Markets: Fixed Income
On Tuesday, global bonds reversed Monday’s gains, as US equities rebounded despite mixed earnings. The S&P 500 closed 1.58% higher, as better-thanexpected results from Merck and Schering-Plough offset Motorola’s decision to suspend dividend payments. The Fed decision to extend its liquidity facilities and currency swap lines with 13 central banks until the end of October contributed to the glimmer of optimism. In addition, supply from Agency and Corporate sectors ahead of the US refunding announcement today may have weighed on the performance of US Treasuries.
Hence, US Treasuries reversed Monday’s gains and yields were up 7 basis points in the 2-year segment compared 15.5 basis points in the 5-year and 16.2 basis points in the 10-year segment. As such, 10-year yields confirmed the break above the neckline of a double formation at 2.60%.
On the European bond market, the losses were more limited, as the gains were more limited too on Monday. The short end continued to outperform and gained further ground ahead of Thursday’s ECB meeting. Hence, German 2-year yields fell again below 1.50% and remain close to the all-time lows at 1.35%. At the longer end of the curve, German 10-year yields rose by 5.2 basis points to 3.33%. If confirmed this would also paint a double bottom formation on the screens and deteriorate the outlook for longer-term European bonds.
US Treasuries reverse Monday’s gains on improved global sentiment
Today, the calendar heats up with the ADP employment report (January), nonmanufacturing ISM (January) and weekly MBA mortgage applications. The Treasury will announce the details of next week re-funding operation. Last month, the organization that is responsible for the ADP employment report revised its approach in an attempt to bring it more in line with the BLS payrolls report. According to the new approach, employment dropped by 693 000 in December, while the BLS reported a number of 524 000 job losses. In January, still leaving some doubts on the correlation between both reports. ADP employment is expected to have dropped by 530 000. We have no clear view on the outcome, but all available evidence points to another awful picture of the US labour market. On Monday, manufacturing ISM showed an unexpected improvement in January. The headline index rose from 32.9 to 35.6 due to an increase in new orders and production. Today, non-manufacturing ISM is forecasted to have worsened marginally in January (39.0 from 40.1) after showing a slight recovery in December. Nevertheless, given the good correlation between both surveys the risk is for a better than expected outcome. The weekly mortgage applications were sharply down in the previous week and have actually lost all the gains registered after the Fed announced it would purchase Agency MBS securities and mortgage rates dropped. However, after touching a low in mid January mortgage rates have gone up again by about 50 and 30 basis points for 15 and 30-year FRM. While these volatile weekly statistics should be looked at in a longer term perspective, more negative figures might get the Fed quite nervous, as it would suggest that its policy isn’t working as expected.
Overnight, the latest weekly ABC Consumer Comfort index was reported at -52, up 2 points from -54 in the previous week, which was the lowest level in the cycle. While positive, we need a few more weeks of observations before eventually concluding that consumer confidence is improving.
The Treasury announcement of the details of next week’s refunding operation will get quite some attention, as abundant supply is a concern for many market participants. Expectations are for a package of about $66B, which would be a record high size. The operation would raise $9.7B, as about $57B of 3, 5 and 10-year Notes mature. The Treasury will pay about $30B in interest coupon payments leading to a cash infusion of about $20B. The composition of the 3-, 10- and 30-year Note/Bond auctions maybe in the neighbourhood of $30-32B for the 3-year Note, $20-22B for the 10-year and $16-12B for the 30-year. All these amounts are record high sizes. The Treasury has in recent months modified its auction cycles and more changes might be announced today. This is needed to accommodate the sharp rise in borrowing needs. Some suggestions we heard in the market are the introduction of a second monthly 52 weeks Bill auction, the introduction of a 7-year Note auction and a reopening of the 30-year Bond. In the TIPS sector, there might be the introduction of a 30-year TIPS auction, an increase in the size of 10-year TIPS auctions, while the 5- and 20-year TIPS issuance might be cancelled. The Treasury introduce a re-opening of the 30-year bond, if decided, might be an indication that the Fed is closer to purchase long term bonds in the framework of its quantitative easing policy.
