Markets: Fixed Income
On Wednesday, global bonds extended Tuesday’s rebound amid ongoing uncertainty about the impact of the US government plans to stimulate the economy and support the financial sector. The deal, reached yesterday evening, between US congressional leaders on the stimulus package failed to change the course of events on the US bond markets, although equities reacted slightly positive.
At the same time, central bankers around the globe appear to be moving ever closer to a quantitative easing policy to overcome the crisis, as the Bank of England suggested it may decide to adopt such a policy as soon as the next meeting. The Swedish Riksbank cut rates by a more-than-expected 100 basis points to a very low level of 1% and several ECB policymakers indicated that the ECB has room to cut rates to below 2%. Supply concerns eased further. Following the strong 3-year Note auction on Tuesday, the 10-year Note auction was also absorbed well.
Both in the US and the euro zone, there was a flattening of the yield curve, as longer-term yields benefited the most from the debate on quantitative easing. In the US, 2-year yields were up 2.5 basis points compared to a decline of 6 basis points in 10-year yields. European bonds outperformed US Treasuries, as German 2- year yields fell 9.8 basis points, while 10-year yields dropped by 15.4 basis points. UK Gilts however performed still better, as yields declined by almost 30 basis points in the 2-year sector and 24 basis points in the 10-year sector in a response to the Bank of England inflation report and quantitative easing policy.
Longer-dated US Treasuries make some additional gains
Today, the calendar contains the retail sales (January), weekly claims and business inventories (December). The retail sales have fallen for an uninterrupted 6 months with especially the last three months showing steep monthly declines of -3.4%, -2.1% and -2.7% respectively. The retrenchment of consumption is exceptional and driven by a too high household debt load and the need to deleverage in the context of a very fast rise in unemployment, slowing income and restraint credit availability. The market expects another, albeit more moderate (0.8% M/M), decline in January. Most categories of spending will indeed decline further, but a price-related rebound in sales at gasoline stations and higher grocery store sales (they fell very sharply in December) put the risk at the upside of consensus though. Last week, initial claims rose to the highest level (626 000) since October 1982 and for the week ended February 7, another awful figure is expected. Market expectations are looking for a figure of 610 000. Continuing claims, which are reported with a one-week lag, are forecasted to set another record high at 4 800 000.
The $21B 10-year Note auction was mixed, as demand was healthy, but bidding a tad sloppy. Indeed, the auction stopped at 2.818%, slightly above the 2.805% bid in the WI at the moment of the stop. The bid/cover of 2.21 was in line with the 12- month average which should be considered as good, given the sharp increase in the size of the auctions over the last year. The Indirect (buy-side) bid was solid with a takedown of 37.8%, above the average for re-funding 10-year auctions of 36.8% and above the overall average of 26.6%. The increased size of the auctions might mean that the Treasury will have to accept some price concessions at auctions, a phenomenon also visible in EMU government auctions.
Today, the quarterly refunding operation will be concluded by a $14B 30-year bond auction. It will be a new issue that will be re-opened in March. The relevant historical statistics is short, as the 30-year bonds are only re-introduced in February 2006. In this period, the bid/cover amounted to 2.1 on average and the stop occurred slightly above the bid in the WI trading at the moment of the stop. These averages however hide very erratic results. The auctions were dealer dominated (81% of the bids) and new issues fared better than re-openings. So uncertainty about today’s auction is high, but the outcomes of the 3- and 10-year auctions in recent days are encouraging. The 30-year sector also cheapened compared to the 2.50% lows registered in mid December, but is 34 basis points off the highs set late last week. The possibility the Fed may decide to buy longer-term Treasuries is another positive, but an article in the WSJ said that the Fed was reluctant to buy longer-term Treasuries, because this could make it harder to reverse course when they ultimately need to raise interest rates. Nevertheless, we are not too afraid of the auction, even if the issue may stop above the WI bid (see above).
Board Fed governor Duke in a speech on the housing market said that more needed to be done to break the current downward slide in the housing market. The government promised on Tuesday that a plan to support the housing market was under preparation. She broke no really new ground on the subject, but her observation that “the potential for an overcorrection of house prices in this cycle seems particularly acute, given the potential for foreclosures to create a glut of properties for sale” is worth mentioning. She offered some possible solutions like a change in terms of the mortgage (changing interest rates/adjusting maturity) or writing down loan principal amounts. Chicago Fed governor Evans, contrary to governor Duke, was more outspoken in his comments on the outlook for the economy. The economy is in for a protracted period of poor economic performance. He sees the current recession resemble more to the severe downturns in the 70s and 80s than to the moderate ones of 1990 and 2001. He expects a markedly fall in real GDP in H1 2009, with some recovery later in 2009. Unemployment will continue to rise into 2010 and deflation is a concern, for which an inflation target may help prevent it.
