Markets: Fixed Income
On Friday, global bonds were hit by profit-taking, as equities extended their recent gains despite a new bag of weak eco data. This raises the question whether the market has discounted enough bad news for now.
Ahead of this week’s BoE and ECB meeting, it was however the long end that was hit the hardest. As such, the steepening of the European yield curve continued, although it was a bear steepening. German yields were up 6.8 bps for the 2-year compared to 12.9 bps in 10-year yields and even 18 bps in 30-year yields. In the US, yields recouped their early losses and closed the day almost unchanged up only 3.9 bps in 5-year yields (due to benchmark change).
Notwithstanding the sharp rise in German yields, the intra-EMU spreads continued to widen dramatically, as the non-German European yields rose even more. Greek 10-year yields surged above 5.50% and are now at their highest level since 2002.
US Treasuries cannot hold on to early gains
Previewing this week’s Treasury trading, the eco calendar is interesting, but investors will also closely watch for news about the future supply, following the TARP and other spending measures decided recently and to be decided in the near future. The borrowing needs and the refunding announcement will be released on Monday and Wednesday respectively. Of course, the presidential elections on Tuesday are another highlight, even if it isn’t easy to second guess how the markets will react. A victory of Obama is likely and thus should already be discounted. Anyway, just like the Bush administration was forced to put its ideology aside when reacting to the financial crisis, we think the policy of the incoming administration will to a large extent be decided by the financial crisis and the recession and not by any grand project. There might be some relief in the market that the endless election campaign and the uncertainty about the winner is over, but it is likely the market will wait on the actions of the new administration before making up its mind.
Regarding the eco data, today the October ISM manufacturing survey & the car sales and the September construction spending will be released. The ISM headline index is expected to have fallen to 42 from 43.5 previously. All 5 regional surveys we monitor showed very steep, awful declines, suggesting activity came to a near standstill in October. The ISM should confirm that view and the risks are firmly on the downside of expectations (levels in the 30’s). All in all, sentiment held up rather well until August and the index hovered at levels well above those that in the past were associated with recession. That will have changed in October. At the same time, we expect the price index to continue its recent freefall and show its first below 50 reading. Construction spending is no market mover, but won’t give a pleasant read either. On Tuesday, the September factory orders will show a modest drop. On Wednesday, we put the risks for the Non-manufacturing ISM (exp. 47.8) well on the downside of expectations, while the ADP employment report won’t get much attention, as its strong link with the payrolls has loosened remarkable in the recent year. On Friday, the October payrolls are expected to have deteriorated sharply, notably a decline by 183 000, which would put the decline closer to levels seen in the midst of previous recessions. The unemployment rate may have ticked further up. Concluding, the eco data will tell us this week that the US economy is in full recession and the outlook is for little improvement, probably until about mid 2009. However, this shouldn’t be a big surprise for markets anymore. Fed speakers are few and probably not very important for markets. Fed Lacker speaks on monetary policy in Israel today, while Fed Fisher speaks tomorrow in Texas on economic challenges. On Friday, governors Warsch and Lockhart speak in NY and Palm Beach.
The Treasury quarterly financing needs (on Monday) and the quarterly re-funding announcements (on Wednesday) are very important. Investors should tighten their seatbelts because there might be quite some surprises in these announcements. Indeed, the recession will affect budget projections to a great extent, higher outlays and less revenue, but it is very difficult to correctly guess the impact of the recession. Secondly, the Treasury might already take into account an extra stimulus package, while the accounting surrounding the TARP is not easier either. The OMB will do it on a cash basis, but according to CBO, the budgetary impact will be limited to the difference between the price the Treasury pays for the assets and their value. For capital injections, there even won’t be an impact. This means that deficit estimates may vary substantially. The FY 2008 deficit, closed in September, reached a new record high of 454 billion $, but the FY 2009 deficit might easily be double that. However, from a Treasury point of view, it doesn’t matter that much how the accounting of the deficit occurs. It will have to borrow the money (for TARP) notwithstanding the way it is accounted for. Therefore, we will see some huge borrowing requirements. The Q3 borrowing, estimated at 142 billion$ in August, will have topped 500 billion $. Q4 borrowing requirement, initially estimated at 142 billion $ will also be raised substantially. The Treasury will release the preliminary Q1 2009 requirement. The Q4 refunding package will probably reach a new high too of maybe 53 billion $. Probably the Treasury will re-introduce the 3-year Note auctions, but besides the uncertainty of the seize (25 billion $?), there is the frequency of the auctions (quarterly?, monthly?). Also the frequency of the 10- and 30-year Notes and Bonds is under revision. Concluding, there is much uncertainty surrounding the Treasury issuance plans and while the sharply increased borrowing shouldn’t come as a complete surprise, it might impress the market and be a hurdle for Treasuries.
