Markets: Fixed Income
On Wednesday, global bonds extended their recent decline on the back of the ADP employment report and the ISM non-manufacturing survey. The negative reaction of the bond markets on the ADP employment report, which was in line with expectations, confirms that sentiment for government bonds has deteriorated of late. Bonds extended their losses following the better than expected ISM nonmanufacturing, but closed off the intra-day lows, as US equities couldn’t hold on to its early gains and closed the day lower.
In the US, the US T-Note future fell temporarily below important support at 121-28+ following the ISM release, but no sustained break occurred. In a daily perspective, US yields were up between 3.3 basis points in the 2-year segment and 5.1 basis points in the 10-year segment. The very long end outperformed, as 30-year yields were almost unchanged. The details of the quarterly refunding showed a record of $67B auctions next week and the introduction of seven-year notes at the end of February.
In the euro zone, the Bund confirmed its break below the neckline of a double top formation at 122.54. The steepening of the European yield curve continued with the spread between 2- and 10-year yields setting new cycle highs at 187 basis points, as 2-year yields rose only 0.3 basis points compared to 2.8 basis points in the 10-year sector. The very long end however outperformed too in the euro zone, as 30-year yields closed nearly unchanged. The slight downward revision of the services PMI had no material impact on trading.
US Treasuries continue to slide lower, but close with only moderate losses
Today, the calendar contains the weekly jobless claims, December factory orders and Q4 Non-farm productivity. Last week, both initial and continuing claims came out higher than expected. Initial claims rose by 3 000 from 585 000 to 588 000. But the figures might have been distorted as the week in question included the Martin Luther’s King Holiday. In the week ended January 31, initial claims are expected to have dropped by 8 000 (from 588 000 to 580 000). Continuing claims, which are reported with a one-week lag, are expected to have risen by 16 000 (to 4 795 000), after climbing sharply in the week before. On the eve of the publication of the BLS payrolls the claims sometimes get more attention, even if the survey week for the payrolls precedes the survey week of the claims. In December, factory orders are forecasted to show the fifth consecutive monthly decline. The consensus is looking for a drop of 3.1% M/M, after falling by 4.6% M/M in the month before. Non-durable orders, the missing part in the factory orders report, should be down too, given the decline in the price of petroleum. The report usually hasn’t that much impact on markets, as the durable orders, part of the factory orders, have already been published in a separate report.
Aside from the eco releases, there are speeches scheduled of the Fed governors Plosser, Bullard and Stern. While Plosser only gives some opening remarks at the food and water conference, Bullard speaks on monetary tools in an environment of low interest rates and Stern tackles the macro and fiscal policy. While interesting, the comments of regional governors in this stage (quantitative monetary policy) should have less impact on markets than in an environment interest rate changes are a key driver in markets. On top of that, none of the three speakers has a vote in this year’s FOMC meetings.
The Treasury announced a $67B refunding package, which is close to expectations, consisting of $32B 3-year Note, $21B 10-year Note and a $14B 30-year Bond. The auctions will be held next week and settle on February 17. The Treasury also announced some significant changes to the coupon auction calendar. From this month onward, the Treasury starts with a new issue monthly 7-year Note auction (end-ofmonth settlement). Estimates are for a size in the vicinity of $25B. The auctions will raise all new cash, as no 7-year Notes mature. The combination of 2, 5 and 7-year Note auctions at month end will give a massive monthly auction package. The Treasury also announced the regular reopening of the quarterly 30-year bond in the month following the initial new offering. So, the first reopening will take place next month. It will raise the number of 30-year bond auctions from 4 to 8 a year. The Treasury will also consider the introduction of a second reopening of the bond. The new initiatives will lengthen the average maturity of the debt that had declined sharply in recent years. The size of the financing needs also means that auctions might go less smoothly and price concessions might be needed. The introduction of the 7-year Note took its toll in the 6-7-year as these became cheaper. The introduction of the 30- year reopening and the possibility the Treasury might decide to open it a second time had only a temporary effect. It might suggest that the Fed is closer to the start of a program to purchase long-dated Treasuries. At the end of dealings, the 30-year had slightly outperformed other sectors of the curve.
