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Sunrise Market Commentary

Bund testing first key support level

Thu, Oct 15 2009, 07:08 GMT
by KBC Market Research Desk

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Markets: Fixed Income

On Wednesday, global bonds were hit quite hard by sharply rallying equities, strong commodities and robust underlying US retail sales. Summarizing, there were signs from the corporate sector that the economy is on the mend favouring riskier assets to the detriment of safe haven bonds. The curve bear steepened in the US with yields up between 1 and 6-7 basis points, while in EMU, the short end of the curve outperformed slightly, elsewhere yields were up about 6 basis points

Intra-day, the Bund opened somewhat lower and immediately lost more ground, as equities powdered ahead. Strong, above consensus, Q3 earnings and revenues of Intel, ASML and later on of BASF were the driver. The decline continued until the start of the US session. The Italian, Portuguese and the German Schatz auctions went well and intra-EMU spreads with Germany narrowed. However, equities were the overwhelming driver for bonds, maybe also for the intra-EMU spreads. Global bonds stabilized, mirroring equities that couldn’t gain further ground on excellent Q3 results of JPMorgan. The US retail sales were better than expected, especially for the underlying sales (excl. cars) and Treasuries spiked lower, but the absence of follow through selling, prices rapidly rebounded to pre-release levels and later on even somewhat higher. At that time equities took a breather. After the release of the FOMC Minutes (see below) bonds spiked higher, but only very temporarily, after which selling resumed pushing US Treasuries (and Bunds) towards the lows of the session. The 2-to-10-year yield widened, especially following the release of the FOMC Minutes. The combination of talk about expanding the Agency MBS purchase program and an upgraded economic outlook indeed justifies such a steepening of the US curve (less likely earlier tightening and more chance on inflation further down the road).

Bund testing first key support level

Today, the calendar contains the euro zone and US CPI inflation data (September), the NY and Philly Fed (October) and weekly claims. The euro zone CPI flash estimate put inflation at -0.3% Y/Y in September. The final figure is expected to confirm this outcome, but following the downward revision to the German results, we put the risks on a downward revision of the EMU HICP to -0.4% Y/Y. In the US, the inflation rate probably remained subdued in September with 0.2% M/M and 0.1% M/M increases expected for headline and core CPI measures. In September, the headline figures of both the NY and Philly Fed survey were reasonable good, but the underlying picture showed some weaknesses. Manufacturing is the most cyclical sector and therefore we would like to see no repetition of these weaknesses. The consensus is however looking for a slight decline in both indices. The initial claims are a weekly and thus volatile indicator. However, it is the timeliest indicator for the labour market. Last week, claims dropped substantially to a new low for the new cycle that started in March 2009 when claims peaked. A marginal increase is forecasted (522 000 from 521 000), but another drop would be important and get noticed.

On the supply front, France and Spain will tap the market today. France will tap three bonds in the 2 to 5-year sector for a total amount of €6.5-8B as well as three inflation- linked bonds for a total amount of €1.2-1.7B. Spain also plans to sell €3-4B of two bonds in the 5- and 10-year sector. Yesterday, the auctions from Germany, Italy and Portugal were well digested and the intra-EMU spreads narrowed slightly. This may however have been more related to the general rise in risk appetite (strength equities and commodities), as the Itraxx Crossover fell sharply to its lowest since June last year, while the intra-EMU spreads are still way above the lows reached at the beginning of August. Today’s French and Spanish auction results may be very interesting, as their latest auctions two weeks ago disappointed a bit. France has recently indicated that their deficit would rise to 8.5% of GDP in 2010 and won’t fall back below 3% over the coming years, as required by the Stability and Growth Pact.

Earnings reports of Nokia, Goldman, Citi before US market opening and Google and IBM after market closure might again steal the show today. Equities broke to new highs, technical significant, but confirmation is needed.

With regard to monetary policy, the ECB will publish its monthly bulletin, which may provide further insight in the outlook for monetary policy. This afternoon, ECB president Trichet will speak in Frankfurt, but no topic has been announced. Yesterday, ECB Bini Smaghi’s speech on monetary policy and asset prices contained no info on the short-term outlook for monetary policy. Bini Smaghi stressed the importance of the use of financial indicators to incorporate financial imbalances in the setting of monetary policy, as these imbalances may pose a threat to the maintenance of price stability. He however warned that monetary policy alone cannot ensure financial stability and that supervisory and regulatory instruments should contribute to prevention of excessive risk-taking and the development of asset price bubbles. During the Q&A session afterwards, Bini Smaghi indicated that he is still cautious on the recovery, as ‘the current situation is surrounded by high uncertainty about the position of the cycle and the speed of the recovery’.

