Markets: Fixed Income
On Friday, global bonds corrected mildly lower, as risk appetite increased modestly. However, following juicy gains thoughout the week, bonds still kept some gains for the week, especially in EMU, where bonds are near the all time lows. The inability of equities to rally convincingly explains why the correction in bonds was mild.
The US equity market reversal late on Thursday and the new measures of US authorities for the financial sector suggested that equities would storm ahead in Friday’s session leading to a pronounced downward correction in the overextended bond markets. US equities closed higher, but it wasn’t a convincing performance at all, even if they ended the session up.
The Treasury/FDIC and Fed announce a rescue package for BoA ($138B of which $20B capital injection). At the same time, the Senate allowed the Obama administration to dispose of the $350B remaining TARP funds from day 1 and the FDIC proposed changes to the TLGP that would prolonge the duration of the loan guarantees (TLGP) to 10 years from 3 years previously.
The US data were mixed: Industrial production was much weaker-than-expected in December, but Michigan Consumer sentiment was better, while December CPI inflation was soft, but slightly less than expected. The data had some very temporarily impact, but it was the global risk sentiment that drove the markets
Intra-day, the Bund opened considerably below Thursday’s close, as it caught up with overnight developments in the US. The ECB decision to cut rates and Trichet opening the door for more easing supported Bunds though, even as equities struggled higher after the European opening. A steep, but brief, fall of bonds in late morning was reversed. In the US Treasury market, the correction was more pronounced and the downside was tested vigorousely. However, equities turned South after the cash market opened, giving Treasuries a boost that allowed them to erase most of the losses. Later on, equities found their composure, dragging Treasuries from the highs and leaving the wings of the curve barely changed for the day, while the belly saw their yields up about 10-to-11 basis points. In EMU, yields even fell almost 5 basis points at the short end, the 5-year yield was little changed, while the 10-year yield was up 4 basis points.
Bund corrects only very moderately
The euro zone calendar is empty today, but later this week we will receive a first sign of how the cyclical manufacturing activity performed at the start of the new year. On Tuesday, the German ZEW survey, a not so reliable precursor for business confidence, is forecasted to show a modest improvement (-42.5 from -45.2). But we see the risks on the downside of expectations as recent data showed that German economic activity is deteriorating at a faster pace than previously thought. In December, we received another extremely weak euro zone PMI figure with all important sub indices deteriorating further and the headline index touching yet another low for the series. For January, conditions are expected to remain very weak in the manufacturing sector and even a marginal worsening is expected. The manufacturing sector is truly an international sector that shows a similar pattern throughout the various trading blocs. In this respect, the first, albeit very fractional, data from the US, the Philly and NY Fed surveys showed no further deterioration anymore. Especially the Philly Fed survey improved versus December. It is too narrow a base to draw many conclusions from these for the EMU manufacturing PMI, but it simply opens the, albeit small, possibility that the EMU PMI’s might stabilize, or even slightly improve.
Besides the PMI’s, market attention will go to ECB speakers. Today, both Constancia, a dove inside the ECB, and president Trichet take the floor. Tomorrow, ECB Nowotny and Sramko, the newcomer from Slovakia, will speak. On Wednesday, we will closely listen to the remarks of Bini Smaghi, an influential Frankfurt-based ECB board governor, who in the past more than once offered some interesting longer-term views from within the ECB. President Trichet’s press conference last Thursday offered some intriguing, but not very clear passus. He warned that the ECB didn’t want to fall into the liquidity trap, suggesting that they wouldn’t follow the Fed and BOJ towards zero rates, but otherwise also hinted that the ECB was using its balance sheet to help ease strains in the funding markets. This sounds like a kind of unofficial quantitative policy. How does this relate to their re-financing rate and the eonia? The latter traded in recent months unusually far below the re-fi rate. Following the latest rate cut, it trades 11 basis points over, but that may be a temporary situation, like we saw following previous rate cuts. So, markets will be eager to get more insights in these comments of Trichet. Will he give them or will Bini Smaghi tell us something more?
New government supply has drawn a lot of attention of recent and with governments implementing stimulus packages and with the deep recession leading to cyclical higher deficits, supply concerns won’t fade away anytime soon. Last week, S&P downgraded Greece and put Spain, Portugal and Ireland’s rating on Negative credit Watch or Outlook. S&P argued that these countries have pronounced imbalances and have lost competitiveness in recent years. The Agency added that in the current bleak global economic environment and given their inability to adjust via the exchange rate, these countries are on the verge of a difficult and painful adjustment process that will deteriorate their public finances. This very much describes the tensions that are inherent to a currency union of countries with very different characteristiques and without a unified fiscal authority. If the situation would deteriorate further to the point of becoming untenable for some countries, it would pose the question of a bail out, expressively ruled out by the Treaty. Should the ECB come to the rescue with the purchase of government bonds of the country that fails. We wouldn’t go as far as suggesting that this would lead to a break-up of EMU, but it would be foolish to rule out some grave problems, if the current economic recession would drag on for a long time.
This week, EMU government issuance amounts to a modest €7B versus €24B last week. On the other hand, there are no redemptions or interest payments scheduled, while last week, these exceeded the amount of new supply. Portugal will hold a €300M reverse auction of its 3.95% 07/2009. The French AFT issues on Thursday three BTAN’s (tap of 2.5% 01/2014 and 2.5% 07/2010 and a new 2.5% 01/2014) for an amount of between €6 and 7.5B and 2 linkers (2.1% 07/2003 OATi & 3.15% 07/2032 OATei). French debt traded well recently and saw little extra widening of spreads versus Germany. Interestingly, Greece will most likely come with a new 5- year syndicated bond. Given recent extreme spread widening and the rating downgrade, it will be interestingly to see how this new issue will be received by the market. It might effect a number of other EMU government bond markets.
Regarding trading, German bonds lost some modest ground, after setting new historical highs in Thursday’s session. Yields at all maturities remain within a few basis points of the lows. This week, only the January PMI’s on Friday and potentially ECB talk will be important. However, supply will continue to get attention especially with Greece coming to the market with a 5-year issue. The US calendar is extremely thin too. So the general theme of risk appetite/aversion will once more the dominating force with the Q4 earnings result season kicking into full swing this week. If equities cannot show a more convincing rally in the next few sessions, the risk is for a retest of the cycle lows. That would be of course a Bund-friendly climate. However, we wouldn’t front-run such a development. The Bund is still overextended and so a deeper correction might be occur, especially should equities after all show more than a tepid countertrend rally of two-three days. The price action on Thursday left on the technical charts a doji-like candlestick (potential trend reversal) at the new highs. While Friday’s price action is a bit confusing, it didn’t really negate the doji. So, while sideways trading might be the name of the game today, in the next days it should become clear whether indeed a more pronounced correction may occur, which is our favourite scenario. From a longer-term perspective, we continue to trade the market from a bullish stance.
From a longer term perspective the picture remains bullish with 122.54 first key support level (buy-on-dips).
