Markets: Fixed Income
On Thursday, European bonds and UK Gilts benefited from the massive rate cut in the UK, where the Bank of England slashed interest rates by a stunning 150 bps to 3%. US Treasuries underperformed and it was only until US equities continued to slide into the closing that Treasuries were able to gain some ground.
Interest rates were cut all across Europe. Besides the Bank of England also the Czech Central Bank (75 bps), the ECB (50 bps), Swiss National Bank (50 bps) and the Danish central bank (50 bps) lowered interest rates. However, in the light of the higher than expected rate cuts in the UK and Czech Republic and the inter-meeting rate cut in Switzerland, the ECB rate cut by 50 bps disappointed. As such, European bonds and US Treasuries had to give back part of the Bank of England related gains. The decline didn’t however run that far, as a very weak performance of the equity markets offered some support.
In a daily perspective, it was again the belly of the European yield curve that outperformed with German 5-year yields falling 10.7 bps to new lows compared to 8.4 bps in 2-year yields and 6.3 bps in 10-year yields. In the US, the yield curve steepened, as 2-year yields fell 5.6 bps and broke below the recent lows compared to a decline of 1.4 bps in 10-year yields.
US Treasuries gain again very moderately
Today, the October payrolls will get all the attention of markets. The wholesale inventories, consumer credit and pending home sales will be largely ignored. Atlanta Fed governor Lockhart will speak on the economic outlook in Palm Beach. On October 20, he last spoke in public. He pointed that inflation was easing and growth would be weak. While not voting in this year’s FOMC, he seems to be behind the policy as it is designed and implemented by the FOMC. We don’t expect him to rock the boat with some controversial thesis.
Regarding the payrolls, evidence the US is sliding ever further into recession means that payrolls cuts should become more pronounced. Especially since mid September (Lehman demise) it seemed that the economy really hit a wall. Recent eco data whether from the manufacturing or from the non-manufacturing sector showed a freefall in confidence and similarly, consumer confidence dropped to a multi-decade low. The October car sales and the chain store sales showed households cut back their spending. In such a context we expect payrolls to be cut by well over 200 000 a month. The question is however whether this will already have happened in October. We guess it has, but otherwise it will be evident in the November figures. The ADP report on private payrolls showed a steep deterioration of conditions on the labour market in October (-157 000 jobs) and the continuing claims saw a consistent rise in recent weeks. Between the September and the October survey weeks, continuing claims edged up by 180 000 units. Initial claims were up 21 000. The October employment indices in both ISM surveys showed steep declines too. Given all these indications, we expect a big loss of jobs maybe more than the 200 000 expected. Of course, there is some obvious difficulties in having the timing correct. Therefore, should the payrolls come out better than expected, it will only postpone the day of reckoning and a big decline will be reported in November.
The Fed Commercial Paper statistics show that the Fed’s holdings rose by 98.9 billion $ to 244.6 billion $. Overall CP outstanding rose by 50.5 billion $ in the most recent week, following a 100 billion $ increase in the previous week. These back-toback gains follow a string of declines. The Fed’s new CPFF facility seems to support the market, but subtracting the Fed’s buying, there still seems to be some contraction. Outstanding Financial and asset backed CP expanded, while non-financial CP contracted.
Regarding trading, Treasury yields fell a few basis points more yesterday, the curve steepened. Once more, it isn’t very clear how to qualify these gains. The sell-off in equities, plunging commodities, weak eco data and eco news (IMF) might have merited more gains and lower yields. So, our concerns remain for the longer end of the curve, without being bearish. In a weekly perspective, the Dec Note future is still up more than 2 points, but all the gains were booked on Monday and Tuesday. It might be that the recent hesitation of Treasuries is only a temporary phenomenon in the run-up to the payrolls, but if the payrolls are better than expected there seem to be room for correction going into the week-end. In this context we stick to our strategy of favouring the short end (2-5-year) and remaining a bit skeptical on the long end, for which we prefer a buy on dips.