The Fed rate cut, risk aversion unwinding and repositioning, also linked to end-ofmonth trading, dominated Treasury trading last week. While 6 month and 1 year Tbills dropped by 46 and 25 basis points, the 2-year Note yield rose by 5 basis points, but the damage further out was more substantial, as 5-to-30-year yields jumped by 25 to 28 basis points higher. In other markets, there were signs of some normalization: Libor rates dropped for the third week in a row, with the 3 month maturity at 3.03% (down from a peak of 4.83% on October 10), the liquidity spread declined too, but at 238 basis points (peak at 364 bps) is still extremely wide. 2- and 5-year Swap spreads narrowed modestly (4-7 bps), the 10-year spread stabilized at 48 basis points, while the 30-year that acted strange recently and even became marginally negative, rose by 8 basis points to a positive 8 basis points.
Regarding trading this week, the eco data will be very weak and thus supportive, but that is not really a surprise; the presidential elections might bring some relief, but conditions in the credit markets and the economy will soon get the upper hand. The quarterly financing needs & refunding announcements might be a key factor, beside the question whether equities, that showed at last some strength last week, might hold on to its gains, something that it was unable to do recently. In this respect big rate cuts in Europe may be a factor too. The technical pictures of the 2- and 5-year remain bullish. For the 2-year expectations about further rate cuts will limit the upside for its yield, while for the 5-year the picture remains positive as long as the yield is below 3%. The picture of the 10- and 30-year is more neutral. The 10-year yield set two higher lows in recent weeks and approaches now key levels at 4.10/17%, while the 30-year yield faces the neckline of a bearish triple bottom at 4.47% (now 4.33%).
Tentatively, we start the week expecting that credit markets will show some further signs of improvement and together with supply concerns and risk aversion unwinding, the environment isn’t very promising, even if one should take recent losses further out the curve into account when evaluating the situation. So, because the fundamental background doesn’t look very promising at the start of the week, we are looking for signs that longer-dated Treasury yields have topped out, before contemplating stepping in the market. The market has to convince us that there is upside. For the shorter end, we are in theory bullish, but with the market discounting a 0.75% FF target rate, the room for more gains is limited.
European yields correct higher, but spreads widen further
In the euro zone, the calendar is very thin today and only contains the final figure of euro zone manufacturing PMI (October). According to the flash estimate, the manufacturing PMI fell in October to its lowest level since the series began 11 years ago. The headline figure plunged from 45.0 to 41.3 and the final figure is expected to confirm this outcome indicating that the euro zone economy is in recession.
Against this backdrop of a very weak economy and a slowdown in inflation, the ECB will decide on interest rates on Thursday. Last week, ECB’s Trichet already hinted that the ECB is likely to cut rates again following their first coordinated move at the beginning of October. A rate cut of at least 50 bps is expected and is also the most likely outcome. The one month Eonia futures do point to a larger rate cut of about 75 bps, but are currently not in line with real expectations, as the Eonia rates do currently trade below the official policy rates, which is also reflected in the futures. We nevertheless think that the market is vulnerable to some profit-taking following the impressive rally at the short end of the curve over the previous weeks. Is a buy the rumour, sell the fact reaction in the making?
Rising supply concerns on the European bond market may fuel such a profittaking move, as the supply is centred on the short end this week. Tomorrow, the Netherlands will tap three different 3-year DSL’s for an amount of between EUR 0-2 B. On Wednesday, Finland will tap its 4-year RFGB for a maximum amount of 1 B and on Thursday both Spain and France will tap the market. Spain will tap its 3- and 7-year bonds for an expected 1 B each, while France will tap four OAT lines for 4.5-6 B. As a result, the net cash flow will be highly negative this week, as there are no redemptions scheduled. Last week, the intra-EMU spreads widened dramatically. Greek and Italian 10-year spreads now trade at their highest level since the introduction of the euro, well above the 100 bps. The digestion of this week’s supply may decide whether the recent spread widening will continue or whether some correction will occur.
Regarding trading, although the technical pictures are bullish for all maturities, we wouldn’t be surprised if Friday’s upward correction in yields continues this week. But as we continue to trade the market from the long side, we would use these rebound to go long again. From a technical point of view, rebounds towards 2.90% in 2-year yields, 3.50% in 5-year yields and 4% in 10-year yields offer good opportunities.
