Markets: Fixed Income
On Thursday, global bonds had a rollercoaster ride dominated by weakness in eco data and supply concerns. As a consequence, the curves steepened sharply. The inverse relationship between equities and bonds broke down.
Regarding supply, the US Treasury announced a rise in the amount of its 2- and 5- year Treasury Notes that will be auctioned next week. The warning of Geithner about the Chinese manipulating their currency unnerved the market. It might lead to escalating tensions and nurture suspicion that the Obama administration might be more protectionist. This might sap the appetite of China for buying more Treasuries. The French BTAN auction went reasonable well with comfortable bid/cover ratios. .
Regarding the eco data, the French consumption spending, EMU new orders and especially US housing data and claims were simply awful. The US housing market, that showed some fragile signs of stabilization in summer 2008, is simply crashing. This puts hopes for an overall recovery on ice.
Intra-day The Bund opened lower, as it caught up with the overnight movement of Treasuries (and US equities), and immediately declined further on an upped risk appetite sentiment. However, a bottom was quickly found, as European equities didn’t share the optimism US investors had shown on Wednesday, and the Bund gradually moved up again. The up-move continued when US traders joined the fray. The US data were awful, but the rally stalled and was followed later on by a sharp correction lower on supply concerns (see higher). Later on, some ground was regained, but it left US longer term yields (10-30-year) higher for the day. The short end of the US curve got support from the eco data and is less vulnerable in the supply issue and thus saw their yields down on the day. In the EMU, the story was similar, but the recovery after the steep decline was very modest, leaving yields across the curve up on the day.
US Treasury curve steepens under influence of supply concerns and weak eco data
Today, the calendar is completely empty. Attention will go to equities, the earnings reports, especially of GE, and developments in the financial sector.
There appeared some signs that strains in the funding markets are rising. The amount of outstanding CP fell $30B in the most recent week, following a $45.8B drop in the week before. All types of CP posted declines. To make things worse, the Fed reported that its holdings of CP increased by $16B, suggesting that the private holdings fell by $46B. While changes remain small and interpretation of these is difficult, the Libors at various maturities are again on the rise: for 1 and 3 month maturities by 3 basis points.
The US Treasury increased the size of its 2- and 5-year Note auctions by $2B each to a record $40B and 30B respectively. The auctions will be held on Jan 27 and Jan 29. The size of the 20-year TIPS, to be auctioned on Jan 26, was unchanged at $8B.
New Treasury Secretary, Mr. Geithner, upped immediately the pressure on China and Asia by explicitly stating that China is manipulating its currency and warning Asia that it should not intervene to prevent their currencies from strengthening. China has indeed kept its currency stable versus the dollar since the summer of 2008. China, the biggest holder and buyer of US Treasuries, probably doesn’t want to change its current FX policy making the FX issue an item for the Treasury market.
Regarding trading, yesterday, Treasuries continued to correct lower at the longer end, despite weak equities, but in a context of supply concerns. If this is only a correction of the first grade, we should be approaching the end of it. From a technical point of view, the March Note future has strong support at 123-09 (previous low), while the 10-year yield tested 2.60 resistance yesterday, but so far no sustained break occurred. The 30-year yield on the contrary broke through first key resistance (3.17%), while the 5-year yield is still some way off the comparable resistance at 1.80/83%. This all points to a steepening with the shorter end clearly favoured in case of corrections, while the longer end has more potential once the correction is over. Given the fact the Fed is out of the picture at least as far as the FF rate concerns, the shape of the curve is driven by the longer end (supply/ev. quantitative easing measures like buying of Treasuries). The calendar is empty today, so equities and the situation in the financial sector (risk appetite/aversion) might drive the action.
Bund joins US Treasuries down
Today, the calendar contains the euro zone PMI business confidence indicators (December). In December, manufacturing PMI extended its decline with all sub indices showing deterioration. For January, conditions are expected to remain very weak in the manufacturing sector and even a marginal weakening is forecasted (33.1). We have no clear view on the risks as the German ZEW index, admittedly not the best pointer and a survey of investors and not businesses, came out significantly stronger than expected. According to the ZEW, the German stimulus package and ECB rate cut might have been behind the improvement. Also in the US, the Philly and NY Fed showed no further deterioration. Nevertheless, economic growth is expected to have contracted sharply in the fourth quarter of 2008 and also in the first quarter of this year, economic activity is forecasted to decline significantly. Also the Services PMI set a new record low in December and is expected to decline further. The consensus is seeking for an outcome of 41.5 (from 42.1).
