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Sunrise Market Commentary

US Treasuries cannot build out recent gains

Tue, Mar 10 2009, 08:02 GMT
by KBC Market Research Desk

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Markets: Fixed Income

On Monday, global bonds started the week with a mostly calm trading session devoid of eco releases, tracking more or less the gyrations of stocks. In the US, yields ended the session narrowly mixed. The price action in Europe was more interesting though. The longer end also had a sideways oriented session that left the German 10-year yield one basis point higher and the German 30-year yields one basis point lower. However, there were more fireworks at the shorter end of the curve. ECB board members Stark and Bini Smaghi rocked the boat and started a campaign against cutting interest rates all the way to zero. See below for more details. This caused quite some selling at the short to middle segment of the curve that left 2- and 5-year yields 9 and 6 basis points higher in the close. As both the 2- and 5-year yield tried to break the cycle lows last Thursday and Friday, profit taking on these comments shouldn’t have been a complete surprise.

The intra-EMU government bond spreads (versus Germany) were little changed, with the high yielders nevertheless slightly outperforming.

US Treasuries cannot build out recent gains

Today, the eco calendar contains only second tier data, which are expected to have no impact on trading. Wholesale inventories are expected to show their fifth consecutive decline, as firms adjust their inventories to the declining demand. The consensus is looking for a drop by 1.0% in January. The IBD Economic Optimism index for March, a diffusion index with 50 the neutral level, is no market mover, but will help us make up our mind on the outcome of the Michigan and Conference Board measures of consumer sentiment that will be released later on. In the same vein, the weekly ABC consumer confidence index, to be released after trading, is expected to stay unchanged at -49.

Fed Chairman Bernanke speaks on “reforming the US bank regulatory system”. Interesting, but probably not market moving, unless it contains news on the PPIF facility, a hot item that is now centre to any solution that would stabilize financial markets. Of course, more likely it will be the Treasury that might come with a statement, but at least yesterday Treasury Secretary unveiled no details when meeting Congressmen. The market worries about the delay in the implementation of the high profile program. Some suggest that the delay is due to the inability to find enough private parties that want and are able to participate in the program. Should there be signs that private money wants to join the government in buying the toxic assets, it might give the hugely oversold equity market a very welcome boost. The equity market indeed will remain jittery as long as there are no signs of stabilization in the banking sector and no hope on a bottoming in the economy. It is disconcerting that the equity market has shown until now no enthusiasm for all those government plans that have been announced in recent months. It shows, we think, that the market expects no recovery whatsoever in Q3 and maybe not even before the end of the year.

The Treasury will issue a record high $34B 3-year Note (new issue) that is part of the $63B of Treasury Notes that will be auctioned this week. It will be followed by a $18B 10-year Note auction on Wednesday and a $11B 30-year Note auction on Thursday. The auctions settle on Monday March 16. The 3-year Note is a new issue that will raise all new cash, as there are no 3-year Notes maturing. Historical, the auction should stop on or very slightly below the WI bid with a bid/cover of 2.3 and an Indirect bid and takedown of respectively 18.3% and 33.1% of the auction. However, it is only the third 3-year Note auction since its re-introduction in November 2008, making it impossible to gauge the bidding details beforehand. The November 2008 auction was a success with a 3.07 bid/cover and a stop 8 bps below the WI bid, but the December and January 2009 were sloppy with a stop of 1.8 and 2 bps above the WI bid and bid/covers around 2.2. The February auction was again better with a stop 1.4 bps below the WI bid and a 2.67 bid/cover. The March auction with its record size might turn out to be weak with a stop above the WI bid and probably a lower bid/cover. As explained yesterday, this week’s $63B supply will be a challenge as the cash flows surrounding the auctions are unfavourable. Indeed, the Treasury will raise $48B of fresh money versus $46B during the February refunding operation. However, more important, the Treasury will pay only $1.6B in interest coupon payments versus $25B during the refunding operation. So, the Treasury will have to mobilise more investors’ money that traditionally is not invested in the Treasury sector

Regarding trading, Treasuries traded essentially sideways yesterday ending the session narrowly mixed and yields down about 1 basis points in the belly of the curve, while up 1 basis points at the wings. More interesting developments in other markets though. The 3-month Libor rate is persistently moving higher in the last 10 to 15 sessions and stands now at 1.31%, up from the 1.22 low on February 10, which is also reflected in the liquidity spread (Libor-OIS) that moved to 105 basis points from a low of 95 basis points. Swap spreads are even widening out faster. The 2-year swap spreads stands at 81.50 basis points from about 60 at the end of February. The widening is smaller at the 5-year sector and even declining further out. So, overall these developments show signs of increased stress in the banking sector. At this stage, we don’t change our view. The eco data won’t drive the market today and the 3-year Note auction is a negative. While equities disappointed yesterday as some technical trend reversal signals (doji, 2e target double top neckline at 665 is reached & so is the Irreg.B at 663 ) were ignored, we still stick to our a buy-ondips strategy. Indeed, the technicals haven’t improved a lot recently. The 5-, 10- and 30-year yields need to drop below respectively 1.62%, 2.60% and 3.40% to have enough evidence to re-qualify the outlook to bullish. The June Note future closed Friday needs to recapture on a sustained basis the 122-28+ level (previous high/neckline double bottom) to justify hope that the upside is unlocked. The inability to do would put the bears again in the driver’s seat and lead to more losses, pushing yields eventually to recent highs, at 2.16%, 3.06% and 3.76% for the 5-, 10- and 30- year, where more enticing entry possibilities (long side) exist.