In the US, the Minutes of the September FOMC meeting brought a number of interesting clarifications in Fed’s thinking on the economy and policy. Firstly, it was decided to re-affirm the size of the large scale asset purchase programs, but to slow the pace of Agency MBS & Agency debt purchases and to extend their completion through the end of Q1 2010 (instead of Q4 2009). While this was already known from the statement that closed the September meeting, the Minutes also revealed: “With respect to the large-scale asset purchase programs, some members thought that an increase in the maximum amount of the Committee’s purchases of agency MBS could help to reduce economic slack more quickly than in the baseline outlook”. Another member (one) believed the improvement in economic conditions could warrant a reduction in the Committee’s maximum purchases. This means that an expansion of the asset purchases programs isn’t totally excluded (in case economic conditions would weaken). Secondly, on growth, the Minutes revealed that “many participants noted that since August, they had revised up their projections for the second half of 2009 and for subsequent years”. This indicates that the idea of a double dip doesn’t live in the Committee, even if most members expect only a gradual recovery with little chance that unemployment would rapidly and substantially decline. There was also debate on the output gap with some members suggesting that the output may overstate the amount of slack in the economy, a discussion that already saw the light in the various speeches (Bullard/Warsh versus Kohn). Thirdly, the FOMC said that it was needed to inform the public extensively on its exit policy, something that they did via numerous speeches in recent weeks. For bond markets the message was mixed. An eventual (but unlikely) expansion of the asset purchases points to another easing and is positive for the short end of the curve (tightening may be further away than expected) but in combination with an upgrade of growth prospects might be less positive for the longer end of the curve, even if there was little news on inflation (expected subdued, with some seeing downward risks short term and some seeing upward risks long term).

Regarding today’s bond trading. Yesterday, bonds have been hit quite hard after another batch of strong Q3 earnings pushed equities above key resistance levels to new cycle highs. This may indicate that resilience of the bond markets against stronger equities is waning and that a further rally on the equity markets would hurt bonds too, despite current ample liquidity conditions and very low policy rates. In first instance, this may mainly hurt the longer end of the curve, as central bankers have given no signal yet that the time to exit has come and investors may start to fear that central bankers are falling behind the curve given the strong rally on the equity and commodity markets. A sustained fall below 121.74 in the Bund future would indicate that this scenario is gaining ground, while the US T-Note future has fallen already below the corresponding 118-16+. On the European bond market, the strength of the euro is another factor that suggests it is still too soon to speculate on a substantial flattening of the yield curve and that first the curve may steepen somewhat further.

Regarding the US Treasury market, early October Treasuries broke key resistance levels suggesting that another up-leg was in store. We didn’t fully embrace the move at the time as it was at odds with our fundamental view and advised to use the break and rally to offload long position, albeit at higher levels than we actually reached. Indeed, the improvement of the technicals suggested that more gains were likely. The correction at the end of last week was technically relevant (re-break of the key levels). At the start of the (US trading) week, we took a step back and waited to see how traders react after the correction. The question was whether it was simply a technical correction or whether it had a more fundamental meaning. We believed that the reaction on the retail sales and on an eventual break higher of equities would learn us more about the underlying sentiment. Now we have this reaction in favour of risky assets including corporate bonds (Itraxx crossover reached new cycle low) and against safe haven government bonds. While this needs confirmation, we would be cautious on bonds and certainly consider offloading longs in case of renewed strength. The technical picture while deteriorated, isn’t outright bearish yet.

Regarding European bond market, the longer-term bullish technical picture of the Bund is coming under test, as a sustained break below 121.74 would be a first warning signal that the underlying sentiment is deteriorating. In German 10-year yields, this would correspond with a rebound above 3.25%. Yesterday, the Bund fell to 121.75, but this morning a new low has been set at 121.65. This means that the first target of the short-term double top with neckline at 122.31 has been reached, the second target stands at 121.58.

In the UK, the calendar is empty today.

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Published on  Thu, Oct 15 2009, 07:42 GMT

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