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Sunrise Market Commentary

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US Treasury curve steepens sharply

Tue, Jan 6 2009, 08:07 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Monday, the European and US yield curves steepened sharply, as supply concerns weighed on the longer end of the curve ahead of this week’s bond auctions and amid talk of more fiscal stimulus in the US and Germany. As such, investors reversed part of last year’s dramatic flattening, even as the Fed yesterday started its purchases of mortgage-backed securities.

On the bond markets, supply concerns moved to the forefront ahead of the 10-year TIPS auction today, a 3-year Note auction tomorrow and a 10-year Note auction Thursday in the US, while in Europe, Germany (Wednesday), France and Spain (Thursday) are planning to tap the market this week. At the same time, both the US and Germany are moving closer to new fiscal stimulus packages, which could be as large as $775B in the US and €50B in Germany. For Germany, this would be more than double the amount expected only a week ago.

The short end of the curve outperformed the longer end, as the supply issue has more impact on longer-date bonds and favourable inflation data in Europe increased hopes that the ECB will still cut rates in January. In the US, 2-year yields declined 5.5 bps compared to a rise of 11.3 bps in 10-year yields and even 23.4 bps in 30-year yields. In the euro zone, German 2-year yields fell 4 bps compared to a rise of 5.6 bps and 6.2 bps in 10- and 30-year yields. German government bonds also underperformed their European peers, possibly on concerns about the additional supply the new fiscal package may cause.

US Treasury curve steepens sharply

The eco calendar is well-filled today with the non-manufacturing ISM (December), November factory orders and pending home sales. Later today, the Minutes of the FOMC meeting of December 15 and 16 will be released. The non-manufacturing ISM took a sharp plunge in November (37.3. from 44.4) due to extreme drops in business activity, new export orders and imports. For December, the consensus expects an outcome of 37.0, but a lower figure is not excluded after the extremely weak manufacturing ISM report released last week. Factory orders are forecasted to have dropped 2.3% M/M in November, after falling aggressively (-5.1% M/M) in October. The risks might be on the upside of expectations after the durable goods orders fell 1.0% M/M in November while the consensus expected a decline of -3.0% M/M. Pending home sales came out better than expected in October, falling 0.7% M/M. For November, the consensus is looking for a decline of 1.0% M/M. Regarding the the Minutes of the December 15-16 historic FOMC meeting, at which the Fed laid down the foundations of its quantitative easing policy. It will be interesting to see whether more details about the policy will be unveiled, as the FOMC statement, released after the meeting was already unusually long and straightforward.

The Treasury will hold an 8 billion $ TIPS auction that will settle on Thursday January 15. The auction raises all new cash. The issue will be re-opened in April. TIPS auctions typically attract quite good demand from the buy-side, on average 28% of total bids for a 42.4% takedown. TIPS auctions have, as a rule, no big impact on the overall market though.

The NY Fed began buying Agency MBS paper yesterday, but the details of the purchases will be released on Thursday. Nevertheless, there was some further narrowing in the spread between Agency MBS and Treasury securities recorded. It is the explicit wish of the Fed to narrow the spread that had become very wide before the program was announced in November 2008. Since, the spread has narrowed. It should be a direct support for the battered housing and mortgage markets.

There was market talk about Obama administration reviving the TARP, by buying distressed products to support the Fed’s efforts of narrowing credit spreads by buying Agency MBS. This was originally the objective of TARP, but it was dropped as the amounts needed to have an impact on the toxic products on the bank’s balance sheets exceeded by far the 700 billion $ allocated to TARP. Therefore, it looks unlikely the Obama administration will use the remainder of the 700 billion $ for purchases of these toxic products.

