Markets: Fixed Income
On Tuesday, global bonds found their composure after a quite violent sell-off in the previous sessions and closed mostly higher, the curve flatter. In the US, yields dropped between 2.5 and 13.4 basis points, while in Germany, yields were flat (5-year) to 6.7 basis points lower (further out the curve) with the 2-year bucking the trend and adding 1.5 basis point.
EMU data, stronger German IFO, had little impact, while weak US data like softer consumer confidence and ongoing decline in house prices had some modest positive effect. The biggest move was associated though with an unexpected strong 2-year TNote auction and some rumours that the Fed might start buying longer-dated Treasuries. The latter stimulated curve trading and resulted in a flattening of the curve. It explains the underperformance of European bonds too. Also technicals played a role. In the US, the March Note future had reached the key 123-09 support, while the Bund didn’t confirm the break below the 122.54 support that occurred on Monday.
Intra-day, the Bund started little changed, but immediately after the opening tested the downside, setting new sell-off lows. However, there was no really follow through selling and also after the release of the better-than-expected IFO, the Bund didn’t drop lower, bottom fishers appeared and gradually pushed the Bund higher, helped by sliding equities. After US traders got involved in trading, Treasuries (and Bund) moved initially somewhat higher, before receding to opening levels, as traders positioned ahead of the 2-year auction. However, weak consumer confidence lifted prices already ahead of the auction. The curve at that stage had already flattened. The auction went very well and Treasuries jumped accordingly higher, probably helped by a good deal of short covering. Some speculation on the Fed announcing soon that it will buy Treasuries might have helped too. Equities traded modestly higher and volatile, but had little impact on Treasury trading.
US Treasuries rebound sharply after a unexpected strong 2-year Note auction
Today, the eco calendar is nearly empty as the mortgage applications are usually ignored. The market will however be very attentive for the FOMC meeting that concludes in last session with the release of a statement.
Following days of concern about supply, the $40B 2-year Note auction went very well with strong demand. The auction stopped at 0.925%, marginally above the 0.923% in the WI at the moment of the stop. The bid/cover of 2.69 compares to last month’s 2.13 and an average of 2.30. This is very strong given the sharp increased size of the issue. Indirect bidders took down 34.6% of the auction in line with the average. Dealer bid amounted to a record $85.3B, but Indirect bidders $20.4B bid was sharply up from December’s bid and close to the record of $23.5B (October 2008).
The FOMC meeting 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 indeed 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 the framework of 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, with no signs that an implementation was imminent. So the market was disappointed and the yield reversed course and stands currently at 3.32%. Of course, other factors may have played a role too. After the December FOMC meeting, we thought that the Fed’s hint on buying LT Treasuries would limit the upside in yields of longer maturities. It is difficult to assess where the pain threshold in terms of yields lays for the Fed, 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. The announcement of the Fed in the fall that they would start buying Agency MBS and later on the effective purchases pushed mortgage rates about 100 basis points lower, a very favourable movement. However, in the past two weeks 15 (and 30) year conventional mortgage rates have gone up by 40 basis points. The increase of Treasury yields is certainly a factor behind the rise in mortgage rates and an argument for the FOMC to start buying longer-dated Treasuries. However, Treasury Secretary Geithner announced last week that a comprehensive stimulus and financial sector relief plan would soon been 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 governor 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. Also other regional governors sounded critical, even if they supported the policy until now. Bernanke later on dismissed the idea of a nominal target making it 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. 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 however 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.
FT commentator Guha stated in Monday’s edition that whether or not the Fed would unveil new programmes when they meet on Tuesday/Wednesday would depend upon whether it had received risk capital for the US Treasury and had political consent to unveil them. Guha seems to be more optimistic than we are about the possibility the Fed will announce new initiatives (or expansions to existing programs) on Wednesday. We thought that the Fed would postpone new initiatives and coordinate it with the expected Obama stimulus and bank rescue program. Another well-known Fed watcher, Steve Beckner, in his column pointed to the divergence of opinions inside the FOMC on the quantitative easing. The expansion of the balance sheet and the Fed venturing in the credit markets led to criticism of governors Lacker who warned that mixing monetary and fiscal policy is fraught with risks, but also Hoenig and Plosser are no unconditional backers of the QE, to say it mildly.
