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Sunrise Market Commentary

US Treasuries lose early gains on late session equity rebound

Fri, Feb 13 2009, 08:01 GMT
by KBC Market Research Desk

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Markets: Fixed Income

On Thursday, global bonds extended their recent gains, but fell off the highs in the US late in the session, as US equities rebounded strongly. Earlier in the session, bonds shrugged off the better than expected US retail sales, while the 30-year Note auction only temporary weighed on the US bond markets. In the euro zone, the dire industrial production figures for December weren’t a major surprise, but nevertheless contributed to the bullish sentiment on the European bond market ahead of today’s Q4 GDP figures. ECB speakers continued to speak very dovish and seem to keep the road open for more non-standardized operations, elsewhere often called …..quantitative easing.....In contrast to the previous days, the US yield curve steepened, as longer-term yields rebounded with 10- and 30-year yields up respectively 3.6 and 7.5 basis points, while short-term yields were largely unchanged. In the euro zone, the bull flattening of the European yield curve continued, although German 2-year yields declined 5.7 basis points and fell to new cycle lows at 1.29%. 5- and 10-year however declined by respectively 8.4 and 10.6 basis points and 30-year yields fell 8.1 basis points.

US Treasuries lose early gains on late session equity rebound

Today, the calendar is thin as it only contains the first figure of University of Michigan consumer confidence (February). In December, Michigan consumer confidence showed its first signs of a recovery (55.3 to 60.1) and this was confirmed by another, albeit modest, improvement in January (61.2). Nevertheless, for February, the consensus is looking for a slight decline (60.2). The ABC consumer comfort index hovers near the all-time lows, little changed from previous levels, while the IBD/TIPP economic optimism index slid slightly in February to 44.6 from 45.4 in January. These reports don’t allow us to distance ourselves from the consensus forecast. The steep rise in unemployment could weigh on the morale of households, while uncertainty surrounding the stimulus package shouldn’t be of any help either. The bond market will close early today in observance of President’s Day that will keep the market closed on Monday.

The House and Senate will today vote on the $789B stimulus bill that is composed of $507B in spending and $282B tax cuts. The bill is expected to pass and to be signed by president Obama at the latest on Monday.

Outstanding CP dropped $31.5B in the most recent week, following a modest $4.4B decline in the previous week, the largest decline occurred in financial CP. Since mid- December the trend is again for a decline in outstanding CP, with a total decline in this period of $155B. The decline is disappointing as it exceeds the $14B that was maturing in the Fed’s CPFF, suggesting that the private sector is retrenching. One possible reason is the robust corporate supply since the start of the year that might replace some CP issuance. On the other hand, the data might also indicate that the market still needs the Fed’s support via the CPFF.

The $14B 30-year bond didn’t go as well as the 3- and 10-year Note auctions earlier this week, but certainly wasn’t a disaster either. The bidding was sloppy as the auction stopped at 3.54%, full 5 basis points above the WI bid side at the moment of the stop. Demand wasn’t really bad, even as the bid/cover of 2.02 was below the average of 2.18. Indeed, one should take into account the record size of the issue. The buyside participation was encouraging. The Indirect bid share (19.5% versus 17.5%) was above average and so was the takedown (33.9% versus 27.9%), while there was a surprisingly high direct bid of $2.6B (takedown of $2.3B).

Regarding trading, yesterday risk aversion dominated trading allowing the market to digest well stronger-than-expected retail sales, but a late-selling rebound in equities erased early gains. The long end of the curve underperformed as the Treasury issued a 30-year bond. The late-session surge in equities and concomitant drop in bonds was seen as driven by news reports that the Obama administration is hammering out a program to subsidize mortgages. The program would help homeowners before they fall into arrears on their loans. The trigger level of part of the income that is spent on their mortgage that decides who would be eligible for relief would be lowered from the current 38%. We admit that resolving the problems on the mortgage market is crucial condition to turn the economy around, but are a bit sceptical that it was a good recent to send equities higher. The principle was already announced by Geithner earlier on. We suspect that the equity rebound was mostly short covering as the bottom of the equity indices (S&P/Dow) was extensively tested. Whether this message about the mortgage market is enough to sustainably bring risk appetite back remains to be seen. However, given the performance of Asian equities overnight and the President’s holiday Day on Monday, return of risk appetite might be the trading theme of the day. Even as yesterday’s reaction on the retail sales was only very temporarily, an upward surprise of the Michigan consumer sentiment might be harder to overcome for Treasuries.