Regarding trading, curve re-positioning was the main driver behind yesterday’s price action. Investors took profit on the dramatic curve flattening that occurred in November and got an extra boost in December, both ahead and after the announcement of the FOMC on quantitative easing. From a high of 261 basis points on November 13, the 2-to-10-year spread dwindled to 124 basis points on December 26. Since, the spread widened again. We referred yesterday already to supply concerns that seem to have moved up on the list of investors’ concerns at the start of 2009. In Barron’s, an article suggested that the bubble in Treasuries looks ready to pop. In the context of a previous dramatic flattening, such supply concerns are a good pretext to take some chips off the table. Also the technical picture of the longer term maturities showed some cracks, reported on in our previous Sunrise, inciting technical oriented investors and traders to join the selling. Also from yesterday, we retain that the price action was very volatile with the March Note contract dropping one full point in European trade, rising again by a similar amount in early US trading, only to hit the skids again later on to test again nearly the intra-day lows. There was some correlation with equities in the US session, while one intra-day decline occurred at 16.00, when construction spending exceeded expectations. Normally it isn’t a market mover and the incidence of the down-move might have simply been a mere coincidence and not a causal relationship. Nevertheless, the absence of a reaction following the weak ISM last Friday suggests that investors might have become more open to positive news. Will this become a feature for trading further out? The upcoming payrolls reports may give us some clues. At this juncture we still see the recent losses of (longer-term) Treasuries as corrective in nature. For the 10-year T-yield, 2.50% (near current level) and 2.80% offer first entry possibilities. The March Note future (CTD is May 2016) is currently testing the broken uptrend channel (123-22+), but investors may wait to consider new long positions for a re-test of 123-02/122-21+ (targets double top).

Germany prepares much bigger than expected fiscal stimulus package

Today, the EMU calendar contains the final figure of December Services PMI and the first CPI estimate (December). In November, CPI inflation dropped 0.5% M/M, while the yearly figure came out at 2.1% Y/Y (from 3.2% Y/Y). In December, inflation is expected to fall below the ECB target of 2.0% Y/Y as the consensus is looking for a figure of 1.8% Y/Y. We see the risks on the downside of expectations after the regional data released earlier came out lower than forecasted. Spanish CPI showed the sharpest drop (from 2.4% Y/Y to 1.5% Y/Y), but also Italian (2.3% Y/Y from 2.7% Y/Y) and Belgian (2.63% Y/Y from 3.14% Y/Y) inflation declined noticeable. The final figure of services PMI is expected to confirm the first estimate of 42.0, but a lower outcome should not surprise after the downward revision in the manufacturing PMI.

The rapid deterioration of the economy along with the drop in inflation might raise fears for deflation in the euro zone. In an effort to ensure investors that the ECB won’t let this happen, ECB’s Constancio yesterday echoed comments of ECB’s vice-president Papademos, when he said that ‘price stability goes both ways’ and the ECB doesn’t want ‘to risk inflation going too far into negative territory’. Constancio added that in such circumstances ‘we can be certain that European monetary policy will respond with interest rate reductions. Since the December rate cut, ECB policymakers have refrained from giving clear guidance on the near-term outlook for ECB interest rates. Some governors even showed some reluctance to cut rates much further given the longer-term implications for price stability. Currently, markets have discounted a 25/50 bps rate cut.

Yesterday, Volker Kauder, leader of the CDU’s parliamentary group, indicated that the Merkelgovernment is considering a second fiscal stimulus package of €50B over 2009 and 2010. This is nearly the double of the amount expected and comes atop of the first fiscal package of €32B. The package would include a combination of infrastructure spending, modest tax cuts, job supporting measures and help for business and should be concluded by next Monday at the latest. The two packages would bring the fiscal boost to about 1.5% of GDP, but would still allow Germany to adhere to the budget rules of the Stability and Growth Pact. Nevertheless, the significant increase in the fiscal stimulus implies a dramatic shift in stance, as the German government has been until recently very reluctant to increase public spending to boost economic growth.

