Markets: Fixed Income
On Friday, global bonds were hit by profit taking, but the extent of the latter differentiated substantially across markets. It was very modest in EMU with yields up between 0.7 and 2.5 basis points in Germany. In a weekly perspective that left German yields still 9 to 26 basis points lower. In the US, yields surged on Friday by 2.5 to 16 basis points, the curve much steeper. In a weekly perspective, US yields declined however a more modest 3 to 10 basis points. In the UK, yields were up on Friday by 5 to 11 basis points, the curve flattening, but in a weekly perspective, yields still declined sharply.
In E(M)U, pronounced pessimism, also by fiscal and monetary authorities, coupled with signs the UK will start soon its version of quantitative easing and the ECB contemplating such a policy too pushed German and UK government bond yields substantially lower. In such a context, Friday’s losses are mild and understandable following a bumper week of gains. However, intra-EMU spreads widened again with Ireland in the focus (see below).
In the US, the combination of the distribution of the supply from the refunding operation, the inability to react on the very weak Michigan consumer sentiment survey and on sagging equities, led to deeper-than-expected profit taking ahead of a long weekend.
ECB’s Stark warns for a crisis in public finances
Today, the euro zone data calendar is empty. Later this week, we will receive the German ZEW index and the first estimate of February PMI business confidence. The German ZEW index is forecasted to show its fourth consecutive improvement in February. The headline index is expected to rise from -31 to -25 due to an improvement in expectations, while the current situation is expected to deteriorate further. In January, manufacturing PMI showed a modest improvement and for February, another slight increase is expected. The headline index is expected to come out at 35.0 (from 34.4). If confirmed, this would indicate that the pace of decline is slowing, as producers are becoming a bit less pessimistic about their business.
Over the weekend, several ECB governing council members indicated that the ECB stands ready to cut interest rates further, but played down expectations that the ECB would soon announce more unconventional measures to boost economic growth. In an interview with the FT, ECB’s Stark defended the ECB’s gradualism approach and stated that ‘overly aggressive reductions in our policy rate when we cannot see any risk of deflation would exacerbate and not resolve uncertainty’. Regarding non-standard measures, Stark warned that ‘an important principle is not to blur the borderline between government and central bank responsibilities’, as he pointed out that, in the US, some of the steps taken by the Federal Reserve had been backed by government guarantees. Stark also warned that soaring public sector deficits in the euro zone were ‘alarming’ and said that the politicians were in danger of creating a ‘crisis in public finance’ that risked ‘prolonging and aggravating the situation’. On Friday, the intra-EMU spreads widened again, as risk aversion flared up over the course of last week on doubts whether the recent US government plans will prove sufficient to overcome the global crisis. On the European bond market, Irish bonds were among the hardest hit on rising doubts about the financial position of Ireland given the huge size of its troubled financial sector. The assets held by its banks are around 10 times the size of its economy, which is the highest ratio within the euro zone following Luxembourg. Last week, Ireland had to inject €7B into its two biggest banks, which resulted in a sharp rise of the CDS on Ireland to a new high of 340 basis points. Hence, despite its AAA rating, the CDS on Ireland is the highest of all euro zone member states. Concerns about a potential default of Ireland were also reflected in a high-profile article in the Sunday Times over the weekend. Concerns about the financial health of the public finances of euro zone member states is likely to lead to a further widening of the intra-EMU spreads. On the supply front, Slovakia, France, Spain and Portugal are expected to tap the market this week. As there are no redemptions scheduled, this means that the net cash flow will again be highly negative to the tune of €15B, but less so than in the previous week (€27.4B).
Regarding trading, the huge gains of the European bond market last week have again improved the technical picture, as 2-year yields fell to new lows and 10-year yields fell again below the neckline of a double bottom formation. The gains came on the back of very soft comments from the ECB, which indicated that the ECB is likely to cut rates again by 50 basis points at their next meeting in March. The ECB may follow the Fed and the Bank of England in their quantitative easing policy. This resulted in a bull flattening of the European yield curve, as the room at the short end of the curve has become limited and longer-term yields reversed their recent upward correction. Indeed, as long as the ECB isn’t finished cutting interest rates and the threat of quantitative easing hangs above the European bond market, a sustainable uptrend in long-term yields looks very difficult. Last weeks gains have now raised the odds for a re-test of the cycle lows at around the 2.9-3% level in 10-year yields. The concerns about the health of the public finances do however support at least some partial profit-taking when these levels are tested. Today, trading may be rather sideways oriented as the US Treasury market is closed and in attendance of this week’s eco data.