Regarding trading, supply concerns eased yesterday after the 2-year Note auction went smoothly. The curve steepened also, as hopes mounted that the Fed would soon step in and start buying longer-dated Treasuries. From a technical point of view, the March Note future rebounded at obvious support, which is a positive. Yesterday’s rebound is encouraging following a quite pronounced sell-off in previous sessions. However, we should see first more signs of improvement in sentiment before concluding that the correction is over. The risk for the Treasuries in the next sessions comes from a further recovery of risk appetite. While equities moved a bit higher recently, suggesting that the sell-off is over, it wasn’t really convincing yet. However, the Obama administration advances with its stimulus packages after the Senate Finance Committee approved a $522B package of tax and spending measures, which should be added to a $356B package approved recently by another Senate Committee. There are also rumours the Treasury will soon announce the creation of a bad bank. All these initiatives might stimulate risk appetite which might weigh on Treasuries, unless the Fed intervenes with purchases of long-dated Treasuries. Today, we expect slow trading ahead of the FOMC meeting with equities in the driver’s seat. The reaction on the FOMC statement will probably depend on whether the Fed announces some new initiatives, especially whether it will soon purchase longer-term Treasuries.
Bund struggles higher in attempt to keep techhnical picture from deteriorating
Today, the calendar contains the German CPI inflation data (January), French consumer confidence and Italian business confidence. German CPI inflation (EU harmonised) is forecasted to have dropped by 0.4% M/M in January, after rising by 0.4% M/M in December. On a yearly basis, CPI inflation is expected to have stayed unchanged at 1.1% Y/Y in the first month of 2009. In the coming months, CPI is expected to continue its decline. According to a forecast of the Bundesbank, inflation will fall below 0.5% Y/Y by mid-2009 and might become negative afterwards. The German CPI data are a pointer for euro zone HICP, released on Friday. The first estimate of euro zone HICP is expected to come out at 1.4% Y/Y in January (from 1.6% Y/Y). The consensus expects to see a marginal worsening in French consumer confidence (-45 from -44) and also Italian business confidence is forecasted to deteriorate (65.5 from 66.6), but we believe upward surprises are not excluded, following a string of better confidence reports released recently.
ECB governor Quaden was quoted as saying to a Belgian newspaper that the ECB “is probably ready to lower interest rates further”. If he was correctly cited, he would be the first governor to suggest in such clear wordings that another rate cut is in the pipeline. The comments of ECB governor Nowotny were interesting too. While Trichet and other Executive Board members recently said that there was no noticeable risk of deflation. Gonzalez-Paramo even called risks to inflation balanced on Monday. Nowotny, however said that the ECB was fighting both inflation and deflation and the scale of the financial crisis leaves authorities no room for a “wait and see” approach. Surprisingly, he said that “we do have a big discussion about how to avoid deflation”. This suggests that deflation is considered as a more important risk than officially recognized. Quaden’s comments did push short term yields somewhat lower from intra-day highs and might have capped the violent correction that took place on Monday.
The Dutch Debt Agency sold €2.015B of three DSL lines, the top of the €0-2 B range (5% July 2011, the 4.25% July 2013 and the July 2015). The spread narrowing between German yields and those of other EMU sovereigns continued yesterday.
Regarding trading, following the violent sell-off in recent days, German (EMU) bonds found there composure and yields ended slightly lower with the exception of the 2-year yield that was still marginally higher at the close. On the positive side, the market didn’t react negative on the stronger IFO and didn’t confirm the break lower in the Bund (and 10-year yield) that occurred on Monday. However, it would be wrong to call yesterday’s price action as a strong answer of the bulls to the recent sell-off. The healing process will need time and we want to see confirmation of yesterday’s move to get more convinced that the downside is indeed blocked. The calendar isn’t very enticing. The business confidence reports in Italy and Switzerland should go unnoticed after similar reports have been published in recent days and also French consumer confidence doesn’t look to be market mover. The German HICP inflation data are more interesting, but markets already discounts sharply lower inflation further out. So only a sharp surprise on the downside might be positive, via talk on deflation installing further out. So overall, the global risk appetite/risk aversion pair fuelled by corporate news and equities moves should dictate the direction. However, ahead of the FOMC, no major moves should occur.
The technical pictures of the Bund and the 10-year yield are under test with risk of deteriorating. The Bund fell below 122.55 and the 10-year yield rose above 3.30% on Monday, painting bearish double top/bottom on the respective charts. The moves were not confirmed yesterday though, preventing at least for now to make the MT pictures bearish. If that would still be the case, next levels are 3.55% for the 10- year yield (38% retracement) and 121.33 for the Bund. The targets of the configuration are still much further away.
In the UK, the calendar is empty today. Yesterday, the Gilts underperformed the Bunds, but yields still dropped at least from the 5-year sector out. There was little reaction on the CBI distributive trades report that showed sales remained weak in January and are expected even weaker for February.
