Markets: Fixed Income
On Friday, global bonds continued the trading pattern that reigned all week long, notably they slid lower, leaving yields sharply higher on the week. Risk appetite returned, while upcoming supply continued to be an item out of the curve. The curve however flattened in the US, following a steepening earlier in the week. In Germany, the curve steepened, as it did troughout the week. Yield changes were extreme in Germany, as 10- and 30-year yields added 13 and 20.8 basis points respectively, while 2-year yields were nearly flat and 5-year yields increased by 8.7 basis points. In the US, the belly limited the losses with yields up 2.5 basis points, while the 2 and 30-year yield went up by 9 and 6.4 basis points.
During the European morning session, bonds held up quite well on marginally betterthan expected manufacturing surveys in France and EMU (see news), but also and even more so underpinned by equity weakness, resulting in an outperformance of the short end of the curve. During the US session, which was devoid of macro data, Treasuries corrected lower, resuming the trading pattern of the previous days, on an increase of risk appetite. Indeed, equities rallied, commodities sprung higher and in the FX market, the euro gained (modestly) against the dollar. Traders also watched the upcoming supply in the US with 2-, 5-year Note auctions scheduled for Tuesday and Thursday.
US Treasuries end the week still in corrective mode
Previewing this week’s trading, the eco data, supply and the FOMC meeting are the factors that will drive the markets this week.
After the crash in housing starts and building permits last week, we will receive some data on the existing & new home sales and the S&P Case Shiller house prices this week. Existing home sales (today) are forecasted to have dropped by 2.0% M/M in December after falling 8.6% M/M in November. We see the risks on the downside of expectations after the plunge in the NAHB index and in housing starts & permits, but ironically the high number of foreclosure has helped the Existing Home market keeping up relatively well. New home sales are expected to have fallen by 1.7% M/M (from -2.9% M/M). In the coming months, there might appear some signs of stabilization in the existing and new home sales, but housing starts and permits are expected to remain weak for still some months. It will also be interesting to keep an eye on the inventories.
In the course of next week, we will get more information on situation in the cyclical manufacturing activity. Earlier this month, the NY and Philly Fed showed some sings of improvement and the Richmond and Chicago PMI are expected to confirm the, albeit slight, recovery this week. While it is too early to draw the conclusion that the worst is over, the recent info might be an indication that the pace of slowdown has no longer accelerated. Also consumer confidence is expected to show a modest improvement, but the risks might be on the downside after the plunge in ABC consumer confidence last week (-53 from -49).
On Friday, GDP is expected to show its second consecutive contraction. Fourth quarter GDP is forecasted to have dropped by 5.0% Q/Q (annualized), the biggest slump since the double-dip recession of early in the 1980’s. An even bigger drop is not excluded.
Government bond markets are currently very sensitive to supply issues, also in the US. The budget deficits are blowing out due to the recession and costly bank bailouts. Deficits are negative affected by both the cyclical stabilizators and the stimulus packages. Last week, the market reacted clearly negatively when the issuance details were announced of this week’s 2- and 5-year T-Note auctions and of the 20-year TIPS auction (combined amount of $78B). The size of the 2- and 5-year issues is raised by $2B each to yet a new record high of $40B and $30B respectively. The market is also afraid that the comments of Treasury Secretary Geithner on China as an FX manipulator might lead to tensions with China, the largest holder and buyer of Treasuries. Over the weekend, the WSJ raised the question of the sustainability of funding of the US public debt by China, Japan and the Saudi. Also Freddie Mac asking for an additional $30-35B to prevent a negative net worth and Fannie Mae probably following suit keeps the question of government deficit and financing needs alive. While one shouldn’t immediately see in the results of the auction whether the Chinese are trimming back their purchases, there might be headlines on this in case the auctions are sloppy.