Regarding trading, Treasuries sold off sharply, effectively reversing Monday’s gains. Many observers point to the Pending Home sales as the trigger for the selling wave, but we don’t buy into it. Firstly, the sell-off started about 15 minutes after the release and the indicator is not very reliable and traditionally no market mover. It also is the least important housing market indicator (see news). We already were suspicious about Monday’s rally that also missed a clear driver. So, we shouldn’t be too surprised with yesterday’s decline. We think that a return of risk aversion and supply are weighing on the market amid a deteriorated technical picture. The Pending Home sales, while not important, of course fit into the reigning sentiment. In this respect, markets ignored the more important and timelier, but dismal car sales figures for January. On supply, corporate issuance remains hefty and the market remain focussed on government supply (today’s refunding announcement). Today’s data are interesting and while the relationship between ADP and BLS payrolls has been weak (see above) a surprise might still impact the markets, especially should it bolster risk appetite. The refunding announcement including the potential changes in the auction cycle might affect the internal curve dynamics.
Re-iterating our weekly strategy, while we aren’t especially bearish on Treasuries, we are simply cautious and don’t feel confident to take long positions. 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 Treasuries. Supply remains an eye-catcher (see higher) which is a negative. Finally, the technical pictures have deteriorated as a ST lower high, lower low and double top and double top have appeared on the March Note contract chart, while 5, 10- and 30-year yield charts show double bottoms.
Technical picture Bund deteriorates
Today, the calendar includes the final figure of the euro zone services PMI (January) and retail sales (December). The services PMI is expected to confirm the slight improvement in the first estimate from 42.1 to 42.5. The December retail sales will give us an indication whether consumers scaled back their Christmas shopping. Euro zone retail sales are expected to show the third consecutive monthly decline in December. On a monthly basis, retail sales are expected to have dropped by 0.2% M/M, but the risks might be on the downside of expectations after the disappointing German retail sales published yesterday morning.
On the supply front, Spain, as expected priced, its new 10-year benchmark at 90 basis points over mid-swaps. Despite the very cheap pricing, the overall narrowing of the intra-EMU spreads continued yesterday. Later on this week, France plans to sell between €6-7B of longer-term OATs (10 and 30-year segment), while again Spain will tap the 2- and 5-year segment.
Regarding trading, European bonds traded mixed yesterday, as the short-end of the curve gained further ground, while the longer end declined and thereby fell below the recent lows at 122.54. If confirmed today, this would further deteriorate the technical picture and raise the odds for a test of the December lows at 121.33. The move was also reflected in German 10-year yields, where a double bottom formation is now on the screens. Today, the market reaction on this afternoon’s US ADP employment report could form an important test for the recent deterioration in sentiment on the bond markets, certainly in case the report would be weaker than expected. For now, we remain cautious and wouldn’t install new long positions despite the weak economic outlook and our expectations for more ECB rate cuts to come. With regard to this Thursday’s ECB meeting, we however expect the ECB to leave rates unchanged, which could create additional room for correction on the bond markets.
In the UK, the calendar contains the services PMI (January). Business confidence in the services sector is forecasted to have stayed broadly unchanged in January. The consensus is looking for a figure of 40.3 (from 40.2), but a higher outcome is not excluded after the upward surprises in manufacturing and construction PMI.
On the supply front, the DMO will tap the very long end, as it plans to sell £2B of its Gilt 4.25% Dec 2049. Recent demand has been quite solid for Gilt issues, but the recent deterioration in market sentiment may weigh on demand today.
Overnight, the NIESR institute forecasted the UK economy would shrink 2.7% in 2009 and urged the BoE to start purchasing bonds and commercial paper. ‘I would be inclined to do it sooner rather than later’, NIESR’s director Weale said and added that he doesn’t see ‘any reason why conventional interest changes should be preferred over this sort of policy.
