Markets: Fixed Income
On Monday, global bonds had a strong session on the back of weak business confidence surveys in the euro zone, UK and the US, where the ISM fell to a 26- year low. US car sales also sank to a 25-year low, while in the euro zone the EU Commission said the European economy has grinded to a standstill.
But whereas the weak US data raised hopes on further rate cuts from the Fed and led to a bull steepening of the US yield curve, the European yield curve flattened in a bullish way. Although there was no immediate strong rationale behind the underperformance of the short end in the euro zone, huge supply centred at the short end may have been a factor, as well as some cautiousness ahead of the ECB meeting on Thursday following the impressive rally over the previous weeks.
In a daily perspective, US yields fell between 12.8 bps in the 2-year sector and 0.8 bps in 30-year sector compared to 1.8 bps for German 2-year bonds and 8.5 for 30- year bonds. The declines in non-German yields were more limited, as the intra-EMU spreads continued to widen also at the short end.
US Treasuries start the week on a strong footing
Today, the calendar is very thin with only the September factory orders for release. Orders are expected to decline by 0.8% M/M, but following the release of the cyclical durable orders last week that are part of the factory orders (55%), the report shouldn’t contain much new info. So, attention will be on the presidential elections, for which the results won’t be available until well after closure. It isn’t easy to second guess how the markets will react (on, Wednesday). A victory of Obama still seems the most likely, but 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. One might argue that a democratic victory raises the odds for a (bigger) fiscal stimulus. 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.
Richmond Fed Lacker, a non FOMC voter this year, known for his hawkish features as he dissented four times in favour of a tighter policy in the past, spoke in Jerusalem. His views are far less pessimistic than those of most of its colleagues including chairman Bernanke. He admits that the economy is in recession, but he is optimistic that a recovery will take place next year. He doesn’t see the credit turmoil as a once in 100 year event that would push the economy in a deep and protracted recession.
He sees the decline in underlying economic conditions as having a bigger role in credit tightening than the financial market turbulence. He suggests that there is no reason to believe that the fundamental creative process that drives innovation and improves well being over time has been mortally wounded. Therefore he is reasonably optimistic on growth going forward (cited low 1% FF rates, lower energy prices and an end to the drag from housing) and warns about complacency on inflation. He isn’t sure that core inflation will follow headline inflation lower and says that one should avoid holding rates very low as the recovery occurs.
Dallas Fed Fisher, a FOMC voter, who rejoined his colleagues since the September meeting after having dissented in favour of a less easy policy throughout the year, said inflation risks had emphatically diminished (vaporized). He also said that his growth forecast was “on the left hand” of the range of policymakers, suggesting a more bearish stance on growth.
The latest Fed Senior Loan Officer survey revealed a substantial tightening in lending standards and terms for nearly all loan categories, mostly to levels that are far higher than those ever recorded. It is clear the economy is in a vicious adverse feedback loop (cf. also dramatic car sales) in which reduced credit availability hit activity that further worsens the situation in the financial sector leading to more credit restraint.
The Treasury announced its borrowing projections. For Q4, the preliminary projection of 142 billion $ was revised to 550 billion $ and Q1 2009 borrowing of 368 billion $ was put forward. Actual Q3 borrowing was put at 530 billion $. Despite the huge amounts, it probably fell a bit short with estimates of the street, but is probably due for upward revision later on. The attention now shifts to tomorrow’s quarterly refunding announcement.
Regarding trading, Treasury yields fell substantially yesterday, steepening the curve. While eco data were weak and the Senior Loan Survey stunning, the rise in Treasuries (and the steepening) was already well in motion before the data were released. Equities couldn’t offer a good explanation either, as they traded mostly sideways, while the financing projections, which were Treasury negative, had no impact at all. We think that part of the explanation of yesterday’s strong run, especially in the beginning, can be brought back to the very thin trading. Volumes in the future contracts were still lower than a usual Monday when they are traditionally thin. For today, we don’t see any firm driver for Treasury trading and count on sideways technical trading with investors sidelined ahead of the results of the presidential election.
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 4.32%).
