Markets: Fixed Income
On Friday, global bonds could never generate a positive momentum, a feature already visible in previous sessions. This happened despite a number of intrinsically bond-friendly factors like eco weakness, month-end extension buying and crumbling equities. This left US yields little changed on a daily basis with the exception of the 5-year yield that went higher by 5 basis points, but mostly due to a benchmark change. In EMU, the curve steepened with the 2-year yield down 3.5 basis points, continuing its correction following last Monday’s brutal sell-off. The 5-year yield was little changed, but 10- and 30-year yields added 3.3 and 6.6 basis points respectively.
The dataflow nicely painted a good picture of the state of the economy. Eco data were weak and mostly weaker-than-expected while inflation has been falling steeply and faster than consensus anticipated. In EMU, the unemployment rate ticked up to 8% (expected 7.8%), while inflation plunged to 1.1% Y/Y from 1.6% Y/Y previously. In the US, Q4 GDP growth (-3.8%) was well above consensus, but only due to an (involuntary) jump in inventories, which will cause firms to trim production even more in Q1 2009 and thus sets the economy on the road for a probably even worse growth performance in Q1 2009. The Chicago PMI business confidence dropped further in January and Michigan consumer confidence, while a tad above expectations remains weak. The Q4 ECI report showed wage inflation is slowing fast and the GDP deflators suggest that talk of deflation will become louder.
Intra-day, the Bund opened sharply lower catching up with the losses in the US market after the sloppily bid 5-year Note auction on late Thursday. The Bund turned soon higher helped by weak eco data, but couldn’t move above Thursday’s closing level. Treasuries started to rise when US traders got involved and after a brief moment of hesitation continued to rally after the GDP data. However, Treasuries turned south even before the Chicago and Michigan sentiment indices were released and despite equities crumbling. The decline however stopped close to opening levels and trading developed in a sideways manner for the remainder of the session.
US Treasuries cannot generate a positive momentum
Today, the calendar contains the December personal spending and income data and ISM manufacturing (January). These and other data will paint a picture of an economy in recession and households trimming their spending in an effort to cope with the downturn and to boost their savings. In the previous months, personal income held up rather well, while personal spending showed five consecutive months of contraction. This indicates that households were cutting back their spending. For December, the consensus is looking for a drop of 0.4% in personal income, after falling by 0.2% in November. Personal spending is forecasted to show a decline of 0.9%. We also look closely to the development of the deflator. Since the start of the new year, we received some encouraging news from the cyclical manufacturing sector. First, the NY Empire State and Philadelphia Fed surveys showed signs of a recovery and this was confirmed by also a less negative Richmond Fed. The Chicago Fed, on the contrary, showed a slight worsening, but recovered somewhat in the month before. The consensus is looking for a marginal worsening in the manufacturing ISM (32.8 from 32.9). This makes it difficult to come up with a forecast that deviates from consensus.
Later this week, we will receive the first labour market data of 2009. Last month, the organization that is responsible for the ADP report revised its approach in order to bring it more in line with the BLS report. In December, ADP employment plunged by 639 000, while the BLS reported a job loss of 524 000. For January, both reports are expected to show a job loss of about 500 000, slightly better than the December figure, but nevertheless awful. The forecast is in line with the movement in initial claims last month, while continuing claims extended their steep upward trend. We are quite confident that another awful labour market report is scheduled for release.
Supply of Treasuries is a big issue as the borrowing requirements are growing to ever bigger amounts due to the negative effects of the recession on the budget and to the stimulus packages and bank rescue offers. The focus on supply will still be magnified in the next two weeks. Today, the Treasury publishes its quarterly financing requirements, followed by the refunding announcement on Wednesday and the refunding auctions next week. The announcement will contain quite some surprises in terms of record breaking size of both borrowing needs and auctions sizes. Borrowing needs for H1 2009 may exceed $800B, following a $1.19T borrowing in H2 2008. This is huge and unprecedented. While the rationale behind these may be defendable (saving the economy from a crash), for investors it remains stunning amounts and with tensions rising between the US and China, the biggest buyer of Treasuries, there is nervousness about the ability of the government to place the issuance without substantial price concessions.
Richmond Fed Lacker explained why he dissented at the last FOMC meeting. He supports the policy of quantitative easing, but pleads for a policy with a neutral effect across different credit markets. The current policy actively discriminates by favouring some markets like the mortgage, consumer credit or small business lending markets. This has negative effects in those markets that aren’t targeted like the commercial real estate market. Therefore, Lacker prefers buying Treasuries. In other comments, he stated that the government injection of capital into banks under TARP may have discouraged private investors from taking stakes in banks.
President Obama said that Geithner will soon unveil a new strategy for reviving financial markets that gets credit flowing again. We suspect that this new plan will dominate trading his week. Will it be accompanied by the Fed buying longer-dated Treasuries?
