Markets: Fixed Income
On Tuesday, global bonds had another strong session, especially in the US, where yields fell quite substantially at the longer end of the curve in a technical inspired move.
The drop in mortgage bond yields prompted investors to buy US Treasuries to increase the average maturity or duration of their portfolios. As such, there was a bull flattening of the US and European yield curve, despite the signs of a further improvement in global risk appetite. Indeed, equities extended their recent rally, commodities climbed sharply higher, the dollar and yen lost ground and credit spreads narrowed, which was also reflected in a narrowing of intra-EMU government bond spreads, which had been widening dramatically over the past weeks.
In a daily perspective, US yields fell between 6.4 bps in the 2-year sector and 19 bps in the 10-year sector compared to a rise of 0.8 bps in German 2-year yields and a decline of 2.7 bps in 10-year yields.
US Treasuries rally, despite a strong day for equities and commodities
Today, the eco calendar is interesting, as it contains the October ADP employment and the Non-manufacturing ISM reports, besides the Challenger job cuts. The latter is a not-seasonally adjusted series of lay-offs that shows no correlation with the payrolls (of the same month). The ADP report has lost much of its appeal as a pointer for the payrolls (that will be released on Friday) in the past twelve months. It has indeed consistently undercut the number of job losses by a large margin. However, as a number of activity reports showed a breakdown in October, the market will be interested to see whether a similar break is visible in the payrolls. Therefore, despite the recent weak correlation between the ADP employment and payrolls, the market may be more sensible than usual for the ADP report. For October, consensus expects a 100 000 decline, which would suggest a 200 000 drop in payrolls. The Nonmanufacturing index is expected to have declined to 47.2 from 50.2. There is a good correlation with the manufacturing ISM, making us side with the consensus by counting on a drop, that may however even be bigger than consensus expects.
Besides the data, the market will look to the Q4 refunding announcement and the Fed’s Schedule 2 TSLF auction. The Treasury quarterly re-funding announcement is important. Investors should tighten their seatbelts because there might be quite some surprises. The Q4 refunding package will probably reach a new high of maybe 53 billion $. Probably the Treasury will re-introduce the 3-year Note auctions, but besides the uncertainty of its seize (25 billion $?), there is uncertainty about the frequency of the auctions (quarterly?, monthly?). Also the frequency and the size of the 10- and 30-year Notes and Bonds are under revision. It isn’t excluded that the Treasury decides to auction 10-year’s on a monthly and 30-year’s on a quarterly basis. 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.
Regarding trading, Treasury yields fell again substantially yesterday, but now flattening the curve in a somewhat strange move. Indeed, rising equities and commodities, narrowing credit spreads and dropping dollar and yen clearly point to a return of risk appetite, maybe a result of an expected Obama victory. In such a context one would expect Treasuries to lose and not to gain ground. However, a more markettechnical factor may have played a role. An Obama victory might mean that a package to help stem foreclosures and the agencies is likely to be voted, and this might have pushed mortgage rates sharply down. Expectations for early pre-payment lead to shorter duration that is compensated by buying Treasuries. Interestingly, the 30- year Bond lagged the belly of the curve, which might have been due to expectations regarding the refunding package (see above). The underperformance of the 2-year might be explained by the technicals, as the 2-year yield was testing the recent lows, which it couldn’t break through, while longer maturities were not hindered by key technical levels. For today, the eco data should be Treasury-friendly, but the market has now got acquainted to bad news. The refunding announcement should be a hurdle, but we admit that Monday’s financing needs announcement was taken well into stride. The Obama victory is a wild card. At first hand, we should think that it increases chances of more fiscal stimulus and thus more supply of Treasuries. In this context, we prefer the shorter on the longer end of the curve, but see the room for gains on the short end rather limited, while the risk for the longer end comes from supply, but there are as of yet no negative signals from the technicals.
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, but rejected the upside when it approached key levels at 4.10. Also the 30-year yield turned south again when it faced the neckline of a bearish triple bottom at 4.47% (now 4.22%) on Monday/Tuesday.
ECB’s Stark hints at aggressive rate cuts
In the euro zone, the eco calendar heats up again today with the final reading of the services PMI and the September retail sales. Both are expected to confirm the bleak outlook for the European economy, but shouldn’t have a material impact on trading. Ahead of tomorrow’s ECB meeting, the FT Deutschland published today an interview with ECB’s chief economist Stark in which he sounds very downbeat about the economic outlook for the euro zone, as he expects only ‘very low growth well into 2009’ and the euro zone economy to recover ‘very slowly’. On the inflation front, he doesn’t exclude that inflation rates will fall into ‘negative territory’ due to the base effects related to the enormous oil price fluctuations, but sees no risk for ‘deflation in the sense of a downwards price spiral, which also effects the real economy’. Asked if further rate cuts would help in the current environment, Stark said: ‘It can help to signal that we are ready to use all instruments at our disposal and the central instrument is interest rate policy’. The interview was already conducted last week and shouldn’t therefore be seen as a last-minute hint that rates may fall more than the currently expected 50 bps. It nevertheless indicates that ECB is prepared to cut rates aggressively over the coming months.
On the supply front, Finland will tap its 4-year bond for an amount of EUR 1 B. Yesterday, the intra-EMU government bond spreads narrowed somewhat for the first time in weeks. This may be a first sign that the recent dramatic widening of the spreads is running out of steam and that the general improvement in risk appetite may also lead to some tightening in the government bond spreads.
