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Sunrise Market Commentary

US Treasuries fall after dismal, weaker−than−expected payrolls report

Mon, Feb 9 2009, 08:15 GMT
by KBC Market Research Desk

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Markets: Fixed Income

On Friday, global bonds ended the session again with losses, the belly of the curve underperforming the wings, as a dismal US payrolls report failed to give bonds any support. In the US Treasury yields rose by 3 to 8 basis points, while in EMU (Germany) the wings still showed a small decline in yields but the belly of the curve added 2-to-3 basis points.

The US December payrolls report was doubtless weaker than the already bleak consensus estimate. Indeed, payrolls fell by 598 000 unit and the results of the previous two months were revised lower to also near 600 000 jobs losses each. The unemployment rate surged to 7.6% from 7.2%, also exceeding expectations. However, on the release there was no noticeable bid and so selling took over driving Treasuries (and Bunds) lower. Treasuries could never really fight back and closed the session near the lows. Why such an apparent strange reaction? Sentiment in the Treasury market was already bearish for some time due to supply concerns and these concerns continued to play in the background. However, it was only part of the story. We suggested already for some days that investors were again looking to take more risk on board. The Obama stimulus package, to be voted this week, and hopes for a big banking plan, to be outlined this week, seem to have convinced investors that it may turn the economy around further down the road. So, equities surged higher, with the financials and the cyclical IT and consumer discretionary sectors leading the overall market, while the defensives like utilities and health care sectors lagged. The combination of rising risk appetite and the upcoming heavy supply calendar explain the fate of Treasuries last week.

In the EMU bond market, the situation is somewhat better, as ECB rate cut expectations are still riding high, partly mitigating supply concerns and abating risk aversion. This protects the shorter end, where yields still fell 14 and 8 basis points (2- and 5- year), and limits the damage further out where yields rose by 7.5 and 4.5 basis points (10- and 30-year) in a weekly perspective.

US Treasuries fall after dismal, weaker-than-expected payrolls report

Previewing this week’s trading, attention will be focussed on the re-funding operation and political Washington, where the stimulus package will probably be approved in the Senate on Monday and the Treasury Secretary will unveil his banking plan, according to the latest news on Tuesday. The economic calendar is thin with only the January retail sales on Thursday a potential key driver.

The retail sales have fallen for an uninterrupted 6 months with especially the last three months showing steep monthly declines of -3.4%, -2.1% and -2.7% respectively. The retrenchment of consumption is exceptional and driven by too high household debt load and the need to deleverage in the context of a very fast rise in unemployment, slowing income and restraint credit availability. The market expects another, albeit more moderate (0.7% M/M), decline in January. Most categories of spending will indeed decline further, but a price-related rebound in sales at gasoline stations and higher grocery store sales (they fell very sharply in December) put the risk at the upside of consensus though.

The $67B record size refunding operation consist of a $32B 3-year Note auction on Tuesday, a $21B 10-year Note auction on Wednesday and a $14B 30-year Bond auction on Thursday. The auctions settle on February 17 and will raise about $30B in new cash, as a $15.6B 5-year and a $20.7B 3-year Note mature. The Treasury will payout for about $29B in coupon payments, leaving the cash flows surrounding the operation slightly negative. While this shortage of about $1B seems small, one should compare it with re-funding operations in past years when the cash flows were highly generous, helping the auctions to go smoothly. The re-introduction of the 3-year Note auction and the upped size of the 10- and 30-year auction explain the negative evolution of the cash flows. Investors will also keep in mind that later this month 2-, 5- and now also a 7-year T-Note auction will be conducted for a combined amount of probably $95B. Investors have been spooked in recent weeks and months by the ever growing financial requirements of the Treasury. While the consequences of the $820B stimulus package that is pending in Congress for supply are probably already discounted, the ultimate cost of the banking plan that will be unveiled this week and certainly top the $350B still available from the TARP plan, might still frighten traditional investors in Treasuries. Other factors besides the financing needs that affect investor’s behaviour are the contraction of the economy (positive), the risk appetite/ risk aversion couple (currently less positive than before), the Fed’s efforts to unfreeze credit markets (negative) and the potential purchases of longer-dated Treasuries by the Fed (positive). We aren’t sure how all these factors ultimately will affect the auctions. It should be clear though that there are risks surrounding the auctions, but we shouldn’t forget that the market has cheapened already quite a lot in recent weeks. So a buy-the-rumour, sell the fact result isn’t excluded, while the Fed may also decide to enter the fray and start buying Treasuries, should the situation spirals out of control.

Tomorrow, Treasury Secretary Geithner will outline the contours of the revamped financial rescue plan. There is still $350B available from the TARP plan, but the administration will probably need a far bigger amount to clean up the financial sector and help the mortgage and other markets. In recent days, the financial press has speculated on the content of the plan that underwent quite some modifications during the deliberations inside the administration recently. There are several venues possible, but it is far from certain how the final version will look alike. The government might purchase toxic assets from the banks (so-called bad or aggregator bank idea), but it seems that increasingly the administration is looking instead to give guarantees on the losses of portfolios of assets in exchange of a fee, as it has done in the case of the Citigroup and BoA bailouts. The advantage is that the upfront cost is minor and asking some fees for these guarantees may make more aid for banks political easier to digest. Congress is indeed highly sceptical and is reticent about throwing more money to the banking sector after the Bush administration redirected the money of the TARP plan away from its original purpose, which was buying toxic assets. At the end of last week, the chairman of the TARP Congressional oversight panel said that the government injected $245B in equity into banks and received in exchange $176B in bank assets, suggesting the government overpaid $78B for its interventions. Some form of capital injections are also likely to be in the plan. Geithner said on Friday that banks will be obliged to modify loans to get aid, but the plan will probably include more help for the troubled mortgage market and homeowners. The administration is also contemplating to support the TALF program of the Fed with more money, allowing the Fed an expansion of its program that should help revive consumer credit, small businesses and student loan markets.