Re-iterating our view, for the longer end, the upside in yields was tested and rejected, but the charts show that the downside was tested too and rejected too. The 30-year yield (now at 4.17%) tested three times the lows at around 4% (all time lows) but couldn’t sustain and is establishing a 4-to-4.40% range. The chart of the 10-year yield (now 3.68%) shows that in mid-September the yield tested the 3.28% (mid March low) level, but couldn’t break it. Since two up-legs in yields were reversed, but always resulting in a higher low, the last one at 3.50%. So, also here a more sideways pattern is developing. In both cases, we would play the range and consider profit taking around the lows. The outlook for the shorter end of the curve is more bullish. The 2-year (1.27%) is testing the cycle (closing) low at 1.34% and a break (confirmation after payrolls needed) would open the way to levels closer to 1%, the all time lows reached in the mid of 2003 (deflation scare) when the Fed funds stood at 1% too. So we would keep long positions and add on up-ticks in yields. The 5-year yield (2.46%) is closing in on recent lows around 2.37%, which if broken would set the yield for a re-test of cycle lows at 2.16%. Also here the recent low was tested twice without success, but the third time might be the good one. The all-time 2003 low stands at 2%. So while we prefer the shorter end of the curve, the downside in yields isn’t huge either.
German 10-year yields testing key support levels
In the euro zone, the calendar is very thin and only contains the German industrial production data. Based on the sharp deterioration in the business sentiment surveys over the past months and yesterday’s drop in the factory orders, a sharp decline can be expected. This will raise further concerns about the outlook for the European economy, ahead of next week’s Q3 GDP data, which are expected to show the European economy contracting for the second consecutive quarter. As such, the question no longer is whether the European economy is in a recession, but how long and how deep the recession will be. Within this environment the ECB yesterday cut interest rates for the second time in less than a month by 50 bps.
At yesterday’s press conference, Trichet however didn’t want to give much guidance on the further outlook for policy rates. Instead, Trichet repeatedly referred to the ECB staff projections, which will be available at the next policy meeting in Brussels. Given the current rapid deterioration of the growth outlook and the sharp decline in commodity prices, we expect the projections to justify further rate cuts and expect the ECB to cut rates again by 50 bps in December, which is currently also discounted by the market. Further out, we still believe rates will drop much further and may even fall below the 2% level, as it will take much more time before the rate cuts will start to support the economy than in previous cycles given the persistent tensions in the money and credit markets. Today’s ECB October bank lending survey will provide some further indication on the tightening of credit conditions in the euro zone. During the press conference, Trichet already hinted at a further net tightening in lending to non-financial corporations, but less so to households.
On the supply front, Spain and France tapped the market yesterday. Decent demand at the auctions supported a further correction on the recent sharp widening of the intra-EMU government bond spreads.
Regarding trading, although the European bond market reacted a bit disappointed on the ‘modest’ ECB rate cut of 50 bps, the limited correction indicates that there is no incentive to go against the flow. As such, we still favour a buy on dips approach. From a technical point of view, rebounds towards 2.90% in 2-year yields, 3.20% in 5- year yields and 3.90% in 10-year yields offer good opportunities. Over the past two days, it was no longer the 2-year, but the 5-year sector that outperformed and broke decisively below the year lows. This also increases the pressure on the downside in 10-year yields, where a break below the 3.65% zone would paint a massive double top formation on the charts and bring the all-time lows at 3% in the picture. Although such a break would lead to a corrective flattening of the curve in the short term, we continue to prefer the short end and steepeners in a longer-term perspective.
In the UK, the Bank of England cut rates by a stunning 150 bps from 4.5% to 3%. In the statement, the Bank justified the move by pointing to the shift in the balance of risks between the downside growth risks and the upside inflation risks. While the first had deteriorated markedly due to global financial turmoil, the latter had decreased significantly. As a result, the MPC concluded there was a substantial risk of undershooting the target of 2% in the medium term, although the inflation rate peaked at 5.2% Y/Y in September. Next week, the inflation report will be published, but it’s unlikely that this dramatic cut in interest rates would be the last of the cycle.
Currencies: BOE and ECB rate cuts don’t change the picture on the currency markets, at least not for now.
On Wednesday, EUR/USD lost some ground throughout the session but after all trading developed in an orderly way, especially if one takes into account the developments in other markets and the ‘uncertainty’ surrounding the ECB interest rate decision. The ECB as widely expected cut its key interest rate by 50 basis points to 3.25 %. In theory this should have been more or less neutral for EUR/USD, but less than one hour after the spectacular 150 bps BoE rate cut, the market was a bit disappointed that the ECB didn’t do more and this temporary weighed on EUR/USD. In the press conference, ECB was not extremely dovish as he refused to give any concrete hints on additional policy steps. However, EUR/USD soon returned to pre-ECB levels in the 1.2850 area. Later in the US trading, EUR/USD drifted again lower, in line with global negative sentiment on other markets. However, as already mentioned yesterday, the negative impact from the decline in stocks (and oil) on EUR/USD was again less pronounced compared to what it was in the recent past. EUR/USD closed the session at 1.2715 compared to 1.2954 on Wednesday.