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 contains the services PMI and the industrial production data. Overnight, the Nationwide consumer confidence unexpectedly rebounded, but the NTC/REC labour market report pointed to a rapid deterioration of the labour market. Ahead of tomorrow’s Bank of England rate decision, 2-year yields fell to new lows.
Currencies: EUR/USD stages powerful rebound.
On Tuesday, global markets were caught by a remarkable feeling of optimism and this also had a profound impact on the currency markets in general and on EUR/USD trading in particular. The positive tone was already visible during the European trading hours and continued in the US. There was not one specific factor to clearly explain this flaring up of investor optimism. The steeper than expected 75 basis points rate cut in Australia probably support market hopes that other major central bankers will also be forced to take decisive action to support the ailing economy, inspiring investors to adopt a less risk-averse attitude. The prospect that the uncertainty on the outcome of US elections would soon be resolved might have been another factor. Whatever the reason, the equities and the series of other riskier assets went materially higher and this also left its traces on EUR/USD. The single currency was traded below 1.2550 in Asia but started a breath-taking ascent that lasted till the end of the US trading session with the pair reaching an intraday high in the 1.3045 area. The performance of the single currency was even more remarkable as the EUR/USD cross rate recently failed to take full advantage of the gradually easing in global market tensions. So, one can suppose that profit-taking on dollar longs (EUR/USD shorts) was also an important factor behind this move. On top of that, similar moves were also seen in other risky/cyclical asset classes (cf commodities). The least one can say is that volatility remains very high. EUR/USD closed the session at 1.2981 compared to 1.2643 on Monday.
Overnight, the market focus turned to the outcome of the US elections. Barack Obama’s victory combined with a Democrat majority in Congress apparently spurred investor hope that it will become easier to conduct a coherent US policy to address the economic crisis. However, after the steep EUR/USD gains yesterday, some consolidation/ profit taking shouldn’t come as a surprise.
Today, the US presidential elections will continue dominating the headlines. Optimism on the Obana victory at first sight might be (moderately) positive for the dollar. However, looking at yesterday’s price action one shouldn’t exaggerate the support for US currency, as investor optimism in general often tends to support the euro more than the dollar. On top of that, we expect any impact from the election outcome on the currency markets to be relatively short-lived. The focus will soon turn to the eco data. Today the European services PMI’s, the US non-manufacturing ISM and the ADP employment report are on the agenda. In this respect we look out whether/how long recent market optimism will be able to resist high profile negative eco data.
Our standing view is 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. Last week, the EUR/USD rebound ran out of steam around the first key resistance level at 1.3259, previous low and also yesterday’s sharp move didn’t really challenge to upward boundary of the MT trading range.
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 1.3259/94 (previous reaction low/reaction high) in a sustainable way to get a first indication that EUR/USD sentiment is improving. Such a move still looks difficult for now. We were surprised by yesterday’s powerful rebound, but maintain our view that upside for EUR/USD should be rather limited medium term. So, we still favour sell-on-upticks approach in case of return action higher in the above mentioned trading range.
On Tuesday, USD/JPY was also supported by the improvement in global investor sentiment. The pair was traded in the 98.50 area early in Asian trading and moved gradually higher during the European and US trading session to set an intraday high around 100.50 around noon in the US. However, despite a constructive stock market sentiment, USD/JPY could not hold on to its gains and the pair closed the session at 99.70 compared to 99.12 on Monday. This should be considered as disappointing performance given the steep gains in other risky asset classes. The dollar losses against most other major currencies (euro, Aussie and a lot other currencies) probably weighed on the USD/JPY performance, too. EUR/JPY yesterday staged a decent rebound, but this pair was not yet able to regain last week’s high (131 area).
There were no market moving eco data in Japan this morning. After some temporary weakness early in the session, the Nikkei resumed its rebound with a gain of 4.50% at the moment of writing. However, this is again not enough to give USD/JPY a boost with pair still trading below the 100 mark at the moment writing.
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. 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 101.30 to 90.93 range with risk aversion/appetite the driver. In a day-to-day perspective, we have the impression that the upside becomes/ remains rather difficult, even if risk appetite improves on other markets.
Yesterday, EUR/GBP extended the forceful rebound that started at the end of last week. So, the improvement in global risk appetite was not able to support the sterling, at least not against the euro. The move was supported by global euro strength with EUR/USD staging a remarkable rebound. On top of that the UK construction PMI came out at an awful 35.10, indicating a sharp contraction in this part of the economy. This fuelled market speculation on an aggressive (more than 50 basis points) rate cut from the BOE tomorrow, hammering the sterling against the euro. EUR/GBP closed the session at 0.8134 compared to 0.7991 on Monday.
Today, the UK calendar is will filled with, among others, the industrial production and the Services PMI scheduled for release. More negative eco data will fuel speculation on aggressive BOE interest rate action tomorrow.
Already for some time, we advocate 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. The pair currently comes again closer to the top of this sideways trading range. It is not that evident to asses the market reaction in case of a steep (+ 50 bp) BOE rate cut tomorrow. However, such a move can be considered as the BOE taking decisive action to support the economy and, despite the sterling losing interest support, this shouldn’t be that negative for the sterling. The jury is still out and we take a close look at the technical picture, but at least for now we hold on to the view that a sustained break of the top of the sideways range won’t be that easy.
