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Sunrise Market Commentary

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US Treasuries underperform ahead of this week's supply

Tue, Oct 27 2009, 07:50 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Monday, global bonds lost further ground in a session devoid of marketmoving data, as US Treasuries fell below key support levels ahead of this week’s record bond issuance of $123B. The correction on the equity and commodity markets deepened, but again failed to offer support and bonds closed the day at the intra-day lows. The 5-year TIPS auction went well, but was also ignored ahead of this week’s 2-, 5- and 7-year Note auctions.

US Treasuries underperformed the European bond market. The US yield curve bear steepened with 2-year yields up by 2.5 basis points, 5-year yields up by 4.1 basis points, 10-year yields 6.4 basis points and 30-year yields 7.3 basis points. In the euro zone, the short end of the curve outperformed with German 2-year yields down by 1.3 basis points, while 5-, 10- and 30-year yields were up between 0.5 and 1.5 basis points. The intra-EMU sovereign spreads narrowed slightly, despite the decline in risk appetite as reflected in the correction on the equity and commodity markets.

US Treasuries underperform ahead of this week’s supply

Today, the calendar heats up both in the euro zone and US. In the euro zone, the M3 money supply and credit growth data (September) are on the agenda and in the US, the calendar contains the S&P Case Shiller house prices (August) and Conference Board’s consumer confidence survey (October). The market will also have to digest a record size $44B US 2-year T-Note auction and a small Dutch auction. Central Bank talk is limited to a speech of ECB Stark on the European Social Economy Model.

In August, M3 money supply growth slowed again more than expected and for September, a further slowing from 2.5% Y/Y to 2.2% Y/Y is forecasted. A lot of attention will also be focused on the credit growth data given the fears about a credit crunch in the euro zone. Recent analysis of the ECB has confirmed that household lending usually leads the turn in the business cycle by around one to two quarters, while lending to non-financial corporations lags the turn by around 3 quarters. Therefore, it will be important to see whether the recent stabilization in household lending is confirmed, as this would add evidence to the ECB’s working scenario that the euro area economy is stabilising. At the same time, a further decline in lending to non-financial corporations shouldn’t be too worrying. In the US, Conference Board’s consumer confidence is anticipated to show a marginal improvement (53.50 from 53.10) in October, after an unexpected deterioration in September. The risks might be on the downside of expectations as both ABC and Michigan consumer confidence deteriorated this month, which might be caused by higher gasoline prices and uncertainty on the economic outlook. S&P Case Shiller house prices are forecasted to show a further slowing in the rate of decline. In August, the decline is expected to have slowed from 13.30% Y/Y to 11.90% Y/Y.

On the supply front, the US treasury will auction a $44B 2-year Note today. Yesterday, the 5-year $7 B US TIPS re-opening went very well. The auction stopped at 0.769%, below the 0.774% in the WI at the moment of the stop, while the bid/cover at 3.1 compares to an average of 2.12. The Indirect takedown at 47.8% was somewhat higher than average too. The only minor was an unaggressive bid of the dealer community, but that doesn’t affect the overall appreciation of the results. The size of today’s 2-year Note auction has been upped by another $1B to a record $44 B. Taken into account the redemption of a $21B issue, the auction will raise almost $23B upon settlement. Last month, the 2-year auction went extremely well with a stop well below the WI bid and the strongest bid/cover in quite a time (despite increased size). The buy-side participated in force. The 2-year yield has been rising since early this month and trades slightly above 1%, which is a positive, but which also may indicate that markets are preparing the exit of the Fed’s extremely loose policy. So, while we have no indications that the auction shall be weak, the result of the auction may affect the overall market.

In the euro zone, the Netherlands will tap three off-the-runs in the 5-, 7- and 18-year sector for a total amount of €0-2B. Despite the recent deterioration in sentiment on the government bond markets, the intra-EMU sovereign spreads have narrowed over the previous days. As such, the spread narrowing has been mainly related to the underperformance of German bonds after the new German coalition showed its preference to first boost growth before tackling the growing deficit. As a result, the net borrowing requirement is forecasted to almost double next year to €86.1B from 47.6B this year. Today’s Dutch auction should benefit from the positive net cash flows due to the redemption and coupon payments from France this week.