Today, the next high profile event kicks in with the US payrolls. We put the risk for the figure to come out on the weaker side of expectations. Whatever the outcome of the report, the market reaction will be interesting. In the recent past, EUR/USD often tended to react in a negative way to (global) negative economic news, even if it came from the US, mostly through the impact on stocks and oil. However, this week we saw some tentative signs that the dollar could also be hurt by high profile negative news from the US (cf. ISM non-manufacturing). In this respect, the market reaction to the payrolls will be an interesting test case.
Our standing view is that a prolonged period of sub par global growth and a deflationary environment is more supportive to the dollar than to the single currency and this theme was an important factor behind the decline of EUR/USD from 1.60 to below 1.24. We hold on to this EUR/USD negative bias longer term. However, over the previous days, the single currency showed somewhat more resilient, even at time times when the global market environment was not really euro supportive (oil, stock market decline). Yesterday’s ECB interest rate decision didn’t change to global picture for EUR/USD either. For now, we hold on to our view that the pair entered a sideways consolidation pattern within the boundaries of 1.231 and 1.3297. As indicated above, we are a bid puzzled on the potential market reaction to a negative payrolls report, but we wouldn’t be surprised if such an outcome would be slightly euro supportive.
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 technical 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. Recently, in line with our long-standing view, we favoured a sell-on-upticks approach in case of return action higher in the above mentioned trading range. From a technical point of view, there is no need to change tactics yet, but a break above the 1.33 area would be an indication that the EUR/USD rebound/correction could have some further to go (at least partial stop loss protection)
No big story from USD/JPY trading on Thursday. The pair roughly hovered in a 0.9750/0.9850 trading range and closed the session near the bottom of that range due to the poor stock market close in the US yesterday evening. A negative start on the Japanese stock markets this morning caused USD/JPY to test bids below 97, but at the moment of writing the pair trades again in the mid 97-area.
On the charts, global market stress hammered the pair through the key 103.50 range bottom early October and the pair set a new reaction low at 90.93 two weeks ago. An easing in global market tension sparked an USD/JPY rebound with the pair reaching a reaction high in the 100.55 area early this week. Recently, we were neutral on USD/JPY. However, the 100.55 reaction high apparently is a hard nut to crack short-term. With market nervousness still high and the global eco picture still awful, a sell-on-upticks approach for return action lower in the 101.55 to 90.93 range is still favoured.
Yesterday, all eyes were on the BOE and ECB interest rate decision. The word ‘historic’ is often used too easily but for yesterday’s BOE action it is justified. The BoE surprised friend and foe with an impressive 150 basis points rate cut, reducing its official interest rate to 3%. This even turned the interest rate differential with the eurozone negative. In a first reaction, the BoE action didn’t hurt the sterling. In the current context of extreme market fear for a protracted period of sub par economic growth, aggressive measures to address the crisis are considered a positive from a currency point of view. So, the sterling even gained ground immediately after the BOE decision with EUR/GBP spiking lower from the 0.8110 area to the 0.8010 area. However, the ‘victory’ for sterling was very short-lived. A negative global market environment (risk aversion) caused sterling to give back the post BoE gains in US trading. The pair closed the session at 0.8139, little changed from the 0.8146 close on Wednesday.
Today, the UK calendar is empty and global factors will set the tone for trading in EUR/GBP.
Already for some time, we advocate a range trading strategy for EUR/GBP within the barriers of the 0.77/0.82 range. Sterling trading within this range implies already quite a negative reassessment of the UK economic performance and structural weaknesses, especially as the situation in the Euro-zone area is growing ever more challenging, too. Nevertheless, the UK is a trade deficit country and its growth was highly depended on credit and domestic demand. In the current environment, these kinds of structural ‘imbalances’ make that sterling remains vulnerable over time. Yesterday, in a first reaction, the market (understandably) reacted sterling positive to the bold BoE approach. However, the question is how long this will last. Yesterday’s BoE action might provide some temporary relieve, but doesn’t change the broader picture, we think. On the contrary, the 150 basis point cut smells like panic and a negative interest rate differential with the euro is no support for sterling either. So, despite yesterday’s intraday sterling rebound, we even tend to become more sterling sceptic again. In a day-to-day perspective, we expect EUR/GBP to continue trading in the upper part of the standing trading range (0.8000/0.8200 area) and even put the risk for a retest of the highs. In case of a (sustained) break above the 0.8200 barrier, the risk for an additional stop-loss sterling selling wave has grown materially. So, stop-loss protection to cover such a break of the longstanding range is (highly) warranted. We avoid EUR/GBP short exposure.