On the money market, the thawing of monetary conditions continued over the year end, as the liquidity spread narrowed and the number of banks participating at the ECB weekly tenders decreased. This may indicate that banks have found other funding sources or are less in search of liquidity, as the amount allotted in the weekly tender yesterday was the second lowest since the ECB started with its fixed rate tender procedure. Conditions however haven’t normalized yet, as the liquidity spread is still way too high and the amount deposited at the ECB remains very high (€281B). Today, the ECB will announce the details for its 3- and 6 months supplementary refinancing operations. These will also be carried out at a fixed rate and under full allotment. In order to improve the normal functioning of the money market, the ECB has announced at the end of December that it will restore the corridor of the standing facility rates from 100 to 200 bps from the 21st of January onwards.

Regarding trading, the European yield curve steepened sharply yesterday, as the longer end of the curve underperformed the short end on supply concerns ahead of this week’s auctions and the possibly much bigger stimulus package in Germany. The latter also resulted in an underperformance of German government bonds compared to their European peers. Looking forward, we still have a bullish view on the European bond market, but first look for more upward correction in longer-term yields before going long again. In the Bund, a break below 123.76 would confirm our bias for more correction, while a break above the contract high at 125.56 would reinforce the bullish environment. Currently, we consider a fall towards the December lows at 121.32 as good entry points to go long bonds again.

In the UK, the calendar contains the December services PMI and official reserves. Services PMI is forecasted to come out at 39.0 (from 40.1), but a slightly higher figure is not excluded after the unexpected rise in manufacturing PMI.

Currencies: euro cedes ground

The dollar started the new trading week at a strong footing. We didn’t see much eco news to justify a strong dollar rebound. Nevertheless, order driving trading early in Europe hammered EUR/USD and the pair swiftly dropped from levels above 1.39 in Asia to the 1.3650 after the first hour of European trading. The dollar tried to build out its gains as soon as US traders joined the action, but the rally stalled and EUR/USD returned to the 1.36 mark during the remainder of US trading and closed the session at 1.3635 compared to a 1.3921 close on Friday. Investors anticipating on the potential positive effects of additional stimulus measures to be announced by presidentelect Obama and speculation that the ECB might cut rates already at next week’s meeting were often cited as the reasons behind yesterday’s EUR/USD decline. However, for now we’re not overly impressed by those arguments especially as the largest part of the move occurred in one big move at start of the session, probably in thin liquidity conditions.

Today, the US eco calendar contains the ISM non-manufacturing. In Europe markets look out for the Euro-zone CPI flash estimate. On Friday, markets largely ignored a very poor US manufacturing ISM. The Europe CPI is an important input for next week’s ECB interest rate decision. The ECB still didn’t give a clear sign whether it will cut rates again next week. Markets growing more confident on a scenario of a January rate cut might be (slightly) negative for the euro short-term.

We don’t have a clear take on what will be the next theme to guide trading on the currency markets in general and for EUR/USD in particular. Compared to the end of last year, sentiment apparently tends to become somewhat more USD constructive. The fear in the market that the Fed’s quantitative easing would derail the dollar has eased and investors apparently tend to become a bit more confident on the US measures (already announced and expected) to kick-start the US economy. In Europe, there is still a lot of uncertainty on the path that the ECB will walk in the months to come. How much and when will the ECB cut rates? The combination of those two factors gives the dollar the advantage of the doubt over the euro at the start of 2009.

Two other remarkable factors: the link between oil and EUR/USD apparently has been broken, at least short-term and (cautious) investor optimism on the economy at this stage tends to support the dollar more than the euro. However, we’re not really convinced that this assessment will stay in place for a prolonged period of time.

