Markets: Fixed Income
On Monday, global bonds extended their recent decline in an uneventful session devoid of market-moving data and amid low volumes, as investors awaited the vote on the US stimulus package, the outlines of the new financial rescue plan and this week’s refunding auctions. The corporate supply calendar was busy and may have added to the intra-day bearish price action.
In the US, the yield curve flattened, as 10-year yields were unable to break decisively above the 3% level and closed the session unchanged. 2- and 5-year yields were still slightly higher (1.6 and 1 basis points), while 30-year yields declined by 5 basis points.
In the euro zone, the yield curve flattened too in a reaction on the sharp steepening over the previous weeks, which had pushed the spread between 2- and 10-year German yields to its widest level since the start of the EMU in 1999. German 2-year yields rebounded off the cycle lows and rose by 5.2 basis points compared to 4.8 basis points for 5-year yields and 3.2 basis points for 10-year yields. 30-year yields were slightly lower by 1.9 basis points.
US Treasuries little changed aherad of Geithner and the 3-year Notez auction
Today, the eco calendar contains a number of second tier releases that usually don‘t affect trading. Wholesale inventories are expected to have declined (by 0.7% M/M) in December, while the February IBD Economic Optimism index is expected to have slid marginally and the latest Weekly ABC Consumer comfort index is seen stable versus the previous week (-52). All attention will go to the speech of Treasury Secretary Geithner who will outline the main features of his banking plan and the 3- year Note auction that will kick off the refunding operation. Also a testimony of Fed chairman Bernanke on the financial crisis and the Fed programs and a speech of NY Fed Dudley on TIPS are worth keeping an eye on.
Overnight the Senate approved the Obama stimulus package by a 61-36 vote. Today start the talks between Senate and House to reconcile both versions of the stimulus bills which should conclude later this week and allowing president Obama to sign the final stimulus bill probably at the end of the week.
Dallas Fed Fisher sounded pessimistic when he spoke overnight. According to news agencies, Fisher sees the recession to last through the whole 2009, with the unemployment rate exceeding 9%, consumption down and the economy contracting 2.5% (in 2009). He sees no confidence in financial markets and says it is too soon to tell if the stimulus efforts will work. He also sees some risks on deflation. In more general remarks, he said that the Fed’s independence is crucial and so the Fed must avoid the perception that it is monetizing the fiscal deficit. The government should also not bow for protectionism. Interesting, he repeated that the Fed purchase of LT Treasuries is possible. We heard other Fed governors also repeating this, which shows that the Fed is sensitive to the rise in longer term yields and tries to manage market expectations. Will that be enough to keep these yields low or should the Fed have to walk the talk.
The $67B record size refunding operation will kick off with a $32 B 3-year Note auction and shall be followed by a $21B 10-year Note auction on Wednesday and a $14B 30-year Bond auction on Thursday. The auctions settle on February 17 and will raise about $30B in new cash, as a $15.6B 5-year and a $20.7B 3-year Note mature. The Treasury will payout for about $29B in coupon payments, leaving the cash flows surrounding the operation slightly negative. Regarding the 3-year Note auction, its size has again been upped to yet another record high. The January auction, the second monthly 3-year since its re-introduction didn’t go well, but the first 3-year auction in November that was part of the refunding operation was aggressively bid. There is very little relevant historical data available to assess the likely outcome and the different reception between the November auction (refunding) and the January/ February one still raises the uncertainty about its success.
Today, Treasury Secretary Geithner will outline the contours of the revamped financial rescue plan. There is still $350B available from the TARP plan, but the administration will probably need a far bigger amount to clean up the financial sector and help the mortgage and other markets. However, it might not yet ask for more money. In recent days, the financial press has speculated on the content of the plan that underwent quite some modifications during the latest deliberations inside the administration. The report may contain various measures. The government might purchase toxic assets from the banks (so-called bad or aggregator bank idea, but with cooperation of the private sector), but it seems that increasingly the administration is looking instead to give guarantees on the losses of portfolios of assets in exchange of a fee, as it has done in the case of the Citigroup and BoA bailouts. The advantage is that the upfront cost is minor and asking some fees for these guarantees may make more aid for banks politically easier to digest. Congress is indeed highly sceptical and is reticent about throwing more money to the banking sector. Some form of capital injections are also likely to be in the plan, but Geithner indicated on Friday that banks will be obliged to modify loans to get aid. The plan will probably also include more help for the troubled mortgage market and homeowners. The administration is contemplating to support the TALF program of the Fed with more money, allowing the Fed an expansion of its program that should help revive consumer credit, small businesses and student loan markets.