Regarding trading, yesterday longer-dated Treasuries eked out moderate gains, continuing the rally that started on Tuesday, while the shorter dated issues ended with moderate losses, flattening the curve. The BoE suggesting it may soon start a policy of quantitative easing lifted also US Treasuries, who profited from a mild return of risk aversion. The 10-year Note auction went reasonable well, but didn’t really move the market. Today, the eco data, while probably weak, may be mixed to better than expectations and therefore not a positive for Treasuries. If the 30-year bond auction goes well, there might be some relief that the refunding is finished, supporting the longer end. The more general risk appetite/aversion theme will be omnipresent. Last week, it seemed that risk appetite began to regain ground, but the sell-off in equities following Mr. Geithner’s remarks on the banking plan put that prospect into question. Also commodity prices eased again. On the other hand, overnight Chinese money and lending figures were very strong, suggesting that some cyclical improvement in the global economy might nevertheless be developing, albeit from very low levels. Therefore, we stay cautious, even if some modest additional gains might be possible. There is no clear LT technical buy signal is available in longer-dated T-yield charts. The situation at the shorter end is more straightforward. Given the Fed outlook, the upside in yields at the 2-3 year maturities is small and some long positions may be considered.
BoE set to install a quantitative easing policy
Today, the eco calendar contains the euro zone industrial production figures (December). Last week, German industrial production showed its biggest monthly drop on record in December. Industrial production fell by 4.6% M/M in Germany, almost twice as much as was expected. On Tuesday, also Italian industrial production surprised on the downside, while French came out in line with expectations. Euro zone industrial production is forecasted to have dropped by 2.5% M/M in December, but the risks might be on the downside of expectations after the weaker than expected German and Italian figures. However, market impact might be limited as the data are outdated.
On the money markets, conditions continue to improve, as demand and the number of participating banks at the supplementary refinancing operations declined sharply. As a result, the amount deposited at the ECB’s overnight facility declined, too. The easing in tensions is also reflected in the narrowing of the liquidity spread, as the Euribor rates have fallen lower with the 3-month Euribor rate even falling below the 2% level this week. This is very important, as many bank lending interest rates tend to adjust in line with the 3-month Euribor rates rather than the ECB policy rate.
In recent days, several ECB policymakers have indicated that the ECB has room to cut rates further given the current outlook for inflation and growth. As such, current market expectations for a 50 basis points rate cut at the next meeting in March now look like a done deal, although the size hasn’t been confirmed. The dovish comments from the ECB policymakers have pushed German 2-year yields again towards the cycle lows at 1.35%, but these will remain difficult to break below, as most policymakers consider zero rates as inappropriate. The approaching of the zero border is however likely to fuel the debate on more unconventional measures in the euro zone too. In this context, yesterday’s comments of the BoE indicate that such measures may become inevitable (see below) and supported the European bond market too. As long as the ECB isn’t finished cutting interest rates and the threat of quantitative easing hangs above the bond market, a sustainable uptrend in yields looks very difficult. Yesterday’s sharp decline in yields was also significant from a technical point of view, as German 10-year year yields fell again below the neckline of a double bottom formation at 3.24% (see graph) and the Bund confirmed Tuesday’s rebound above the neckline of a double top formation at 122.54. This raises the odds for a re-test of the cycle lows at around the 3% level in 10- year yields. We would however consider profit-taking on longs at around these levels, as these have already been tested and rejected 3 times.
For the first day in several weeks, the intra-EMU spreads widened again too, even though the German Bund auction wasn’t a success. Belgian government bonds in particular underperformed, as the Fortis shareholders voted against the nationalisation of the Belgian and Dutch banking and insurance activities and thereby also rejected the sale of the Belgian banking activities to BNP Paribas. The result means that BNP Paribas now has to choose between renegotiating the deal, pursuing the acquisition in court or abandoning the deal all together. In the worst case of an abandoning, the Belgian government would have to assure the funding and liabilities to protect the savers, which would put a heavy burden on the public finances and lead to a further widening of the spreads.
In the UK, Gilts outperformed sharply yesterday, as the Bank of England painted a very bleak picture of the UK economy and indicated it could start a quantitative easing policy as soon as the next meeting. In its February inflation report, the Bank projected a very deep recession and expected inflation to fall to 0.5% and to remain well below the 2% target in the medium term. If the movements in the policy rate prove insufficient to meet the inflation target in the medium term, the Bank stated that it could start purchasing a range of financial assets, including government securities (Gilts) and the private sector assets targeted by the current Asset Purchase Facility( corporate bonds, commercial paper and paper issued under the Credit Guarantee Scheme), by expanding the quantity of its central bank reserves.
Today, the DMO will issue a new IL Gilt 1.25% Nov 2027 for an amount of £1.1B.