Regarding trading, Treasury yields rose last week steepening the curve sharply. The long end was particularly hard hit as the Fed didn’t announce it would start buying Treasuries. The Fed opened the door for such purchases a bit further, but on the conditionality that purchasing Treasuries would be particularly effective in improving conditions in private credit markets. Coupled with huge borrowing needs, it creates unrest and thus selling at the longer end of the curve. The issuance of bank bonds with FDIC guarantee (while not on the long maturities) is of course also a negative for Treasuries. We still believe that the Fed will take action if the sell-off at the longer end continues, but the question remains when it will do so. In the mean time, such an expectation might give some support. Looking forward, there are various potential factors lining up to influence trading. Firstly, the eco data will continue to be weak and thus supportive, but contrary to the situation in Q4, the data itself are more mixed versus consensus. Falling inflation and deflation fears remain a positive longer term feature. Secondly, the Obama administration looks set to come out with a new rescue banking plan soon (including bad bank?) and the stimulus package may follow in a week or two. While many government efforts have passed the revue with apparently not yet really a breakthrough in the financial markets, equities may in a first reaction shoot higher on returning risk appetite and damage for Treasuries, even if at the current juncture a re-test of the lows cannot be excluded either. Thirdly, supply will be the eye-catcher (see higher) which is a negative. Finally, the technical pictures have deteriorated as a ST lower high, lower low and double top appeared on the March Note contract chart. The pictures of the 5-, 10- and 30-year yields showed cracks too.
In this context, cautiousness is warranted. We don’t feel confident enough to use the current upward correction in yields to add to long positions. We prefer waiting for signs that this correction is over before contemplating new longs. On the other hand, we certainly shouldn’t play it on the short side with potential Fed purchases of Treasuries and an, albeit maybe temporarily, return of risk appetite hanging above the market in an overall underlying picture of risks for deflation.
Moody’s revises Ireland’s credit rating outlook to negative
Today, the calendar is thin as it only contains the final figure of January manufacturing PMI. The final figure is expected to confirm the first outcome of 34.5, which showed a slight recovery. Nevertheless, a weaker outcome is not excluded.
Later this week, the calendar heats up with the euro zone December retail sales, German factory orders and industrial production figures. On Thursday, the ECB will announce rates. Euro zone retail sales are forecasted to have dropped by 0.2% M/M in December after falling by 0.1% M/M in November. If confirmed, this would be the third consecutive contraction in euro zone retail sales and raise fears that household consumption will have put a serious drag on fourth quarter GDP. In November, both German factory orders and industrial production surprised on the downside. Factory orders plunged by 6.0% M/M, while industrial production showed an even steeper drop (-6.4% M/M). In December, both factory orders and industrial production are forecasted to show a more modest decline (2.0% M/M and 2.5% M/M).
Moody’s revised the outlook of Ireland’s AAA rating down to negative, but left the AAA rating unchanged. Earlier this month, S&P had already done a similar move. There was no clear reaction on the decision. The 10-year yield spread with Germany stabilized at 225 basis points, while the 5-year spread was slightly wider. Over the weekend, details of the recapitalisation plan for the Irish banking sector suggested that the Irish government would inject EUR 7-8 B, which is substantially more than the 2 B announced under the original plan in December. On the supply front, France and Spain are planning to tap the market this week. France plans to sell between EUR 6-7 B of longer-term OATs (10 and 30-year segment), while Spain will tap the 2- and 5-year segment. Over the past days, the intra-EMU government spreads have narrowed somewhat, but it’s too early to say that the widening trend has turned.
ECB governor Wellink said in the weekend that the financial crisis was not over and new problems were springing up due to a worsening economy in the credit card and commercial mortgage backed securities. ECB governor Liikanen said on Friday that the risks on deflation were small in the euro area, an element that is important in the debate on how low the official rate could fall. Over the weekend, the WSJ also reported that the ECB is drawing up guidelines for European governments that are considering ‘bad banks’ to move toxic assets off the banks’ balance sheets. This should prevent unilateral action that could harm other EU member states.
The ECB shadow Committee voted 13 to 2 in favour of a 50 basis points rate cut at this week’s monetary policy meeting. As headline inflation dropped to 1.1% and the ECB rate standing at 2%, the real official rate is raising. This suggests that the ECB has more room to cut rates. However, Trichet signalled at the January ECB press conference that the ECB would review the situation at the March meeting, making us think that the ECB will stay put in February.
Regarding trading, the technical picture of the Bund is still positive but the ongoing test of the key 122.54 level is a concern and the picture looks heavier every session. A neat break lower might trigger follow through selling. We advocated recently to buy-on-dips towards the 122.54 (with stop loss at 121.33 Dec low) and as long as there is no firm break of that level, we would stick to that point of view. However, we would very well understand those who want to wait until the market has finally made up its mind before contemplating to enter the market from the long side. The more as we expect the ECB keep rates on hold, which may disappoint the European bond market and result in more losses. Hence, ahead of the ECB meeting and US Payrolls report, we would be careful to install new long positions unless equities would break below last year lows.
In the UK, the January manufacturing PMI is expected to fall back towards the alltime lows registered in November at 34.5.