The FOMC meeting (Tuesday/Wednesday) apparently looks to be a non-event for markets. Indeed, in December, the FOMC decided to lower the FF rate to effectively zero (range 0-25%) and no change is expected neither at this week’s meeting, nor at subsequent meetings. So, one important uncertainty that surrounds those meetings is off the table. In December, the FOMC statement said “.....likely to warrant exceptionally low levels of the federal funds rate for some time.”
Nevertheless, there might be some surprises and a number of important issues remain on the table of the governors. Firstly, will the Fed announce new initiatives in its Quantitative Easing (QE) policy? At the start of December, Bernanke said “the Fed may start to purchase longer term Treasuries on the open market in substantial quantities to push long term yields lower”. The idea wasn’t lost to market participants and the 30-year T-bond yield dropped swiftly to about 2.5% from 3.25% on speculation the Fed would implement such a program. However, in the December 16 FOMC statement, it was still put forward as a simple possibility. So the market was disappointed and the yield reversed course and stands currently at 3.32%. After the December FOMC meeting, we thought that the Fed’s hint on buying LT Treasuries would limit the upside in yields. It is difficult to assess whether the pain threshold is for the Fed is reached, but if they feel that they have to counter the current upward trend in yields, a formal announcement of the start of purchases of LT Treasuries would be a major event for markets. However, Treasury Secretary Geithner announced last week that a comprehensive stimulus and financial sector relief plan would be worked out by the Obama administration. In such a context, the Fed might want to wait and coordinate its actions with those of the administration to have the maximum effect. Secondly, Philly Fed Plosser suggested that to counter longer-term inflation concerns about the QE policy, it might be good to introduce a nominal target for the size of the Fed’s balance sheet. However, as Bernanke later on dismissed the idea, it is unlikely to appear in the FOMC statement. Thirdly, the Fed will discuss the central tendency forecasts for real GDP growth, unemployment rate and inflation for 2009 to 2011, but we suspect these to be released on later on. The previous forecast dated from October and was still relatively optimistic on growth and unemployment rate, while inflation remained relatively high. We suspect that growth forecast will be downgraded sharply, but are especially interested in the inflation forecasts. Will they suggest some deflation threat? Fourth, the Fed will discuss the latest Senior Loan Officer survey, which will be made public a few days after the FOMC meeting concludes. As the credit crisis stands central in the Fed’s policy, the findings of the survey are of capital importance for policymakers and markets.
Concluding, while the FOMC statement may be little changed from to the previous one and without new initiatives about the Fed’s credit policy, there are a number of interesting features that may lead to surprises with potential impact on markets.
Regarding trading, last week, the Treasury market showed two different faces. The short and longer end of the curve traded as separate markets. The short end was supported by ongoing bad eco and corpoorate news (equities), while the longer end focussed on supply. As a consequence, the curve steepened dramatically. The 2- year yield was up 9 basis points, but the 5, 10 and 30-year yields climbed by 16, 30 and even 44 basis points, a real crash. For the long bond, it was even the steepest weekly loss since 1987.
The financial sector was under severe pressure. The S&P banking index fell 9% on the week and tested, but did not break sustainably, the cycle lows. So, Libors moved slightly (4-5 basis points) higher and so did swapsspreads (with exclusion of the 30- year spread). Divergence in corporate spreads with investment grade tightening 7 basis points, but high yield spread moving out (+/- 90 bps).
Looking ahead, the eco data should be weak again, but whether they will still be weaker compared to consensus is less certain. The supply (2-5-year) is a hurdle. In recent months, the auctions of 2 and 5-year Notes received a quite good bid from the buy-side, but concerns linger, because of the recent rift with China on FX and also because of Chinese new-year holiday week, that might affect demand. The FOMC meeting could pass without new initiatives announced regarding the purchase of Treasuries. However, looking to the March Note future (and 10-year yield) technical picture, the contract tests previous low and if broken would put a bearish double top on the charts. Well aware that supply is a negative factor that may remain a theme, given recent falls, we would consider a long position in the March contract, but putting stop loss protection (eventually close to 121-28+/121-15+).