ECB’s Stark and Bini Smaghi warn too low interest rates may be counterproductive

Today, the euro zone data calendar is thin, as it only contains the French industrial production figures and the German trade balance. In France, industrial production is forecasted to show the sixth consecutive monthly decline. The headline index is expected to have dropped by 0.6% M/M in January, after falling by 1.8% M/M in December. This morning, the German trade surplus narrowed more than expected, as exports continued to fall sharply reflecting the deepening recession in the global economy.

On the supply front, the Netherlands and Austria will tap the market. The Netherlands will tap its 3-year DSL 2.5% Jan 2012 for an amount of €2-3B, while Austria will tap its 5-year RAGB 3.4% Oct 2014 for an amount of €1.65B. The Dutch auction shouldn’t pose major problems, as short-term bonds and Dutch bonds in particular have been well in demand by investors. Austrian bonds on the other hand have been underperforming quite sharply since the critical Moody’s report on the Austrian banking exposure to Central and Eastern Europe. Compared to the inaugural auction of the bond in mid-January, the spread above Germany has widened by 40-45 basis points. Ahead of the auction, the bond has been underperforming. Regarding the intra- EMU spreads, Irish bonds continue to underperform, especially at the shorterterm maturities, which may point to rising concerns about the funding capacity of Ireland.

On the ECB front, several ECB council members (Mersch, Weber and Hurley) are scheduled to speak today. Yesterday, ECB’s Stark echoed comments from Bini Smaghi over the weekend, as he warned that very low interest rates could be counterproductive and sounded hesitant to introduce more unconventional measures. Instead, Stark called for ‘resolute action to restructure, consolidate and recapitalize the banking sector in order to sustain an adequate flow of credit to the non-financial sector’. Too low interest rates will ‘not fundamentally solve the problems that have caused the financial crisis’, and may even ‘aggravate’ them, as they ‘have the potential to weaken the incentives for banks to clean up their balance sheet of troubled assets and monitor their credit risk carefully’, ‘tend to foster lending to unprofitable business’ and may even ‘lay the foundations for another asset price bubble’. Cutting interest rates too low may also threaten the improvement noticed in the functioning of the money market, as ‘this may lower incentive to trade funds in the market rather than depositing them safely, at the same low return, with the central bank’. Today, several national ECB governors will speak and it will be interesting to see whether they share the view of the board members Stark and Bini Smaghi. Over the past months, it appeared that the national governors were more in favour of lower rates and this may also be the case this time, as Trichet has indicated during last week’s press conference that 1.5% won’t be the bottom of the cycle. As such, we keep our target for ECB rates at 1%.

Today, the ECB will hold its weekly refinancing operation as well as its special term refinancing operation for the duration of the maintenance period or 28 days. Since the turn of the year, the amounts allotted in the refinancing operations have come down slightly as well as the number of banks participating. By providing unlimited funds at a fixed rate and against an expanded range of eligible collateral, the ECB wants to prevent a liquidity crisis and wants to ensure the transmission of their monetary policy decisions through the bank lending channel. In this context, it’s encouraging to note that according to the MFI interest rate statistics for the month of January, the recent sharp cuts in interest rates are being passed on to the real economy. Indeed, the interest rates on loans for house purchases and loans to non-financial corporations fell quite sharply in January. This may signal that the transmission mechanism of monetary policy isn’t significantly impaired and may lessen the need for more unconventional measures in the direction of a quantitative easing policy. In his speech yesterday, Stark signalled that by ‘accepting corporate loans as part of collateral in its regular liquidity operations, the ECB has already significantly contributed to providing funding to non-financial corporations and thereby an easing of credit conditions’. ‘Buying corporate debt outright would circumvent the banking sector’.

Regarding trading, the hawkish comments from ECB’s Stark and Bini Smaghi resulted in a bear flattening of the European yield curve, as the short end underperformed. Also at the longer end of the curve, the Bund failed to break above the recent highs in a sustainable manner, although it set a new high at 125.63. The comments from Stark indicated that one shouldn’t expect the ECB to follow the Bank of England soon in its quantitative easing policy. As such, we hold on to our long-standing strategy not to front-run on a break higher, but to buy on dips. Therefore, we look to the recent lows at around 122.97.

In the UK, Gilts first gained further ground on the quantitative easing, but fell prey to profit-taking, as the test of the all-time lows in UK 10-year yields (2.95%) failed.

Overnight, both the RICS house price survey as well as the BRC retail sales monitor painted a grim picture of the UK economy, as the number of home sales dropped to an all-time low and the retail sales fell again following an upward surprise in the previous month. Later on today, the calendar still contains the January industrial production figures. On a monthly basis, industrial production is expected to have dropped by 1.2% M/M after declining by 1.7% M/M in December.

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Published on  Tue, Mar 10 2009, 08:09 GMT

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