Markets: Fixed Income
On Thursday, global bonds gained only moderate ground, as investors shrugged off a combination of very weak eco data. In the euro zone, German factory orders registered the second largest monthly drop in December and Spanish industrial production plunged by almost 20% on a yearly basis. In the US, concerns about the state of the labour market flared up again ahead of the US Payrolls report today, as the initial claims hit a 26-year high. US factory orders showed a larger than expected decline in December too.
Despite these very weak eco data, US equities recouped the opening losses throughout the session and closed with decent gains. The strong intra-day rebound of the US equity markets put a lid on the gains of the bond markets, which closed the session only moderately higher. In the US, 2-year yields were down 1.5 basis points compared to 3.9 basis points in the 5-year sector and 2.3 and 3.4 basis points in the 10- and 30-year sector.
In Europe, the ECB and Bank of England interest rate decisions didn’t surprise the bond markets, as the ECB left rates unchanged and the Bank of England cut rates by 50 basis points to 1%. During the ECB press conference, Trichet bolstered rate cut expectations by saying that the euro zone economy is undergoing an extended period of significant economic downturn and indicated that the 2% level won’t be the bottom of the interest rate cycle. Hence, the steepening of the European yield curve continued unabatedly, as German 2-year yields dropped by 7 basis points compared to 2.4 basis points in the 10-year sector and even a slight rise of 2.1 basis points in the 30-year sector.
US Treasuries end the session moderately higher ahead of US payrolls release
Today, the January payrolls report will retain all attention, while the consumer credit data and a speech by San Francisco Fed Yellen complete the calendar. The market is expecting a decline by a net 540 000 jobs, while the unemployment rate should have climbed further to 7.5% from 7.2% previously. We have no reasons to distance us from the consensus expectations. It should be obvious that the report should paint a grim picture of labour market conditions. Initial and continuing claims are at levels last seen in the severe 1981-82 recession. The string of companies announcing mass lay-offs in January was impressive and scaring, while several other labour market indicators brought no solace either. It is impossible to give even an educated guess about the January outcome. Technical factors may play an important role. January is the month with the biggest seasonal adjustment factor, which means that relative small changes in the survey results could be magnified in the SA figure on which markets concentrate. Given the current massive changes in the labour market, this might result in big surprises in the headline figure. In the last 5 years, the actual payrolls were always below the consensus for an amount of 50 000 to 100 000, but this might have been a co-incidence more than a systemic bias in the methodology.
Fed governor Bullard said the US was in a pretty sharp recession and expected Q4 2008 GDP to be revised lower. The contraction would continue in the next months, as the global slowdown is a worrying aspect to the current recession. He defended the zero rate and the QE policies and said the latter can be every bit as effective as interest rate policy. He is aware that if the Fed’s balance sheet increase is permanent it will cause inflation and that the Fed may find it difficult to reduce its involvement in MBS market to shrink balance sheet. . Currently, there is disinflation, but no deflation. On financial markets, he still sees strains despite some improvement and is afraid the financial sector is not returning to health sufficiently rapid to put the economy again on a growth trajectory. Tackling toxic assets on the balance sheets is a priority and the second $350B of TARP should be used for that purpose. Interesting on the subject of the Fed buying long-dated Treasuries, Bullard said a decision ought to wait until it is clear how other credit programs work out. The speech of Governor Stern on the economy brought no real new insights, while Governor Plosser didn’t comment on monetary policy or other for overall markets important issues.
Regarding trading, Treasuries ended yesterday’s trading with some modest and technical insignificant gains. Once more the intra-day price action was a bit disappointed, as early gains on weak eco data (claims & factory orders) were largely wiped out when equities rebounded. Some pre-Payrolls prepositioning might also have taken place. The price action of Treasuries happens against the background of supply concerns (next week’ huge refunding operation), the stimulus package that makes its way through Congress and the banking plan that is expected to be announced next week (Monday). All these background themes are Treasury negative as they may give risk appetite a boost. The Fed entering the play by purchasing long-dated Treasuries, in which we believe, but when? At which levels?)