Bunds lose further ground, but intra-EMU spread widening still more important theme
Today, the calendar is empty, but later this week, a few interesting data are scheduled for release, especially from the manufacturing sector. Will these show some signs of stabilization (at rock bottom low levels?), like the PMI, released last Friday, suggested. Tomorrow, the German IFO (January) business climate indicator is expected to extend its decline, coming out at 81.0 (from 82.6). The current assessment is forecasted to worsen, while the consensus expects to see a slight improvement in expectations. The January German PMI, released last Friday, was still down, suggesting that indeed the IFO may show a slight further decline, contrary to situation in a number of other EMU countries. The European Commission confidence indicators are expected to show a modest decline in January after falling sharply in December. But a less negative outcome is not excluded after the PMI’s showed a marginal improvement last week. However, in the past the PMIs mostly led the EU Commission survey result with one or more months. On Friday, the first estimate of euro zone CPI (January) is expected to come out at 1.4% Y/Y (from 1.6% Y/Y). The risks might be on the downside of expectations, but the German regional inflation data, to be released on Wednesday, might give us a good indication.
The ECB will hold a non-monetary policy meeting on Thursday. Afterwards we listen always careful to the comments bankers give trough their speeches, as unofficially they do speak about markets and policy during the meeting. This won’t be different this time, but after Trichet ruled out a rate change at the February meeting, there might be less info available afterwards. We have noticed the public appearance of 4 ECB governors, notably Gonzalez Paramo & Weber today and Nowotny and Liikanen on Tuesday. Over the weekend, ECB governor Mersch, a hawk, warned that he would be unwilling to see the ECB refi-rate fall much lower than the current level of 2%, due to the dangers of a liquidity trap. He also signalled unease with the idea of greater supervision powers for the ECB, but coming from Luxembourg’s central banker we shouldn’t maybe too surprised.
The issuance calendar is busy this week, with heavy issuance at the shorter end of the curve. Today, Belgium taps 4 maturities for an amount of maybe each 1 billion. On Tuesday, the Netherlands reopens the July 2011, 2013 and 2015 issues for an amount of maximum €2B. Italy offers the Sept 2010 for €2B on Tuesday, follows with a linker issuance on Wednesday (Sept 2019 BTPei, Sept 2035 BTPei) and concludes on Friday with a 2015 CCT (€1.5B) and taps of the Sept. 2011 BTP and March 2019 BTP (each €3.5B). The cash flows surrounding the auctions are however only negative to the tune of approx. €1.1B versus €7.7 B last week, as there are large redemptions.
Intra-EMU government bond spreads versus Germany widened further last week with Greece (close to 300 Bps) and Ireland (close to 200 bps) the eye-catchers, but the movement was generalized and hit all sovereigns. Some respite was seen on Friday though. The issuance this week is concentrated at the shorter end, which is a positive, but no guarantee that the worst is over. The downgrades last week’s led to expectations of more countries downgraded. Rumours and talks centred around the UK, denied by the rating agencies, and France. In the weekend, a German parliamentary leader of the CDU suggested that the borrowing requirement might be €50B (or even €56B) this year, which would be higher than the €36.8B the government would put forward when it presents its budget on Tuesday. The Czech FM, Kalousek a budgetary orthodox, will put the refinancing risks on the agenda of the February Ecofin meeting.
Regarding trading, also in EMU, the market corrected lower, the curve steepened. However, the short end of the curve (2-year) was largely immune to the worsening, as investors bet on further ECB easing. The correction was at first more subdued that in the US, but that changed towards the end of the week. We were looking for a correction to allow us re-entering the market from the long side. Now it is time to stand by our recent idea. From a technical point of view, the 122.54 support level (previous low/neckline double top) in the Bund and 3.25/30% levels for the 10-year yield, are good levels to enter this trade. However, being not blind for current sentiment, we would put stop loss protection around 121.33 (Dec 12 low). For the shorter end of the curve, we would go long, but only after some more pronounced correction.
