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Sunrise Market Commentary

US Treasuries eke out small gains in rollercoaster ride

Tue, Feb 24 2009, 10:13 GMT
by KBC Market Research Desk

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Markets: Fixed Income

On Monday, global bonds recouped early losses and gained marginally ground, as equity markets crumbled. However, the gains on the bond markets remained rather limited compared to the huge losses on the equity markets with the S&P 500 falling 3.5% to the November lows and the Dow Jones closing at its lowest level since 1997. Ongoing concerns about the state of the financial sector and its impact on the real economy crushed equities, but were counterweighed on the bond markets by concerns on the upcoming supply. In the euro zone, ECB president Trichet warned for a credit crunch and in the US, both Citigroup and AIG are involved in new talks with the US government that could give the government a significant stake in both companies.

Intra-day, global bonds were closely related to the movements in the equity markets, as the data calendar was empty both in the US and the euro zone. As such, bonds recouped their opening losses in the course of the day, as equities slid away, and closed at the intra-day highs.

In the US, there was a bull flattening of the yield curve, as 2-year yields declined by 0.8 basis points compared to 2 basis points in the 5-year sector and 3.4 basis points in the 10-year sector. In the euro zone, yields were still somewhat higher in the cash market, but this is mainly related to the early closing, as bonds gained further ground afterwards. Intra-EMU spreads tightened further with Greek and Belgian bonds outperforming following a strong Belgian bond auction.

US Treasuries eke out small gains in rollercoaster ride

Today, the calendar heats up with the S&P Case Shiller house prices, consumer confidence and Richmond Fed. Recently, the pace of the decline in house prices slowed somewhat. Last month, S&P Case Shiller house prices showed a drop by 18.18% Y/Y in November and the consensus is looking for a figure of -18.3% Y/Y in December. While there is some bottoming in the Y/Y readings visible, that doesn’t mean that prices have stopped declining. Stabilization in house prices is a condition for the financial market to stabilize and the economy to find its composure. It will probable take a few months before the effects of the Obama housing plan become visible in housing data. Both the NY and Philly Fed showed deterioration in business confidence in February, after the slight improvement in the month before. Although the consensus is looking for a stable outcome of the Richmond Fed, we expect to see a decline in business sentiment after the weaker than expected NY and Philly Fed, even if we have to add that the Richmond Fed index has declined relatively more than compared to other regional indices. Also consumer confidence is expected to have weakened in February. Conference Board’s consumer confidence is forecasted to set a new record low after the worsening in Michigan consumer confidence. If confirmed, these data indicate that both producers and consumers are becoming still more pessimistic.

The Treasury will issue $40 B of 2-year Note that will raise about $22 B fresh money at settlement next Monday. The Treasury will pay out about $1.4 B in interest coupon payments. The size of the 2-year Note auctions have been consistently increased from $18 B in September 2007, but has held steady compared to last month. So today’s auction is very similar compared to last month’s both in the size and in the surrounding cash flows. The 2-year Note auction is part of the monthly auctions that also contains a $32B 5-year Note and a $22B 7-year Note auctions, to be conducted tomorrow and Thursday for a record total amount of $94B of issuance this week. Last month’s 2-year auction went very well despite big size, even if the auction stopped slightly above the bid side in the WI at the moment of the stop. Bid cover was strong and Indirect bidders showed up (average takedown). There was also an unusual large direct bid. The 2-year yield at 0.94% is slightly, but not meaningful higher than last month (0.83%). The renewed concerns about the financial system (Citi, BoA and AIG) and the economy is certainly a strong positive for the auction, but the size remains a hurdle even if it is unchanged from January. Indeed, there is now an extra $22B of 7-year Notes and $2B of extra 5-year Notes that will be auctioned this week compared to January. So, overall we think that the Indirect bidders will again be present, but there might be some price concession to be made that might show up in a stop above the WI bid. The risks for a weaker auction may concern the 5 and still more the 7-year auctions later this week.

The US banking regulators issued a statement affirming their firm support for the banking sector and saying it ensures that banks have the capital and liquidity they need to provide credit to the overall economy. The regulators said they want to preserve the viability of systemic important financial institutions and announced the stress-testing to start soon.

Fed chairman Bernanke will give his semi-annual testimony before Senate Committee. It is always a key event for markets, as often the longer-term path of policy is discussed. The eco and inflation picture were extensively communicated via the Minutes of the January FOMC and does Bernanke probably won’t surprise on this item. Attention this time will go especially to quantitative easing and especially whether and when the Fed will start buying longer-dated Treasuries. Bernanke will explain the Fed’s QE policy and stress both that the Fed is ready to do more and that it has an exit strategy to quell inflation concerns that may arise from its unorthodox policy. While, at first views, the chairman will reiterate remarks made recently, there is always scope for surprises.

