate remains Treasury positive, but given the positive impact of safe haven flows in recent weeks and the current stance of the market, any easing in tension should lead to a correction. Should the payrolls show a very big decline, confirming the message from the ISM report that the economy cracked, we might see a spike higher, but this might be the moment to contemplate about booking some profits on longs.
Short-term yields fall, as Trichet hints at an early ECB rate cut
Today, the focus will be on the US payrolls report, as the euro zone calendar is thin and only contains the euro zone retail sales (August) and the final figure of the September Services PMI. Retail sales are expected to remain weak rising only 0.1% M/M in August and to come out at -2.4% Y/Y compared to an upwardly revised -2.3% Y/Y in July. The preliminary release of the Services PMI showed a slight decline from 48.5 to 48.2. The escalation of the financial crisis and sell-off on the equity markets since does point to a downward revision of the final figure in line with what we have seen in the manufacturing PMI earlier this week.
Yesterday, the ECB took an important step on the road to lower rates, as it acknowledged that the weakening of demand has diminished the upside risks to price stability somewhat. As such, a rate cut at the December meeting looks increasingly likely, while an earlier rate cut at the November meeting or in the event of a coordinated action between the major global central banks cannot be excluded in case the tensions in the financial markets intensify further and the economic outlook continues to worsen rapidly. In this context, we feel comfortable with our bullish view at the short end and favour a further steepening of the European yield curve.
On the money market, the ECB repeated its liquidity absorbing operation for the second consecutive day and drained EUR 200 B after banks deposited 48.5 B with the ECB overnight. At the same time, banks lent again 15.4 B from the ECB at the marginal lending rate at 5.25%, which underscores the lack of confidence within the financial system. This was also reflected in the higher Euribor fixings, despite the increased speculation on ECB interest rate cuts. As a result, the liquidity spread widened further to new record highs. In the introductory statement, Trichet explicitly referred to the tighter financing conditions as a factor behind the weakening of the euro zone economic activity.
During the weekend, France will organize a summit with Germany, the UK and Italy on the current financial situation. Recent leaks do however suggest that not that much should be expected, as the proposal of US style bail out plan has been squandered. According to the FT, the summit will now focus on the existing efforts to tighten regulation of rating agencies, improve coordination between supervisors and a review of mark-to-market accounting rules. In the US, the House is expected to vote today on the bail out plan, but uncertainty still reigns whether it will be passed.
Regarding trading, the US Payrolls report, equities and the vote on the US bail out plan will dominate trading today. As stated above, we hold on to our bullish view at the short end of the curve and a further steepening of the European yield curve. Yesterday’s weak demand at the French and Spanish auctions suggests the widening trend in intra-EMU spreads is not over yet.
In the UK, services PMI is forecasted to fall back in September, after an unexpected rebound in August. The consensus is looking for a figure of 48.0, but a lower outcome should not surprise after the plunge in manufacturing PMI and the drop in confidence in the UK services sector in the EU commission confidence indicator.
Currencies: Euro hammered as ECB opens the door for rate cuts
On Thursday, EUR/USD remained under pressure. The approval of the bail-out plan in the US Senate and the ECB interest rate decision dominated the conversations in the market. The first factor could be considered a slightly positive for the dollar, but we wouldn’t give too much weight to this argument as the decisive vote on the plan will take place in the House of Representatives later today. The ECB decision to leave interest rates unchanged was also no surprise for markets but investors were keen to hear the assessment of Mr. Trichet on the recent financial developments and on the (quickly deteriorating) European economy. EUR/USD already set now shortterm lows in the run-up to the ECB interest rate decision. In its press conference, ECB’s Trichet stressed the importance of anchoring inflation expectations, especially at times of high uncertainty. However, Trichet openly acknowledged that recent data clearly confirm weakening growth and that inflation risks have diminished. This can only be seen as a first step to the ECB cutting rates in the near future. In the Q&A session, Mr. Trichet even admitted that, while the decision for unchanged rates was unanimous, a rate cut was also discussed. European interest rates dived lower on these remarks and EUR/USD moved in step, dropping below the 1.38 barrier during the press conference. A very high/bad US initial claims report published at the time of the start of the press conference had no impact and was soon forgotten. After the press conference, the pressure on the euro eased somewhat. The US stock markets recording ever bigger losses (temporary) slowed the ascent of the dollar against single currency. EUR/USD closed the session at 1.3855, compared to 1.3819, compared to 1.4009 on Wednesday.