So in a daily perspective, Treasuries might lose some modest height ahead of the long weekend, also as Treasuries eked out juicy gains this week, which may seduce some traders to book profits.

European bonds surge higher, as ECB considers more unconventional easing

Today, all eyes will be on the euro zone fourth quarter GDP figures. In the third quarter of 2008, the euro zone economy slid into a technical recession. Both in the second and third quarter of last year, economic activity contracted by 0.2% Q/Q and all evidence points to a sharper contraction in the fourth quarter. In its press conference, ECB President Trichet warned for “very negative quarter on quarter growth in the last quarter of 2008” and the European Commission expects a decline of 1.5% Q/Q. The consensus is looking for a figure of -1.3% Q/Q, which is in line with the Belgian GDP figures. Nevertheless, Spanish Q4 GDP came out slightly higher than expected, while this morning, German GDP surprised on the downside. In the fourth quarter of 2008, the German economy contracted by 2.1% Q/Q, while a narrowing of 1.8% Q/Q was expected. This outcome raises fears that also euro zone GDP will show a shaper contraction than previously thought. We would not be surprised to see a figure of -1.5% Q/Q.

The awful Q4 GDP growth data do also imply that the December ECB staff projections for growth and inflation will be sharply revised down in March. The new Survey of Professional Forecasters, published in yesterday’s ECB monthly bulletin, point to a contraction of 1.7% Y/Y this year and forecast the euro zone economy to grow by only 0.6% Y/Y next year. This compares to the December ECB mid-point staff projections of -0.5% Y/Y and 1% Y/Y. The much weaker than expected economic activity is also reflected in the inflation forecasts. The new SPF participants’ inflation expectations have been downwardly revised to 0.9% Y/Y this year and 1.6% Y/Y next year. This compares to the ECB December mid-point staff projections of 1.4% Y/Y and 1.8% and indicates that inflation is expected to remain below the 2% level over the next two years. This should set the stage for another rate cut at the March meeting, as several ECB governing council members have indicated over the past days that the ECB has room to cut rates to below 2%, if the new staff projections would point to a further diminishing of the inflation risks. As a result, German 2-year yields extended their recent decline and even fell below the cycle lows at 1.35% yesterday. The short end however underperformed the longer end, as the room at the short end has obviously become more limited now that rates are approaching the zero level. In this context, it’s worth mentioning that due to the ECB’s unconventional measures (unlimited amounts at a fixed rate on the tenders) the overnight interbank rates have effectively already fallen to 1.1%, way below the official policy rate of 2%. Hence, the ECB’s monetary policy is in practice already much more accommodative than the official rate would suggest. Yesterday, several ECB policymakers indicated that more unconventional measures may be needed, but called for cautiousness as many uncertainties remain.

As long as the ECB isn’t finished cutting interest rates and the threat of quantitative easing hangs above the European bond market, a sustainable up-trend in long-term yields looks very difficult. This week’s sharp decline in yields was significant from a technical point of view, as German 10-year year yields fell again below the neckline of a double bottom formation at 3.24% and the Bund confirmed Tuesday’s rebound above the neckline of a double top formation at 122.54. This raises the odds for a re-test of the cycle lows at around the 2.9-3% level in 10-year yields. Nevertheless, following the steep declines in yields over the past two days, some correction is likely today. The gains in the Asian equity markets this morning support this view.

On the supply front, Italy will tap four of its BTP’s in the 4-, 12-, 14- and 20-year sector for a total amount of between €5.5-8B. Over the past days, in accordance with the general increase of risk aversion, the intra-EMU spreads have been widening again. Although the spreads are still some distance away from the recent highs, the CDS on Belgium for instance set a new high yesterday following the rejection of the sale of the Belgian Fortis banking activities to BNP Paribas by the Fortis shareholders on Wednesday. The vote increases the risk that the Belgian government will have to assure the funding and liabilities of Fortis Bank Belgium to protect the savers, which would put a heavy burden on the public finances and lead to a further widening of the spreads. The CDS on Ireland spiked higher too yesterday following a scandal in the banking sector. The CDS of Ireland is already the highest amongst the euro zone countries, despite its AAA rating at all three major rating agencies.

In the UK, the Gilt market outperformed the European bond market again yesterday, as yields extended their steep decline following the dovish comments from the Bank of England and the outlook for a quantitative easing policy.

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Published on  Fri, Feb 13 2009, 08:12 GMT

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