There were interesting comments of ECB members Bini Smaghi and Mersch reported in the media. Bini Smaghi entered the debate on how far the ECB could lower rates. He said it would be risky and unjustified at present to take rates close to zero, a point of view also defended by president Trichet recently. He didn’t completely exclude the possibility though and explained under which extreme conditions, that aren’t fulfilled currently, this might happen. Only when deflation was a substantial risk nominal rates should be taken to zero. The extreme situation he referred to was specified as “one in which inflation remains at very low or negative levels on a sustained basis and expectations shift in line with actual inflation, which is equivalent to deflation.” He does see in the next months a sharp disinflation but no risk of deflation. In other comments, he said that he saw no risk of EMU unravelling or that a euro country would default on its debt. The current level of default risk implied in the CDS of some countries was quite irrational he added. In a related issue, ECB Mersch said the ECB would be reluctant to extend emergency financial help to countries hit by the credit crunch outside the euro zone. He added that the ECB’s rules only applied within the EU borders. As the ECB already did help Hungary and Poland, we suspect that he only refers to countries outside EU, like Serbia, Croatia and Ukraine.
The remarks of Bini Smaghi indicate that currently our expectation for a 1% bottom in ECB rates is appropriate. As market expectations stand at about 1.1% the scope for lower rates at the short end of the curve are limited for now. One caveat, the rate expectations are derived from Eonia futures, that take into account that it is currently allowed to trade below the ECB repo-rate.
Regarding intra-EMU government bond trading, the Portuguese, Irish, Greece, the usual suspects, but yesterday also Belgium yield spreads versus Germany widened noticeable, while spreads of France, Spain and Italy amongst others stabilized or even narrowed slightly. The S&P rating downgrade of Portugal once more highlighted the weak position of a number of governments.
Regarding trading, German bonds were in correction mode since the end of last week and that continued on Thursday. At the start of the session, the correction was driven on the hope of a return of risk appetite, but that argument vanished when European equities traded weak following a strong opening. So, the Bund recovered erasing all early losses, until a new violent correction took place in the afternoon session on the back of US supply concerns (more US supply and Geithner’s remarks on Chinese Fx policy). After a bottom was reached, there was a slight rebound, leaving the curve steeper and the long end quite a bit lower. Today, the PMI data might play a role in trading, but we have no reasons to distance ourselves from consensus The US eco calendar is empty. So equities (GE earnings) might play a more prominent role than yesterday.
Our strategy remains unchanged. We are positive on the short end of the curve, but the room to rise is limited with yields at 1.41% (2-year). Therefore a buy-on-dips is appropriate. We are also bullish for the longer end and look to enter the market in case of corrections (that are occurring now). Good entry point for the 10-year is in yield terms 3.25/30% or in Bund terms 122.54.
In the UK, the calendar contains the first estimate of fourth quarter GDP and the December retail sales. Fourth quarter GDP is expected to confirm the sharp recession the UK is facing (and officially entering). The consensus is looking for a contraction of 1.2% Q/Q, the weakest quarter since the recession of the 1990’s. Yesterday, GDP figures from China and Korea already proved that global growth fell of the cliff. UK will be the first EU country to publish its GDP results. UK Retail sales are expected to have dropped by 0.7% M/M in December after a rise of 0.3% M/M in November. The ONS measure is forecasted to show a softer decline compared to the BRC figure as it removes the effect of price discounting.
Talk about a downgrade of the UK rating that flared up in recent days. Earlier S&P dismissed it and yesterday Moody’s said that the UK debt rating is no weaker than that of other nations with AAA ratings, despite the bank bailouts. Moody’s of course also said that the government balance sheet had obviously deteriorated, but also that it didn’t make the UK a clear outlier vis-à-vis its AAA peers. In the morning a very weak CBI industrial trends report offered some support for Gilts. Gilts outperformed bunds for the second consecutive day, which is a corrective move on the sharp underperformance that occurred since the start of the year. As was the case elsewhere, the curve steepened with supply an ongoing issue. Today’s eco data might impact the market.