On the money market, the ECB will hold its weekly refinancing operation. Last week, the amount allotted fell to its lowest level in six years at €49.8B, which indicates that the need for central bank funding is decreasing and suggests that money market conditions are normalizing. A further decline in the ECB’s refinancing operations may persuade the ECB governing council to scale back their refinancing operations next year. This should reduce the excess liquidity available in the money market and should start to push money market rates again higher in the course of 2010. In recent days though, money market rates are again easing somewhat. The 1-year eonia swap fell 6 basis points to 0.772%, still well below the ECB repo-rate.

With regard to monetary policy, ECB Stark speaks, but on a subject that shouldn’t immediately affect markets, even if he may of course drop some interesting suggestions. However, recently the main tone of the ECB speeches was one of caution, rather dovish talk. There seems to be a broad consensus inside the board to avoid giving the impression that near term changes to its loose monetary policy stance are needed.

Regarding trading today, supply concerns may continue to impact trading today. The eco data are interesting, but probably not of crucial importance. The decline in the US equity markets failed to support the bond markets both on Friday and on Monday. Asian stocks suggest that another round of profit taking may happen. From a technical point of view, the equity correction has indeed more room to develop. So for bonds, the main issue is whether we face a correction or a change in trend. We favour the former, as we think the bottoming out phase (that shall be followed by an uptrend in yields), isn’t over yet. Therefore, there should perspective on a change in monetary policy. However, we stay open-minded and a major break in the technical picture, if it occurs, shouldn’t be neglected.

Regarding the European bond market, the longer-term bullish technical picture of the Bund started to deteriorate two weeks ago when the bund fell below a previous reaction high at 121.74. This was a first warning signal that the underlying sentiment was deteriorating. Last week, the Bund also fell below its long-standing uptrend channel, which could now lead to a test of the September lows at 119.85 (KEY). However, only a fall below the September lows would put an end to the higher high, higher low pattern and suggest that a substantial downward correction is looming. In 10-year yield terms, the key level to watch out is 3.43% (potential neckline double bottom)

Regarding the US Treasury market, early October, Treasuries broke above key resistance levels, suggesting that another up-leg was in store. However, recent price action has been disappointing and the drop below 118-17+ (prev. high) and 117-20+ (Oct 16 low) (T-Note future) only confirmed the deterioration of the technical picture to neutral from positive. Next key support stands at 116-18 (Sep 9 low/ uptrendline). A break of this level would turn the picture bearish. In the cash markets, the re-break above 3.30% (10-year) and 4.15% (30-year) confirmed the technical picture of the futures, with the 10-year yield now testing resistance at 3.53/60% (neckline inverted Head & Shoulder/Aug 24 high). A loss of this level would be a major negative that might point to a retest of the year highs around 4%. We wait on the outcome of the current test of resistance to set up a strategy. Tentatively, we would think that the correction has nearly gone far enough, but nervousness in the market may be prolonged into next week (FOMC/payrolls).

In the UK, the calendar contains the CBI distributive trades report. In September, the CBI showed the first positive sales figure since April 2009 and for October another slightly positive figure is expected.

Yesterday evening, BoE Posen said that the QE policy will not cause a future surge in inflation, but also played down the GDP drop in Q3. He especially focussed on a lack of credit for medium sized firms referring to the Japanese experience in its lost decade. He once more argued that the problems in the financial sector need to be fixed before macroeconomic stimulus is withdrawn. He didn’t directly address the question whether QE needed to be expanded, but as he said that its impact should be viewed from a flow as well as from a stock perspective and added that the program would be more effective if it included more corporate debt, we suspect he is in favour of an extension of the QE policy.

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Published on  Tue, Oct 27 2009, 08:04 GMT