Today, markets will look out for the debate and the Vote on the US rescue plan in the House of Representatives. However, with the payrolls and the ISM nonmanufacturing on the agenda the market will also get some timely information on how close the US economy to an outright recession.
Recently, EUR/USD was in the eye of the storm. The dollar got the advantage of the doubt even if the (political and financial) headlines from the US were far from inspiring, too. However, the fragile hope for a US Bail-out plan still supports the market view (justified or not) that the US is taking the lead in an organized approach to the crisis. In Europe, the situation is deteriorating very quickly, too, but at least for now the market tends to be skeptical on the ad hoc approach from the European authorities. There are also a lot of rumours of political bickering with respect to ‘Sarkozy summit’ and this is also no support for the single currency. To be honest, all this has more to do with perception, rather than hard economic analysis. There is no clear answer as to which region will come out best/least worst out of this crisis. Yesterday’s change in the ECB assessment in this context was also interpreted as euro negative.
Looking forward, the approval of the US bail-out plan (even if the execution of the plan remains subject to a high degree of uncertainty) still could be moderately positive for the US currency. With respect to today’s US eco data (Payrolls and ISM manufacturing) we tend to be much more cautious as we wouldn’t be surprised to see another awful figure, raising the fears for a full-grown US recession going forward. However, economic data recently were not the most important driver for currency trading and in an environment of high uncertainty and unwinding carry tradelike transactions, the yen and the dollar apparently are favoured over the euro. This is the main reason why we stay cautiously euro negative/dollar positive for now. Declining oil and commodity prices also remain a slightly positive for the US currency.
From a technical point of view, EUR/USD rebounded from the 1.3885-area and set a new reaction high in the 1.4865 area. This was a significant correction, but the key 1.4900/10-area (reaction highs) was not challenged and this week EUR/USD turned again south. The pair now extensively tests a series of key support levels. The previous low (1.3882) and the longstanding daily uptrend line since 2002 (today in the 1.3978 area) are under heavy strain. Especially the latter, should not be evaluated on a daily basis. However, the euro needs to return above the 1.40-area soon and in a convincing way otherwise the risk is for another (down-leg). For now, we are skeptical on a sustained rebound of the euro going forward. The market reaction to today’s payrolls will be interesting.
Yesterday, USD/JPY slipped lower throughout the day. The lackluster market reaction the Senate approval of the US bailout plan and later in the session, the poor US stock market performance kept USD/JPY under moderate pressure. However, given the steep losses on the US stock markets yesterday evening, one can only draw the conclusion that the yen is obviously losing attractiveness as outstanding safe have currency, at least vis-à-vis the US dollar. USD/JPY closed the session at 105.33, compared to 105.71 on Wednesday and still trades in that area this morning.
There were no eco data in Japan this morning. Asian stocks show losses of (on average 1-to-2 %, which is not excessive given the steep losses in the US yesterday evening).
On the technical charts, USD/JPY set a reaction low in the 103.55 area after the Lehman crisis. The hope on a US bail-out plan propelled the pair again higher in the 103.55/110.68 trading range, but the gains could not be extended and renewed global market stress causes the pair to retest the range bottom earlier this week. Recently, we indicated that we are not impressed by the yen performance and the rejected test of the 103.50/55 support earlier this week confirms our feeling that the downside in this pair won’t be that easy. For now, we take a neutral attitude towards USD/JPY. More sideways trading in the 103.50/108.02 area is likely.
Today, the UK calendar contains the services PMI. Markets expect a decline from 49.2 to 48.0. The risk probably is to the downside of consensus. As indicated, markets (especially EUR/GBP trading) recently didn’t give much attention to disappointing UK data. However, with next week’s BOE meeting (and the expected rate cut) coming closer, one could expect negative UK headlines to get (slightly) more market attention.
Early September, 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 ongoing poor UK eco data) and dropped below a series of intermediate support levels. Since last week the sterling rebound against the euro lost momentum, but the negative trend obvious wasn’t really broken. We hold on to our view that we don’t see much need for a major/sustained comeback of the sterling based on the eco picture. However, we have to admit that (potential) global euro might become a factor to watch out for. EUR/GBP dropping below the 0.7844 previous low, raises a first alert. 0.7760 remains the key medium support for our longstanding sterling skeptical approach.
