Markets: Fixed Income
On Tuesday, global bonds showed important divergences. The correction lower initially continued both in EMU and US, but later on in the US, Treasuries recouped losses, while European bonds managed only to stabilize. As a consequence, EMU yields rose by 5 to 21 basis points, steepening the curve, while in the US, yields fell by 0.1 to 3.4 basis points flattening the curve.
The divergence has probably two factors. The correction in the US market that started already on December 31 was initially ignored in EMU, where bonds only corrected really lower yesterday. Technically, the Bund broke through a first key support level, while in the US, the March US contract found support at an important support.
Intra-day, the Bund was clearly negative affected by a better than expected PMI and later on tried in vain to rise on a bond-friendly inflation report, often signs that the market is ripe for a correction. In the US the downward correction stopped after a better- than-expected Non-manufacturing ISM (admittedly the factory orders and pending home sales were very weak) and the market rose further after a strong TIPS auction, which is normally no market mover. This market reaction often indicates a correction is over. We will see today whether these conclusions still stand.
US Treasury correction over?
Today, the calendar contains the weekly mortgage applications and ADP employment report (December), while Kansas Fed Hoenig speaks on the economy and the Treasury will auction $30 billion of 3-year Notes. In early December, markets were shocked by extremely weak payrolls figures for November. According to the payrolls report, employment dropped 533 000, while the ADP survey reported only a decline of 250 000 in employment. The organization that is responsible for the ADP employment estimate recognised the problem and revised their approach. The new method also includes initial unemployment claims in the estimation process. This indicates that there will be less new information in the ADP employment report than before, but hopefully the results correlate better with the payrolls as per BLS report. According to the revised approach, November employment dropped 472 000 and for December, the consensus is seeking for a 493 000 decline in ADP employment. Due to the changed methodology, we have no clear view on the outcome and suspect that market reaction after publication will be subdued too.
The $30 billion 3-year Note auction will be interesting, as it is the first nominal coupon issue of the year and the size is a record high one, up another $2 billion from December. The issue will raise all new cash upon settlement. The market is nervous too, as supply is certainly an issue in 2009, as the deficit will balloon under the weight of the recession, the bank bail outs and the fiscal stimulus package under preparation. The 3-year Note will only be auctioned for the second time in the cycle of monthly 3-year Note auctions, raising uncertainty about the attitude of the buy-side and the dealer community. The 10-year TIPS auction went extraordinary well yesterday, but should not be considered as a good gauge for the way today’s auction will go. Tomorrow, the Treasury will conduct a 10-year Note auction.
The Minutes of the historic December 15-16 FOMC meeting, where the Fed laid down the foundations of its quantitative easing policy were interesting. According to the Minutes, the Fed feared the economy would be stuck in a painful recession for a prolonged period. The Fed acknowledged that the adverse feedback loop has intensified as credit conditions tightened further. As a consequence, they decided top set a target range for the FF rate at 0-0.25% and decided to buy MBS and other types of securities. There was no discussion about purchases of Treasuries, which might have disappointed some and explain the initial negative market reaction on the release. So the Fed’s quantitative policy is inspired by actions to get credit markets normalize (spread compression). In other words, the action is driven by the asset side of its balance sheet. The consequence is, of course, an enlargement of bank excess reserves (liability side) and here the Fed’s QE differs from the BOJ’s that was inspired from creating excess reserves (liability side) with the rise in government bonds on the active side of its sheet the consequence. The announcement of QE in November 2008 triggered an ebullient rally in Treasuries on the expectation that the Fed would buy Treasuries, just like the BOJ did some years ago. However, the Fed decided to concentrate on credit markets and spread compression. The FOMC statement kept the possibility of buying Treasuries wide open though. The rally (before the actual implementation) in Treasuries meant purchasing these is no urgency, but we are quite convinced that the Fed won’t let Treasury yields go up too much, before buying some Treasuries. Therefore, we think it remains a buy-on-dips environment and don’t buy the stories about the Treasury “bubble” busting. The FOMC Minutes contained interesting remarks on communication and other issues, but it surpasses the objective of the Sunrise to dig into these.
The 8 billion $ 10-year Note TIPS auction went very well. Strong bidding and huge buy-side demand made it a success. The auction stopped at 2.245%, about 10 basis points below the WI bid just before the stop. Indirect bidders took down 47.3% of the issue. The bid/cover of 2.48 compares to an1.94 average.
Regarding trading, the correction that hit the lower end and steepened the curve in the previous three sessions ran out of steam yesterday. Whereas in previous sessions, it seemed that investors were reacting asymmetrically to eco data by ignoring weaker data (like ISM) and reacting negative to stronger data (construction spending), that attitude was put into doubt yesterday. At first the correction continued, but when Non-manufacturing ISM, factory orders and pending home sales were released, the market turned and Treasuries rallied for the remainder of the session. The data were mixed, but the Non-manufacturing ISM, the most important and timeliest one, was better than expected. Later on, the market received the 10-year Note TIPS auction, normally no market mover well. There was a slight, but only temporarily, disappointment after the release of the FOMC Minutes. For today, the 3-year Note auction might weigh on trading initially, while we have no clue whether the revamped ADP employment report will incite some reaction. Equities did rather well, but hadn’t major impact on Treasury trading. Markets may still contemplate about the direction to take in early 2009 and with the release of payrolls looming (Friday), we suspect more volatile price action but without a clear direction.
