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Sunrise Market Commentary

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Fitch warns governments on public finances

Wed, Jul 1 2009, 06:55 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Tuesday, global bonds were moderately lower in erratic trading, probably due to the end of the second quarter.

During the morning session, global bonds were still rather well supported on the back of sharper than expected slowing in the euro zone money supply and credit growth data, which indicated that the risk on a credit squeeze shouldn’t be underestimated. This may still force the ECB’s hand to expand their credit enhancement scheme beyond covered bonds over the coming months. The inflation data were broadly in line with expectations, although they fell for the first time into negative territory. In the afternoon, global bonds turned south after the Case Shiller house price index showed some moderation in the decline of house prices. This offered hope that the US housing market is finally stabilizing. Bonds however rebounded again later in the session, as equities declined following the unexpected drop in US consumer confidence.

Overall, US yields were moderately higher with a steepening bias, as 2-year yields were up by 1.6 basis points, while 10-year yields rose by 5.5 basis points. In the euro zone, German yields were mixed. 2-year yields were unchanged, 10-year yields were up by 1.6 basis points, but 30-year yields were down by 3 basis points.

Fitch warns governments on public finances

Today, the calendar contains the final figure of euro zone manufacturing PMI. In the US, the calendar is more attractive with the June ADP employment report and the manufacturing ISM as well as the May pending home sales.

The final figure of euro zone manufacturing PMI is expected to confirm the first estimate (42.4), which came out slightly above expectations. In the US however, the June manufacturing ISM is scheduled for release. The consensus is looking for the sixth consecutive improvement from 42.8 to 44.6.

In the previous two months, US payrolls came out significantly better than expected. Last month however, the improvement in the official payrolls report was not visible in the ADP employment report, which showed a decline in employment by 532 000 (compared to 345 000 in the payrolls). For June, the ADP report is expected to show a drop in employment by 394 000. We have no clear view on the risks. US pending home sales are forecasted to show the fourth consecutive increase in May, but the pace is expected to have slowed (0.5% M/M).

On the supply front, Germany will tap its 10-year benchmark 3.5% July 2019 for an amount of €6.0B. Demand should be well supported, as there are two major redemptions of German bonds scheduled for next week. Regarding the overall outlook for public finances, Fitch warned yesterday that governments may need to start tightening fiscal policies as soon as next year even if economic conditions remain patchy, as the debt-to-GDP ratios risk to spiral out of control. In the euro zone, the debt-to-GDP ratio is expected to climb to 83.8% in 2010 up from 66.0% in 2007. In an interview with the FT and in line with comments from the BIS, the Swedish PM warns that more money may be needed to prop up the banking sector.

On the money market, the decline in Euribor rates slowed yesterday, as the impact of the record amount allotted in last week’s 12-month refinancing operation waned. The amount deposited at the ECB rose also more slowly to €242.2B. The latter should start to decline over the coming days, as the allotment in the weekly refinancing operation fell sharply to €105.9B from €167.9B in the previous week and even €309.6B in the week before. The question for the ECB however remains whether the lower interest rates will filter through into the real economy and even more important whether banks will step up lending. Yesterday’s sharp slowing in lending to nonfinancial corporations and even a decline in lending to households indicates that the risks for a credit squeeze shouldn’t be downplayed in the euro zone.

Regarding trading, the rebound on the bond markets halted yesterday, as the Bund declined in a bearish engulfing way, which is from a technical point of view a potential trend reversal figure. We would however be careful to draw too many conclusions out of yesterday’s session, as trading may have been influenced by the end of the second quarter. Nevertheless, the upside in the Bund may indeed have become more difficult now that the targets of the short term double bottom with neckline at 119.31 have been reached and strong resistance looms at around the 121.55 level, which is the neckline of a major double top formation on the continuation charts. Also from a fundamental point of view, we are not convinced longer-term yields should fall much lower due to the deterioration in public finances and the additional capital that still may be needed to prop up the banking sector. At the short end of the curve, the expectation that the ECB will have to keep rates at very low levels for a prolonged period of time and may have to expand its credit enhancement scheme should keep short-term yields low.

Also in the UK, the calendar contains the manufacturing PMI (June), which is expected to extend its recent rebound. In June, the consensus is looking for an outcome of 46.4 (from 45.4), which would be the fourth consecutive improvement.

On the supply front, the DMO will tap its 5-year Gilt 2.25% March 2014 for an amount of £5.25B. At the same time, the Bank of England will hold a reverse auction for an amount of £3B.

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Published on  Wed, Jul 1 2009, 07:08 GMT