Intra-EMU spread widening raises calls for a single European government bond issuer
In the euro zone, the eco calendar only contains the PPI data, which isn’t a market mover. A decline in the PPI will however ease further concerns about the pipeline pressures stemming from previous increases in food and energy products. Yesterday, the EU Commission published their autumn forecasts for growth and inflation. But notwithstanding a sharp downward revision of the growth forecasts for this (1.2% vs. 1.7% Y/Y) and next year (0.1% vs. 1.5%) and a slow recovery in 2010 (0.9% Y/Y), the inflation forecasts were still revised up for this year (3.5% vs. 3.1% Y/Y) and left unchanged for next above the critical 2% level at 2.2% and at 2.1% in 2010. Especially, the inflation forecast for 2009 is surprising given the sharp downward revision in the growth outlook and the positive base effects related to the energy and food prices filtering through. We wouldn’t draw too many conclusions out of these forecasts, as the EU forecast seems overly pessimistic on inflation, even if the combination of very weak growth and still rather elevated inflation levels as such suggest that the room for the ECB to cut rates may be more limited than generally thought. In a short-term perspective, there is little reason to go against the flow, as the overnight rate decision (-75 bps) of Australia indicates, even while we would wait on a correction higher in short-term yields before adding to long positions.
Yesterday, the underperformance of the short end is likely to be related to the supply, which is centred at the short end this week. Today, the Netherlands will tap three of its very short-term bonds, which will mature in 2009, each for an amount between EUR 0-2 B, while Ireland is planning to issue a new 3-year bond via syndication. According to the Dutch State Treasury Agency, the tap should help funding the increased need due to the recent capital injections in the financial sector. In the run up to the auctions, Dutch and Irish government bonds underperformed their peers, just like we have seen last week in the run up to the Italian bond auction. The sharp widening of the spreads increases the calls for a unified single European government bond issuer. Press reports indicate that French, Dutch, Belgian and Spanish debt management offices are supportive of the idea, but as could be expected this is much less the case for Germany. As long as there are no more specified plans, we would be careful to put too much weight on the issue.
On the money market, the ECB will hold its weekly refinancing tender at full allotment and a fixed rate. In previous weeks, banks continued to ask for an enormous amount of money, which along with the persistent usage of the deposit and marginal lending facilities at the ECB indicates that there is still a lack of confidence within the financial sector, although the Euribor fixings resumed their gradual decline. Later on this week on Thursday, the ECB will hold a special longer-term refinancing operation for a maturing matching the length of the reserve maintenance period.
Regarding trading, the technical pictures are bullish for all maturities, but following the failed test of the 10-year yields to break below the year lows at 3.65% over the previous weeks, we are looking for some upward correction before adding to long positions. 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, the calendar is empty today.
Currencies: EUR/USD continues to fight an uphill battle
On Monday, EUR/USD again delivered a disappointing performance. The pair traded in the high 1.28-area early in the European session, but there was again no room for further gains of the single currency despite a decent start on the European stock markets. The EU commission in its autumn forecasts painted a very bleak picture for the European economy for the second half of 2008 and going into 2009. This only confirmed the market feeling that the single currency will continue to lose interest rate support in the near future as even the ECB will be forced to execute aggressive interest rate cuts, starting with this week’s meeting. However, later in the session, the US ISM manufacturing index came in at an awful 38.9, suggesting that the US heading for a deep recession, too. However, at that time this release failed to give EUR/USD any lasting support. On the contrary, EUR/USD extended and even accelerated the intraday decline that started early in US trading and closed the session at 1.2643, compared to 1.2726 on Friday. The steep decline in the oil price apparently is still an important guide for EUR/USD trading, as the eco data fail to set the tone for trading at the current juncture.
Overnight, the dollar only extended its rebound, or probably even better, the euro extended its decline (USD/JPY lost ground in Asia) and the pair trades in the 1.26 area at the moment of writing.