Regarding trading, last week, Treasury yields rose again while the curve steepened. As said in the general bond part of the Sunrise, supply concerns and reviving risk appetite drove the market, while eco data didn’t get too much attention. The technical picture already changed for the worst and continued to affect investors’ behaviour. Swap spreads and Agency spreads versus Treasuries were mixed, corporate spreads narrowed again a few basis points. Corporate supply remained very high at more than $25B with names as Novartis, Altria, Caterpillar, Procter & Gamble, BoA and KfW amongst other in the market.

The technical pictures of the 5-, 10 and 30-year yields are bearish as they are all reined by double bottoms or said differently, the downtrend in yields has been violated. The 5-year yield currently at 1.92% is well above the neckline double top at 1.80% and targets at 2.30/42%. The 10-year yield, currently at 2.96, has a neckline at 2.60% and targets at 3.07/17%, while the 30-year yield, currently at 3.68% has a major resistance at 3.86%. The targets of the 10- and 30-year are not too far away and are worth a buy, as it would surprise us if the Fed would allow longer-dated yields to spiral out of control, jeopardizing its efforts to bring private credit market rates down. The 2-year yield, currently at 0.95% has also risen about 35 basis points from the lows, but as the Fed will keep rates probably low for (much) longer, risks for a further increase of the yields are much smaller.

For the week to come, the refunding operation and the political trepidations surrounding the stimulus and banking plans will dominate the price action via its impact on risk appetite and supply. These events are risks for the Treasury market, but one shouldn’t forget the extent of the sell-off that took already place since the start of the year and the oversold character of the market. While we don’t like to go against the technicals that turned negative, we would consider a buy-on dips (in price) when the above mentioned yield levels are reached.

ECB’s Bini Smaghi repeats his warning against zero interest rates

This week’s eco calendar in the euro zone looks very thin and will only heat up towards the end of the week, when the euro zone industrial production and GDP figures will be released. These are widely expected to paint a very dismal picture of the European economy and therefore shouldn’t have much market impact anymore. Indeed, last Thursday, the ECB already stated in the introductory statement that it expected ‘very negative quarter-on-quarter real GDP growth in the last quarter of 2008’ and sounded downbeat on the growth outlook which it sees ‘undergoing an extended period of significant economic downturn’. These statements fuelled ECB rate cut expectations and markets now expect the ECB to cut rates again by 50 basis points in March to 1.5%, although Trichet didn’t want to confirm the size. German 2- year yields benefited from the dovish comments too and fell again towards the cycle lows at around 1.35%, as markets believe 1.5% won’t be the bottom for ECB rates. During the weekend, an influential member of the ECB executive board, Bini Smaghi, once again warned that ‘interest rates close to zero in the absence of deflationary pressures are counterproductive and create distortions’ and added that ‘it’s more useful that rates go to a level where it is credible that they can remain for a long period of time, so that those who buy long term bonds do not fear a capital loss due to an unexpected increase in rates’.

Despite the bullish sentiment at the short end of the curve, the technical picture at the longer end deteriorated over the past two weeks, as the Bund fell below the neckline of a double top formation at 122.54. Since the mid-January lows at 2.85%, German 10-year yields have risen by more than 50 basis points to 3.37% on Friday. Concerns about supply and a general improvement in risk appetite were the main drivers behind the up-move. This was confirmed on Friday, when bonds declined and equities gained despite another dismal US Payrolls report (see intro above). Friday’s market reaction suggests that the current downward correction on the bond markets may have further way to go. A break below the December lows in the Bund at 121.33 would lend support to this view. However, as long as the ECB isn’t finished in cutting interest rates and the threat of a quantitative easing policy hangs above the market, we don’t feel inclined to install short positions.

The divergence between the short and longer end of the curve has resulted in a further steepening of the European yield curve with the spread between German 2- and 10-year yields widening to its highest level ever since the start of the EMU in 1999. Given current elevated levels, we would consider profit-taking on recent steepeners, as German 2-year yields may fail to break below the cycle lows at 1.35% and correct somewhat upwards too.

On the supply front, the Netherlands (new 10-year), Austria, Germany (10-year) and Italy (5- and 15-year) are all planning to tap the market this week. Over the past two weeks, the intra-EMU spreads have been narrowing albeit from very elevated levels, as general sentiment and liquidity conditions improved. Besides the auctions, much attention will also go out to the Fortis shareholders’ meeting on Wednesday, which if the shareholders vote against the sale of the Belgian banking operations to BNP Paribas may lead to an underperformance of Belgian government bonds, as the Belgian government may then have to reassure Fortis’ obligations.

In the UK, the calendar is empty today.

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Published on  Mon, Feb 9 2009, 11:24 GMT

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