Regarding trading, Treasuries lost some additional ground on Wednesday. There was a clear negative reaction after the eco data, even if the ADP report was near expectations. Supply remained a concern (see higher for the refunding operation). Corporate supply included Petrobas, Novartis, Altria and FDIC supported bonds of BoA and Goldman. The data recently caused an asymmetrical reaction in Treasury markets in the sense that better or as expected eco data were a reason to sell Treasuries, while weaker data had little to no effect. Ahead of the payrolls release, we suspect positioning to be the main factor for trading today. Recent losses have been quite substantial and so we don’t expect some additional pre-payrolls selling anymore. Of course, the general sentiment is still bearish. We speculated that some risk appetite would return to the markets. While this wasn’t yet very obvious in the case of equities, we don’t leave that track for now. Eco data are more mixed to slightly better (than expected). Other indications like a surge in the Baltic Dry index yesterday (shipping costs of commodities) and some signs that Chinese companies are upping their purchases of some commodities, while fragile, go in the same direction. On the other hand, the correction has brought Treasuries close to important levels that may give support. The March Note contract nears 121-29/121-15+ (Flag bottom/38% retracement from 109-25). Regarding the 30-year yield, the sell-off has been substantial and we still think that the Fed shall not allow the carnage to continue. In yield terms, levels around 3.85% (now 3.68%) might be the line in the sand. Concluding, we are still looking for signs that the correction has gone far enough to re-enter from the long side.
ECB to hint at rate cut in March
Today, the ECB and Bank of England rate decisions will be the highlights of the day. With regard to the ECB rate decision, the outcome shouldn’t surprise, as Trichet clearly indicated at the January press conference that the next important rendez-vous is in March. As such, the ECB is set to leave rates unchanged today, but Trichet will likely hint at another rate cut in March. Besides the size of the rate cut, the market will focus on the chances the ECB will engage in a policy of quantitative easing and how low rates may fall.
In January, Trichet warned that the ECB didn’t want to fall into the liquidity trap by lowering rates too far, but nevertheless didn’t exclude that rates may fall below the 2% level. As such, we will scrutinize his comments. For now, we expect the ECB policy rate to bottom at 1%, but with downside risks and increased risks on an implementation of a quantitative easing policy. This should keep the short end of the curve well protected, even while the bullish sentiment at the longer end has shown some cracks over the past days.
On the supply front, France and Spain will tap the market today. It’s already the second time this week Spain will tap the market, as it already sold €7B of its new 10- year benchmark via syndication. Today, Spain plans to sell €4-5.5B of its 2- and 5- year bonds. France on the other hand will sell €6-7B of three OATs in the 10- and 30- year sector. Despite the huge amounts in the offing, Spanish and French bonds haven’t underperformed in the run-up to today’s auction. On the contrary, the narrowing of the intra-EMU spreads over the past two weeks may signal that the widening has gone far enough. Supply however remains an important issue that may still influence trading, especially at the longer end of the curve. The recent deterioration of the technical outlook in the Bund and German 10-year yields should therefore be seen as a warning signal that the direction in longer-term yields is not unidirectional downwardly oriented.
Regarding trading, European bonds lost more ground yesterday. Thereby, the Bund confirmed the break below the neckline of a double top formation at 122.54. The move deteriorates the technical outlook, but only a break below the December lows at 121.33 would open the door for significantly more losses. In German 10-year yields, this corresponds with a sustained break above the 3.30% level. Yesterday, 10- year yields closed at 3.36%. Recent trading action has shown the vulnerability of government bonds and has raised the odds for more downward action. However, given the outlook for a protracted economic downturn, the expectation for more ECB rate cuts and the chances on a quantitative easing policy we don’t go short, but wait until the correction has run its course before installing new long positions.
In the UK, the very long end of the yield curve outperformed following the successful 40-year Gilt auction. Today, the Bank of England rate decision will be in the focus. A 50 basis points rate cut from 1.5% to 1% is widely expected, but a smaller or unchanged decision cannot be completely excluded, as the MPC already discussed a pause in the easing cycle at the January meeting and following the recent slight improvement in the UK eco data. The uncertainty with regard to the rate decision has pushed 2-year yields around 20 basis points higher this week.