For today, the US presidential elections will dominate the headlines on all news wires. However, the least one can say is that the election, just like the eco data, until now had hardly any impact on (currency) trading and we don’t see any reason why this should change today. In case of an Obama/democratic victory, a more stimulating fiscal policy (and thus less room for monetary easing) in theory could be dollar positive in a first stage, but we wouldn’t give much weight to this argument at the current juncture. With the outcome of the election only available tomorrow morning, one might expect investors to keep a wait-and-see attitude. The market focus will probably remain with the economic crisis and the interest rate cuts that will be executed in the days and weeks to come. At least in the recent past, this focus on the global crisis proved to be a negative factor for the single currency.
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 behind 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 that might develop within the boundaries of 1.231 and 1.3297. Indeed, the EUR/USD rebound ran out of steam around the first key resistance level at 1.3259, previous low, which we singled out as a potential entry point in a sell euro-on-up-ticks.
From a technical point of view, EUR/USD since the last week of September 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, 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 last week. EUR/USD needs to return above the 1.3259 reaction low in a sustainable way to get a first indication that pressure is easing. Such a move looks very difficult for now. The short-term trend in EUR/USD is again down with the 1.2330 reaction low the most obvious short-term target. A break below this level could put the trigger for an additional down-leg.
On Monday, USD/JPY again showed some wild intraday swings. However, as the Japanese markets were closed one should be cautious to draw firm conclusions from yesterday’s price action. The pair was sold at the start of the US trading session, maybe due to the ongoing negative global economic sentiment, but remarkably, the pair gained ground later in US trading, despite a very weak US manufacturing ISM and a rather lackluster US stock market performance. So also for this pair, we didn’t see much of a strong economic logic to explain yesterday’s price action. Trading again was mostly inspired by technical factors. The pair closed the session at 99.12 compared to 98.46 on Friday.
Today, Japanese markets restart trading after yesterday’s holiday. The Nikkei showed quite an impressive gain (more than 6% at the moment of writing). However, even this positive news fails to give USD/JPY a strong boost. The pair even trades slightly lower compared to the close yesterday evening.
Later this week, the calendar in Japan is thin, but the minutes of the BOJ meeting will get quite some attention. In the US, the eco calendar is important (Payrolls) and should confirm the US is in recession. 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 on Friday two weeks ago. 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 unfounded, even if we admit that in a longer term perspective, the yen did very fine and was the world outperforming currency. Even on the recent stock market rally, the losses for the yen should be considered as rather contained (except for the spike on Tuesday last week). Short term, we are neutral for USD/JPY and the pair may consolidate in the wide 99.70/101.30 to 90.93 range with risk aversion/appetite the driver. In a day-today perspective, we have the impression that the upside becomes more difficult.
EUR/GBP traded extremely volatile over the last two weeks and this pattern hasn’t changed yesterday. The pair traded in the 0.7850 area at the start of European trading, but the sterling was again sold quite aggressively throughout the European trading session. The UK manufacturing PMI came out at a low 41.50, but the outcome was even slightly better (less worse) than expected. However, this didn’t prevent some market watchers to speculate on an aggressive BOE rate cut later this week and this weighs on the sterling. EUR/GBP closed the session at 0.7990, compared to 0.7921 on Friday. Overnight, the sterling lost further ground as EUR/GBP trades in the 0.8035 area at the moment of writing.
Today, the UK calendar contains the October PMI construction survey. However, this release is no market mover. Eco news is recently also less important in trading, that seems to be mostly order-driven, as the economic situation in the UK is maybe worse than in Euroland, but not so different. Regarding the rate decisions, in both countries a 50 basis points rate cut is expected, but some analysts are going in the UK for a bigger cut. We have no strong opinion on it. However, a steeper-thanexpected rate cut in the UK may have some impact on the sterling.
Already for some time, we advocated that we don’t see the need for a sustained comeback of the sterling against the euro based on the eco (and financial) picture in both areas. Our view came under pressure two weeks ago with EUR/GBP extensively testing the key 0.77 support area. However, the range held and the pair in extremely volatile trading even revisited the highs in the 0.8200. Longer-term we think that the established sideways trading pattern between 0.7700 and 0.81/82 can hold in the foreseeable future. In a day-to-day perspective, we put the risk for EUR/GBP on the upside due to lingering uncertainty on the amount of Thursday’s rate cut.