Regarding trading, in thin dealings, Treasuries remained under downside pressure at the start of the new trading week, but closed well off the lows. Effectively since mid January Treasuries have slid ever lower with corrective moves very rare. It wasn’t a particular violent correction, the decline occurred in a kind of slow motion mode. Yesterday, the downside was tested in a session devoid of eco releases or other main events. Investors and traders were waiting for the Geithner plan and the refunding operation and the test of the downside occurred in synchronization with an intra-day revival in equities. Hedging surrounding deals of Cisco ($ 4 B) and Unilever ($ 1.5 B) and the unwinding of these also help to explain both the initial fall and the subsequent rise of Treasuries. The March Note future still tested the bottom of a bull flag and the 38% retracement, but couldn’t take them out, leading to some short covering later on. The 3-year sector underperformed ahead of today’s auction, while the curve flattened. The 30-year yield traded very volatile, but outperformed in daily perspective. It initially rose by about 10 basis points to 3.76%, but turned sharply and fell subsequently very fast to 3.64%. The 10-year yield tested the 3%, but couldn’t sustain. For today, Geithner’s plan and the 3-year Note auction are intrinsically Treasurynegatives, but given recent price action, the technical supports that may kick in (see below) and the Fed waiting in the wings with potential purchases of longer-dated Treasuries, we wouldn’t be too surprised if a buy-the-rumour, sellthe- fact would occur. So a buy-on-dips (see below for corresponding yield terms) might be considered.
The technical pictures of the 5-, 10 and 30-year yields are bearish as they are all reined by double bottoms or said differently, the downtrend in yields has been violated. The 5-year yield currently at 1.94% is well above the neckline double top at 1.80% and targets at 2.30/42%. The 10-year yield, currently at 2.97, has a neckline at 2.60% and targets at 3.07/17%, while the 30-year yield, currently at 3.64% has a major resistance at 3.86%. The targets of the 10- and 30-year are not too far away (the 10-year one was even nearly attained yesterday) and are worth a buy, as it would surprise us if the Fed would allow longer-dated yields to spiral out of control, jeopardizing its efforts to bring private credit market rates down. Fed’s Fisher comments (see above) show that concerns are rising about the rise in long yields. The 2-year yield, currently at 1% has also risen by about 40 basis points from the lows, but as the Fed will keep rates probably low for (much) longer, risks for a further increase of the yields are small.
European yield curve flattens, as 2-year yields fail to break to new cycle lows
In the euro zone, the eco calendar remains thin with only the French and Italian industrial production data for December scheduled for release today. These will once again highlight the arduous conditions in the industrial sector at the end of last year, which will result in very negative quarter on quarter GDP growth data later on this week. This is widely discounted by the market.
Overnight, ECB’s Weber advocated the idea of a symmetrical monetary policy. This would imply raising and lowering rates at a similar pace during upturns and downturns. As such, Weber indicated that he does not oppose aggressive rate cuts in a steep economic slowdown, but stressed that such decisions have medium- and long-term consequences which shouldn’t be overlooked. Weber therefore concluded that in symmetrical monetary policy central banks would also ‘consider a higher key interest rate in the event of an increase in risk in the financial markets, even in the absence of inflationary risk or macroeconomic risks’. Although Weber’s comments are balanced in a medium term perspective, in the current environment they indicate that the risk for ECB rates is still on the downside.
On the supply front, the Netherlands and Austria will tap the market today. The Netherlands will issue a new 10-year benchmark 4.0% Jul19 for an amount of €5B, while Austria will tap its 11-year RAGB 3.9% Jul20 for an amount of €0.75B. The new 3-year Greek benchmark, which will be issued via syndication in the course of this week, is likely to be priced at around 190 basis points over mid-swaps, according to sources close to the syndicate. Ahead of the auctions there was again no underperformance of the Dutch, Austrian or Greek government bonds. On the contrary, the intra- EMU spreads narrowed further, which indicates that the recent improvement in risk appetite is continuing. This was also the case for French government bonds, despite the plans of the French government to lend €6B to the troubled auto sector.
On the money market, the ECB will hold its weekly main refinancing operation as well as a special term refinancing operation covering the current maintenance period (28 days). Both will be conducted under full allotment and at a fixed rate of 2%. These unconventional liquidity measures should ensure that the ECB’s monetary policy is effectively transmitted into the real economy. In this context, the decline in the Euribor rates and the MFI interest rates charged to households and non-financial corporations since the tender procedure has been altered rates indicate that these measures are having an effect. Indeed, since the peak at 6.30% in threemonth Euribor rates, the rate has declined by 420 basis points to 2.10% currently, which is even more than the 225 bps easing the ECB has decided since October. In a similar vein, yesterday’s MFI statistics on interest rates showed another significant decline in December. Although these data tell nothing about the amount of credit provided to the private sector, the declining trend in interest rates charged provide some comfort to the ECB and indicates that its monetary policy isn’t ineffective.
Regarding trading, the bearish sentiment remained intact on the European bond market, even while there was some correction on the recent sharp steepening of the European yield curve. Indeed, in contrast to the previous days it was the short end of the curve that underperformed yesterday, as 2-year yields failed to break below the cycle lows and rebounded. At the longer end of the curve, 10-year yields moved higher too, but the sustained failure of the bund future to break below the December lows at 121.33 indicates that the current correction has little momentum. As such, we are increasingly looking for signs that the correction on the European bond market is running out of steam. A re-break above the neckline of the double top formation at 122.54 would be such a first sign.
In the UK, the calendar contains the December trade balance. The deficit is expected to have contracted from -£4478 to -£4250 after widening in November. However, both imports and exports are forecasted to have declined, as global trade experienced one of its worst contractions in history.
On the supply front, the UK will also tap its 10-year benchmark 4.5% Mar19 for an amount of £3.25B. Recent auctions have showed decent demand, despite the massive amount of supply.