Since mid November we had a USD negative approach. At the start of 2009 we turned more neutral on EUR/USD. The US payrolls and the market reaction to this report will be a first pointer on market thinking/behaviour. It’s probably a bit too early to front-run on a sustained economic rebound. As we are cautious on a quick improvement of the (global) eco data, we don’t preposition on a sustained comeback of dollar at this stage, even if the day-to day momentum is dollar positive. The ECB assessment on monetary policy (to cut or not to cut in January) will be another factor of importance. However, this is more a debate on the time of next rate cut rather than on the long-term (cautious) approach of the ECB. As a risk factor, we also keep an eye on the auctions of European government bonds that will be brought to the market over the next few weeks. If some governments with a less strong credit profile would have to pay ‘excessive’ spreads, this could be a negative factor for the single currency. At this stage we don’t have any strong indications that this will be the case, but we stay alert on this theme.

From a technical point of view, EUR/USD in December broke above the previous sideways trading pattern and an important downtrend line (cf. graph). This has made the LT picture for EUR/USD positive. However, the rebound lost momentum in the second half of December. Yesterday, EUR/USD dropped below a ST-term support area (1.3840/22 area) and this suggests that the EUR/USD correction might have some further to go. The top of the previous sideways trading range (1.3300 area) now is the next level to look out for on the charts.

Yesterday, the overall USD-constructive sentiment also supported the dollar against the yen. However, as was the case in EUR/USD, the dollar spiked higher early in European trading, but the move lost momentum later especially as US stocks failed to build out the gains from the end of last week. Nevertheless, USD/JPY closed the session with a decent gain (93.44 compared to 91.83 on Friday).

This morning, Asian/Japanese stock markets are mixed to cautiously higher. There were no important eco data on calendar in Japan.

Looking at the charts, global market stress and overall dollar weakness in the wake of the US Fed’s announcement on quantitative monetary easing hammered USD/JPY and the pair set a reaction low in the 87.20 area on December 17. Since then, the pair entered calmer waters, settling in a sideways trading pattern close to the 90 mark and tried to move higher during the first two trading days of 2009. Before the holiday break, we had USD/JPY negative bias. In a short-term perspective, the picture for USD/JPY turned more neutral again. If stocks remain positively oriented, the rebound in USD/JPY can go still somewhat further short-term. The 93.91 level (Dec 08 high) is a first resistance level on the technical charts. The long-term trend in the pair remains negative and we still look to sell USD/JPY in case of a more pronounced rebound. A sustained rise above the 96 area (23 % retracement MT) would question our standing yen positive bias.

Until yesterday, sterling failed to take any big advantage from the easing of global tensions seen in some other markets. However, this pattern changed yesterday. The global correction in the single currency this time also triggered a significant correction in EUR/GBP. The pair started trading in the 0.9550 area but lost ground throughout the whole trading session and closed the day at 0.9274 (compared to 95.69 on Friday). A very poor UK PMI from the construction sector had no impact on sterling trading.

Overnight, Nationwide consumer confidence dropped further to -47 from -51, the worst level on record since the survey began in 2004. The Nationwide house prices fro December came also out below the market consensus. Prices declined 2.5% M/M and 15.9 % Y/Y. Later today, the PMI for the services sector is scheduled for release.

On the technical charts, the break above a series of high profile resistance levels in November/December has made the long term technical picture outright positive for EUR/GBP. Yesterday’s correction was remarkable but in our view didn’t change the long-term sterling negative picture yet. We maintain our view that a negative interest rate differential vis-à-vis the euro, combined with ongoing negative eco news contains the risk for sterling to come under pressure again. We are well aware that a lot of negative news is already priced in for sterling at the current levels. However, as long as we don’t receive a sign that the weakness of sterling gets more weight in the BoE’s monetary policy assessment and/or unless we get a clear sign on the technical charts, we hold on to our sterling skeptic attitude and see the current move as an correction on the steep sterling losses last month. Long term, we still look to buy EUR/GBP on dips but we’re not in a hurry and wait to see how far the current correction has to go. From technical point of view, a drop below the 0.90 area (0.9049 is LT break-up; 0.9000 is LTMA) would indicated that the correction gains momentum. A sustained return below the previous high (0.8663) would question our long-standing sterling negative attitude.

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Published on  Tue, Jan 6 2009, 08:20 GMT