Regarding trading, Treasuries had a wild rollercoaster ride that ended with tiny gains and a flatter curve. It was all risk aversion and equities that drove markets. Treasuries were sold in three waves at the start of the Asian, European and US sessions. Investors reacted on hopes the talks between Citi and the government would calm down fears about nationalization of the important bank. The US regulators tried to boost confidence by a statement on banks, but in vain. Equities crumbled again in the US cash session, also due to fresh concerns about AIG, allowing Treasuries to stage a powerful rebound and erasing earlier losses. In the cash market, yields even fell slightly. However, given the ultimately steep losses of equities one cannot but consider the price action of Treasuries as again rather disappointing. We suspect that the supply that will flood the market this week goes a long way in explaining the all in all disappointing price action. Today, while the eco data will probably be again Treasury friendly, we suspect that equities, supply and Bernanke will be the driving factors for Treasuries. It will be a key day for equities, as we underlined abundantly recently that the 790-741 area in the S&P is key. Yesterday’s price action left again a Marobodzu-like pattern on the charts that in the past was often, but not always, the precursor of a rebound. Usually it coincided with one or another plan of the government that boosted confidence in an oversold market. However, recently there was an inflation of plans that however had ever less effect. Will it be difficult this time around? Supply will certainly weigh on the market today with the Treasury issuing $40B 2-year Notes. In this context, we stick to our strategy we started the week with.

Indeed, the technical pictures of the Treasuries remain neutral despite intrinsically Treasury-friendly factors of recent. This keeps us cautious. Equities dropping below 741 (S&P) should be a positive, but there is a decent chance for an eventual rebound, while supply should be difficult to digest. So, we confirm our neutral view on Treasuries and see risks more for a down-move than for an up-move.

ECB’s Trichet warns for a credit crunch

Today, the calendar is well-filled with the industrial new orders (December), German IFO indicator, French consumer spending and Belgian business confidence. Industrial new orders are expected to show their fifth consecutive monthly decline in December. The consensus is looking for another sharp decline (-5.0% M/M), but the data are rather outdated and therefore no market reaction is expected. The German IFO business climate indicator is expected to stay unchanged at 83.0, after showing a marginal improvement in January. The expectations sub-index is forecasted to show a rise (81.1 from 79.4), while the current assessment is expected to have deteriorated (84.9 from 86.8). We believe the risks are on the downside of expectations after the PMI’s, released last Friday, surprised on the downside.

On the supply front, the Netherlands will tap three bonds in the 2-, 4- and 7-year sector for an amount between €0-2B. Following yesterday’s successful Belgian bond auction, we expect again good demand for the Dutch auction given the rather strong fiscal position of the Netherlands within the euro zone. Intra-EMU spreads narrowed further yesterday with Belgian bonds outperforming in the wake of the auction. Whether this narrowing trend in intra-EMU spreads will continue is however highly uncertain, as concerns are rising that a new round of bank recapitalizations will be needed in the euro zone too. Yesterday, France decided to support Group Banque Populaire and Groupe Caisse d’Epargne, which are expected to merge, by another €5B. This may further increase pressure on the public finances at a moment the budget deficits are already rising sharply. Yesterday, ECB’s Gonzalez- Paramo once again warned that ‘these excessive deficits and very high levels of indebtedness are a warning to investors because of the risk of countries having to face problems of solvency in the repayment of their debt’. In this context, European Commission president Barrosso yesterday dismissed the idea of the launch of a single euro bond on the behalf of the euro zone to help countries in trouble, as this idea has been opposed by some member states.

On the ECB front, ECB president Trichet yesterday spoke about the future of European financial regulation and supervision. To strengthen the financial system, Trichet pleaded to ‘extend regulation and oversight to all systematically important institutions, notably hedge funds and credit rating agencies, as well as all systematically important markets, in particular the OTC derivatives market’. He also sounded increasingly concerned about the evolution of bank credit, as he in recent weeks saw ‘first signs of falling credit flows’. Although he acknowledged that this is partly demand driven, Trichet added that also supply-side factors like tight financing conditions associated with a phenomenon of deleveraging are playing a role. This is the first time Trichet explicitly warns for a credit crunch in the euro zone. Accordingly, he issued a thinly veiled warning to the financial sector that ‘if this behaviour became widespread, it would undermine the raison d’être of the system as a whole’. On the other hand, Trichet pointed also to some positive elements in the corporate bond market, where the issuance has reached a record high in January. The increasing problems in the intermediation role of the banking sector will increase the pressure on the ECB to ease financial strains by buying directly for example commercial paper, corporate bonds or even longer-term government bonds. Until now, the ECB has acknowledged that it is discussing more unconventional measures, but has refused to provide further details, as it still sees room to cut rates further first. As such, the ECB is widely expected to cut rates by 50 basis points to 1.5% at their next meeting in March.

Regarding trading, German bonds gained only moderate ground yesterday, in spite of the huge losses in the equity markets. This is somewhat disappointing and may indicate that the underlying sentiment is not that bullish. This week supply will again come to the forefront both in the euro zone and the US and this may especially weigh at the longer end of the curve. As such, we don’t front-run on a break higher in the Bund, but prefer a buy-on-dips approach towards last week’s lows at 124.37.

In the UK, the Gilt market underperformed the German bond market. Today, the calendar contains the CBI distributive trades report. Last month, the report showed an improvement in the total volume of sales, but the index is expected to have deteriorated in February. This morning, BoE’s Sentance will speak on the state of the economy.

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Published on  Tue, Feb 24 2009, 10:52 GMT

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