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Sunrise Market Commentary

Bund still close to key longer−term support levels

Wed, Jun 3 2009, 08:28 GMT
by KBC Market Research Desk

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Markets: Fixed Income

On Tuesday, global bonds rebounded slightly from the recent lows, as equity markets stabilized at around their key resistance levels, despite better than expected US pending home sales. The latter is usually no market mover, but the sharpest rise in seven years nevertheless caused a temporarily spike higher in the equity markets and lower on the bond markets. The S&P500 however didn’t convincingly break above the year highs at around 943.85.

In a daily perspective, there was a bullish flattening of the US yield curve, as 2- year yields were unchanged, while 5-year yields decreased by 3.1 basis points and 10- and 30-year yields fell by even more than 5 basis points. The declines in yields were however very limited compared to the increase on Monday, when longer-term yields rose by more than 20 basis points. Despite the decline in yields, the break even inflation rate on 10-year bonds rose to above the 2% level for the first time since September last year.

In the euro zone, there was a bullish steepening of the German yield curve ahead of today’s 30-year Bund auction, as 2- and 5-year yields declined by around 3 basis points compared to a decline of 1 basis point in 10-year yields and only 0.3 basis points in 30-year yields. The intra-EMU sovereign spreads were mixed.

Bund still close to key longer-term support levels

Today, the euro zone calendar contains the final May services PMI and the preliminary estimate of first quarter GDP. According to the first estimate, euro zone GDP contracted by 2.5% Q/Q in the first quarter of this year. The preliminary figure is expected to confirm this outcome, but more important might be the breakdown. Investments and exports are likely to show the biggest negative contributions; but also inventory changes might have put some downward pressure on growth. Consumer spending is forecasted to show a slight negative contribution. The final figure of euro zone services PMI is forecasted to confirm the first estimate of 44.7.

In the US, the calendar is well-filled with the ADP employment report (May), nonmanufacturing ISM (May) and April factory orders. In April, the ADP employment report showed an unexpected easing in the number of job losses (-491 000 from -708 000), which was confirmed by the official payrolls report. For May, the consensus is looking for a slightly lower outcome (-525 000) and we have no reasons to distance ourselves from the consensus. The non-manufacturing ISM is forecasted to extend its rebound in May (45.0 from 43.7), the risks might be on the upside of expectations after the better than expected manufacturing ISM. For the (April) factory orders, the consensus is looking for an increase by 0.9% M/M after falling by 0.9% M/M in March. We believe that an upward surprise is not excluded after the 1.9% M/M jump in durables.

On the supply front, Germany will tap its 30-year Bund today for an amount of €4B. The auction result will give an indication on the demand for longer-term bonds. Yesterday’s strong demand for the 40-year Gilt and 10-year Greek bond suggests the auction should go rather well. Later on this week, France and Spain will tap the European bond market too. The net cash flow will be highly negative this week, as there are no redemptions scheduled. In the US, no auctions will take place this week. On Thursday, the Treasury will nevertheless announce the amounts for next week’s 3-, 10- and 30-year auctions.

On the ECB front, we are currently in the ‘purdah period’, which means that the governing council members should refrain from commenting on the monetary policy outlook. Following last month’s rate cut to 1%, no rate change is expected at this meeting, as Trichet called current rates ‘appropriate’. Markets will however look out for the details of the covered bonds program and the new ECB staff forecasts for growth and inflation. A preview on the ECB meeting will be published on our website in the course of the day. Yesterday, German Chancellor Merkel sharply criticized the Fed and the Bank of England’s unconventional monetary policies and to a lesser extent also the ECB when she said “I’m very sceptical about the extent of the Fed’s actions and the way the Bank of England has carved its own little line in Europe”. “Even the European Central Bank has somewhat bowed to international pressure with its purchase of covered bonds.” She added “We must return to independent and sensible monetary policies, otherwise we will be back to where we are now in 10 years’ time.”

Regarding trading, although, the sell-off on the government bond market halted yesterday, the short-term technical picture is still bearish. Also from a longer-term perspective, we are now very close to key support at 118.48 in the Bund and key resistance at 3.68% in German 10-year yields. A sustained break higher in the equity markets (S&P above the year highs at 943) and above the 3.68% level in German 10-year yields (below 118.48 in the Bund) would signal that the sell-off on the bond markets isn’t over. Although we don’t front-run on such a break and would still keep existing long positions open, tight stop-loss protection is warranted in case such a break would occur.

Last week’s positive correlation between equities and bonds indicated that US yields have arrived at levels where investors become worried about and this should cap the upside in yields. Indeed, any further rise in longer-term yields may push up mortgage rates and thereby threaten any stabilisation in the US housing market, which is key for an economic recovery. The rise in US longer-term yields may therefore heighten pressure on the Fed to augment their asset purchases at a time the dollar is already very weak. A further rise of the euro on a trade weighted basis may also become an increasingly important issue for the euro zone economy and put the ECB under pressure to become more aggressive too. This should also be seen as a supportive factor for the European bond market.

In the UK, the calendar also contains the May services PMI. An increase to 49.5 (from 48.7) is forecasted, but an outcome above 50 is not ruled out.

Yesterday, 10-year Gilts underperformed ahead of today’s 10-year auction for an amount of £3.5B. Meanwhile, the BoE will purchase £3B Gilts maturing between September 2015 and March 2018.

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Published on  Wed, Jun 3 2009, 11:10 GMT

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