Reiterating our longer term outlook, at this juncture we still see the recent losses of (longer-term) Treasuries as corrective in nature. For the 10-year T-yield, 2.50% (tested yesterday) and 2.80% offer first entry possibilities. The March Note future (CTD is May 2016) tested the broken uptrend channel (123-27+ today), but investors may wait to consider new long positions for a re-test of 123- 02/122-21+ (targets double top).
Germany and the UK will tap the market today
Today, the calendar is rather thin as it only contains the German unemployment figures (December) and euro zone PPI (November). In Germany, unemployment is expected to show the first increase since January 2006. Last month, unemployment dropped 10 000, but a rise of 10 000 is expected in December. We see the risks on the upside of expectations as unemployment remained rather low in the previous month. The unemployment rate is forecasted to stay unchanged at 7.5% in December. In November, euro zone PPI is expected to have dropped 1.0% M/M after falling 0.8% M/M in October. No market reaction is expected as the PPI data are rather outdated and the CPI of December is already published.
Yesterday, the flash CPI once again surprised on the downside and indicated that euro zone headline inflation has fallen below the 2% level to 1.6% Y/Y for the first time since the summer of 2007. The eye-catching fall in inflation and economic growth raises fears for deflation in the euro zone. At a press conference in Lisbon, ECB’s Contancio yesterday warned of the threats of deflation and said that ‘any risk of inflation consolidating far below this value (2%) should be contained pre-emptively with interest rate reductions’. At the same time, he also called for more fiscal stimulus, as ‘we cannot for get that monetary policy, which is always less effective in responding to recessionary risks than to risks of high inflation, is at the moment particularly limited in its transmission possibilities by the lack of confidence and liquidity in various segments of the monetary and credit markets’. His comments indicate that the jury is still out with regard to the rate decision of next week’s monetary policy meeting. We believe it’s currently more a question of timing when the ECB will cut rates instead of whether the ECB will cut rates any further and expect ECB rates to fall to 1% in the course of the year.
On the money market, the ECB will hold two supplementary longer-term refinancing operations for 3 and 6 months. The fixed rate has been set at 2.5% and all bids will again be fulfilled. Over the past weeks, there have been increasing signs of thawing, as the liquidity spread continued to narrow.
On the supply front, Germany will tap its 10-year Bund 3.75% Jan 19 for an amount of €6B. This will prove a first test for real investor’s appetite for government bonds in 2009, as supply is becoming an increasingly important issue given the massive increase in government spending plans to support the economy. Earlier this week, Germany was reported to be considering a second fiscal stimulus package worth €50B over the next two years. Later on this week, France and Spain are also planning to tap the market.
Regarding trading, the correction on the European bond market continued yesterday, especially at the longer end of the curve where the Bund fell below its first important support level at 123.75. This suggests that the downward correction has a further way to go and may lead to a test of the December lows at 121.32. The latter may be considered as a good entry point to go long again. At the short end of the curve, the room for correction should remain much more limited and therefore a further resteepening of the European yield curve is preferred.
In the UK, the DMO will hold its first auction of the year, as it plans to sell £2B of the 4.75% 2038 Gilt. This year the UK plans to sell a record amount of £146B. The details of the auction will be closely monitored, as concerns have arisen whether there is enough appetite among investors to buy such a large amount of UK government bonds. Signs of weakness may lead to a further rise in UK yields, especially at the longer end of the curve. At the short end, the upcoming meeting of the Bank of England tomorrow will keep yields low. In an interview with the FT, Chancellor Darling gave a downbeat assessment of the UK economy and hinted that the recession may last longer than previously thought.
Currencies:
The forceful decline in EUR/USD that started on Monday morning was extended yesterday. Investors continued to look at the US economy through rosy glasses as they were growing more confident that fiscal and monetary policy measures will generate their effect in a not that distant future. On the other hand, the lower than expected European inflation data (and ongoing poor EU final PMI’s), reinforced the feeling that there might be room for additional ECB rate cuts already at next week’s policy meeting. So, EUR/USD continued its downward correction and even came close to the 1.3292/1.33 support area at the start of US trading. The technical level did its job and the pair settled in the 1.34 area awaiting the US data. Those data were mixed. The ISM nonmanufacturing surprised on the upside but the factory orders and the pending home sales were materially weaker than expected. We consider the ISM as the most relevant release for the (currency) market, but the dollar failed to gain further on this news and this triggered a euro rebound. In the Minutes of the December meeting, the Fed signaled seriously taking into account a protracted period of poor economic growth despite the measures already put in place. In this context interest rates will also be kept low for an extended period of time. The Fed minutes contained no major new info for the currency markets but as such, this message is no support for the dollar. EUR/USD extended the rebound that started earlier in US trading and closed the session at 1.3536, still almost one big figure lower compared to the 1.3635 close on Monday evening.