What will be the market’s reaction on the payrolls? Given the above elements, we think that in case payrolls losses are much higher than expected, let’s say 625 000, Treasuries will rally, but it won’t clear the way for a sustained multi-day up-leg that turns the medium picture again positive for Treasuries. After the initial rally, selling may kick in. In terms of the March Note future, the rally may stall ahead of the 123- 11+/09 level (MTMA/neckline double top). Should the contract clearly close above, we need to re-assess the situation as our reasoning might be wrong.
A better-than-expected payrolls, let’s say losses of 450 000, might stimulate the bears to sell Treasuries. In terms of the March Note future, the 121-26+/15+ level (Flag bottom/38% retracement) may be broken, confirming the MT bearish picture. Given the oversold conditions, the selling might stop at the 121-05+/04+ (break-up daily/Bollinger bottom).
Given the binary risk of Fed purchasing L-T Treasuries we are afraid of short positions at this juncture, even if we think that risk appetite might increase further in the days to weeks ahead. Overnight the Shanghai composite index took out an important technical level, painting a bottom on the charts. It is still early days, but such a configuration often ends downturns. The Chinese equities are of course a cyclical play on the world economy. Yesterday we signalled that the Baltic dry index shot higher on Wednesday and this continued overnight. All signs that maybe, just maybe, the market sniffs some improvement in economic conditions very far on the horizon. Of course, this stands in opposite to our weekly view that we are still looking for signs that the correction has gone far enough to re-enter from the long side. We look closely to markets and data to get a clearer view on the way to module our strategy going forward. The reaction on the payrolls may help us.
European yield curve steepens further
Today, the euro zone calendar contains the German industrial production data for December, the ECB bank lending survey and a speech of ECB’s Gonzalez- Paramo. Yesterday’s very weak German factory orders and Spanish industrial production data for December once again confirmed the extraordinary pace of decline in the economy at the end of last year. This is likely to be reflected in today’s German industrial production too, but this should hardly surprise anymore, as Trichet already indicated that growth will have been ‘very negative’ in the last quarter of 2008.
More interesting will be the ECB bank lending survey, although the survey is unlikely to move the market. During yesterday’s press conference, ECB president Trichet already shed a light on the results of the survey, as he indicated that ‘there are some indications that the pace of tightening of bank credit standards is stabilising, albeit at high levels by historical standards’. During the Q&A, Trichet specified that for the first quarter of this year, banks expected a considerable decline in net tightening for all categories compared with the actual tightening in the fourth quarter. The ECB is nevertheless increasingly concerned about the financing conditions in the euro zone, as the lending growth to households has fallen to historical low levels (almost a standstill) and lending growth to non-financial corporations showed their first monthly decline in December. Hence, despite the substantial reduction in interest rates since October last year, there is little evidence that this has had a stimulating impact on lending growth. As we are approaching the zero bound with ECB interest rates, this may further fuel the debate on quantitative easing.
The speech of ECB’s Gonzalez-Paramo is only scheduled for this evening at 6 o’clock and will therefore be too late to influence trading.
Hence, regarding trading on the European bond market, this afternoon’s US Payrolls report will prove decisive too. Over the past two weeks, global bond markets have corrected lower, as investor’s risk appetite showed signs of improvement. This was mainly reflected in the rise of longer-term yields, but also in the narrowing of the intra-EMU spreads. Yesterday, European bonds gained ground, especially at the short end of the curve, as Trichet suggested that ECB rates have further too fall probably as soon as in March and did not want to exclude the ECB to embark further into ‘non-standard mode’ or quantitative easing. Hence, although the technical picture of the Bund deteriorated this week following the break below the neckline of a double top formation at 122.54, we don’t feel inclined to install short positions as long as it is clear that the ECB isn’t finished in cutting rates and the introduction of a quantitative easing policy still hangs above the market. A break below the December lows in the Bund at 121.33 would nevertheless suggest that the current correction has further way to go.
In the UK, the Bank of England cut interest rates by 50 basis points to 1%. The statement sounded very similar to the January statement and as such contained little new info with regard to the outlook for interest rates. Today, the PPI and industrial production data will be published.