In the UK, manufacturing PMI is scheduled for release. Last month, UK manufacturing PMI plunged from 45.3 to 41.0, the lowest level since series began in 1992. In October, another decline is expected to 40.1. On Friday, several banks raised their rate cut expectations to 100 bps for this week, which heightens the risk on some disappointment following the decision. In the market, a 75 bps rate cut looks almost discounted. Today, BoE’s King will testify before the UK Treasury Committee, but ahead of Thursday’s meeting we don’t expect him to comment on the near-term outlook for monetary policy.
Currencies: Currencies take a breather
On Friday, EUR/USD lost more ground, following the turnaround in Thursday’s session. So ahead of the European session, the pair dropped from 1.2922 to about 1.2670. However, the pair stabilized, was marginally lifted and hovered for the remainder of the day in a tight sideways range, closing at 1.2727. So while weaker Asian equities had some negative impact on the euro, as one would expect, the euro couldn’t profit from a better run of equities later in the US session. This isn’t a good sign for the euro, but we wouldn’t draw too many conclusions from it.
Overnight, Asian equities are sharply higher, pushing the EUR/USD pair again towards 1.29.
This week, currency traders will have to cope with weak US eco data and an ECB rate cut. Following ECB comments, a rate cut is a done thing and it probably will even be a 50 basis points one. ECB Weber, a hawk, spoke about the need for some aggressiveness and not one ECB member has tried to manage market expectations away from the 50 basis points rate cut that is fully discounted. So, all in all, the market won’t be that much surprised and a rate cut shouldn’t be euro negative. Equities may confirm last week’s gains that in the past would have been euro positive, but that shouldn’t remain the case.
We advocated that a prolonged period of sub par growth and a deflationary environment is more supportive to the dollar than to the single currency and this was an important factor of the decline of EUR/USD from 1.60 to below 1.24. This is also the main reason for our EUR/USD negative view longer term, which remains intact. Shorter term, following the rebound of the pair last week, we think that the pair is looking for some sideways trading range that might have boundaries of 1.231 and 1.3297. Indeed, the EUR/USD rebound ran out of steam around the first key resistance level around 1.3259, previous low, which we singled out as a potential entry point in a sell euro-on-up-ticks. The latest IMM data showed that currency speculators trimmed dollar long positions, a sign that more normal trading conditions may get installed.
From a technical point of view, EUR/USD over the previous month tumbled from the 1.4866 reaction high to levels below the 1.24 mark early last week. High profile intermediate supports like the longstanding daily uptrend line since 2002 (today in the 1.4050 area), the previous low at 1.3882 and the 1.3259 10 Oct reaction low were all taken out with remarkable ease, but a powerful rebound occurred in recent days. EUR/USD needs to return above the 1.3259 reaction low to get a first indication that pressure is easing. However, Tuesday’s move constitutes an outside key reversal/bullish engulfing move, confirmed yesterday, that might be an indication of a medium term low in place.
On Friday, USD/JPY at first dipped lower, setting an intra-day low at 96.36 (from 98.60) on the back of plunging equities that reacted disappointingly to the BoJ rate cut. However, most of the equity losses were registered in the final hour of trading. Later on, global equities steadied and in the US even rallied, erasing early losses and closing little changed at 98.46. So, the risk aversion/risk appetite complex was again responsible for the price action.
Today, Japanese markets are closed for Culture Day Holiday. In a thinner market, the yen is losing some ground, USD/JPY trading at 99.50. The soil remains not so fertile at the onset of the week. Asian equities are thriving well, helped by a stimulus package in South Korea and a rate cut in India.
Later this week, the calendar in Japan is thin, but the meetings of the BOJ meeting will get quite some attention. In the US, the eco calendar is important (ISM/Payrolls) and should confirm the US is in recession. The financing needs and refunding announcements might be interesting for Japanese big buyers of Treasuries and thus may have some impact on trading. An eventual post-election equity rally on the contrary should be yen negative.
On the charts, global market stress hammered the pair through the 103.50 range bottom three weeks ago and the pair set a new reaction low at 90.93 last Friday. Longer term, the break below the March 2008 USD/JPY low means that little key support is seen before the all-time (April 1995) low at 79.75. Recently, we were not fond of buying yen on the argument of extreme stress, as the yen may rapidly lose ground if the financial markets stabilize and the past sessions show the argument isn’t totally unfunded, even if we admit that in a longer term perspective, the yen did very fine and was the world outperforming currency. We still don’t want to run after the yen, also not following the correction. From a technical point of view, the picture is however still bullish with a triple top on the charts with targets that stand below the 79.75 all-time low. The neckline of the configuration stands at 101.30 and should of course hold or its positive implications disappear. Short term, USD/JPY may consolidate in the wide 99.70/101.30 to 90.93 range with risk aversion/appetite the driver.