Today, the eco calendar in Europe contains PPI and the German labour market data. However, markets will in first place take a close look at the US ADP labour market report, still considered a reasonably good point for Friday’s payrolls. A job loss of well above 500K could question the constructive investor sentiment that reigned since the start of the new year and might also cap the dollar enthusiasm.
Yesterday, we indicated that we didn’t have a clear take on what should be the next theme to guide trading on the currency markets. Over the previous days the debate between the USD believers and non-believers was also very prominent in the financial press. The dollar believers stress the rebound potential of the US economy in the wake of the multiple policy measures put in place. They also point to the potential loss of interest rate support for the euro as the ECB might be forced to cut rates soon and in an aggressive way as the European economy is sliding deeper in recessionary territory. The dollar non-believers in the first place stress to risks for quantitative easing for the US currency. We are more inclined to join the second group but stay open minded. This debate most probably won’t be decided overnight and in the meantime we take a close look at the technical charts. The US payrolls on Friday are the next key eco release that might help markets to make up their mind.
From a technical point of view, EUR/USD in December broke above the previous sideways trading pattern and an important downtrend line (cf. graph). This had made the LT picture for EUR/USD positive. However, the rebound lost momentum in the second half of December and in a forceful correction, EUR/USD yesterday came close to the top of the previous sideways range (1.3300 area). If this level holds, it might be an indication that the easiest part of the current dollar rebound might be behind us. We don’t speak too loud as there is no clear trading theme yet to guide currency trading. However, we continue to take a close look at the 1.33 support area. If a next test is again rejected, we are inclined to buy EUR/USD on dips. However, tight stop-loss protection is warranted if the pair was to clear this area.
In line with USD/EUR, the dollar was well bid against the yen during the morning session in Europe, but had to give back most of the intraday gains later in US trading. The pair temporary traded above the 93.91 resistance level, but a sustained break didn’t occur and USD/JPY closed the session at 93.65, little changed from the 93.44 close on Monday.
This morning, Japanese stock markets extend the gains of the previous sessions. There were no important eco data in Japan this morning. In the Japanese press there is a report that the government is considering injecting money into regional banks to shore up their capital base, but committed of the authorities to this plan is still far from clear.
Looking at the charts, global market stress and overall dollar weakness in the wake of the US Fed’s announcement on quantitative monetary easing hammered USD/JPY and the pair set a reaction low in the 87.20 area on December 17. Since then, the pair entered calmer waters. USD/JPY first settled in a sideways trading pattern close to the 90 mark and tried to move higher during the first trading days of 2009. Before the holiday break, we had USD/JPY negative bias. In a short-term perspective, the picture for USD/JPY turned more neutral again. If stocks remain positively oriented, the rebound in USD/JPY can go still somewhat further short-term. The 93.91 level (Dec 08 high) is a first resistance level on the technical charts and is under test at this stage. The long-term trend in the pair remains negative and we still look to sell USD/JPY in case of a more pronounced rebound. A sustained rise above the 96 area (23 % retracement MT) would question our standing yen positive bias.
Yesterday, the sterling rebound that started earlier this week continued. The UK data were mixed (Nationwide house prices declined more than expected. The services PMI was less negative than expected). During the morning session, EUR/GBP joined the decline in EUR/USD but even as EUR/USD rebounded later in the session sterling managed to hold on to its gains against the single currency. The UK chancellor of the Exchequer Alistair Darling warned that the UK is far from through the recession and suggested that projections that the economy will recover in the second half of the year might be abandoned. However, even those headlines had no negative impact on sterling. EUR/GBP closed the session at 0.9070 compared to 0.9274 on Monday.
Today, there are no important eco data scheduled for release in the UK.
On the technical charts, the break above a series of high profile resistance levels in November/December has made the long term technical picture outright positive for EUR/GBP. Since start of this week, EUR/GBP showed quite a forceful correction but in our view didn’t change the long-term sterling negative picture yet. We maintain our view that a negative interest rate differential vis-à-vis the euro, combined with ongoing negative eco news contains the risk for sterling to come under pressure again. We are well aware that a lot of negative news is already priced in for sterling at the current levels. However, we think it is too early to expect already a sustained sterling rebound at this juncture. We remain sterling skeptic as long as we don’t receive a sign that the weakness of sterling gets more weight in the BoE’s monetary policy assessment and/or unless we get a clear sign on the technical charts. In this framework we consider the current move as a correction on the steep sterling losses last month. Long term, we still look to buy EUR/GBP on dips but we’re not in a hurry and wait to see how far the current correction has to go. From technical point of view, a drop below the 0.90 area (0.9049 is LT break-up; 0.9015 is LTMA) would indicate that the correction gains momentum. A sustained return below the previous high (0.8663) would question our long-standing sterling negative attitude.
