Markets: Fixed Income
On Monday, trading was much thinner than usual, as US markets were closed in observance of President’s Day. German bonds rallied on risk aversion pushing German yields 6.5 to 8.8 basis points lower. The 2-year yield set new lows and the 5-year yield tested the all-time lows.
Doom and gloom was again the main driver in a session devoid of eco reports. The Anglo-Saxon press published over the week-end very negative analysis of Ireland suggesting the country might default and other articles saw an implosion in Central Europe leading to the second phase of the global meltdown. For more details, see lower. The risk aversion led to a pronounced widening of the intra-EMU bond yield spreads with benchmark Germany. Greece, Portuguese and Austrian 10-year yield spreads widened by about 17 basis points, Ireland and Belgium followed by 13/14 basis points, while Italy held up slightly better at +7 basis points. Overnight, a Moody’s research piece said that the East European crisis weighs on bank ratings.
US Treasury trading resumes
Today, the calendar contains the NY Empire State Manufacturing index, NAHB housing market index and weekly ABC consumer confidence. Last month, the national ISM business sentiment showed a positive development, as the headline index rose from 32.9 to 35.6, while only a marginal improvement was expected. In February, the NY Fed is expected to show a marginal decline (-23.75 from -22.2), following a gain in January. But a slight improvement is not excluded and this might have a positive impact on investor’s sentiment. Later this week, the Philly Fed is also expected to show a modest, albeit irrelevant, decline.
Last month, the picture on the housing market was mixed. We received some encouraging news from the existing housing market. Both existing and pending home sales were rising after sharp declines in the months before. But it was too early to become more optimistic as about halve of these sales were foreclosed houses that were sold at distressed prices. Housing starts and permits on the other hand, set new record lows in December and another weakening is expected for January. Today, the NAHB housing market index is expected to stay unchanged at the record low of 8.
This week, attention will also go to the January inflation data. Consumer price inflation is forecasted to show its first year-on-year decline since 1956, which will stoke fears of deflation. On a monthly basis however, inflation is expected to have risen by 0.3% M/M in January, which might be partially due to the stabilization in oil prices in January. Also core CPI, excluding food and energy, is expected to show a rise in the month-on-month figures after staying flat in the two previous months. Although the monthly figures might stabilize in the coming months, the yearly figure is expected to decline further.
Regarding trading, Treasuries were hit sharply by profit taking on Friday, ahead of the long weekend, as dealers distributed the new supply of the refunding operation. Treasuries trading restarted in Asia with a stellar performance. Risk aversion is returning with a vengeance with now Central and Eastern Europe in the eye of the storm having negative repercussions for the European banking sector too. Gold is another outperformer. The global theme of risk aversion may later on also affect the US market. We have no strong view on the outcome of the NY Fed survey on manufacturing, but a renewed steep fall in the current environment and following dismal Japanese data yesterday (GDP) and today (PMI-Tertiary index) would be a positive. The fate of the carmakers is also in the focus, as they have to present their restructuring plan to officials. Equities will be closely watched, as the indices (S&P and Dow) linger still near the key support area of 790-741 for the S&P. While we don’t want to front-run an eventual break through that support area, a test shouldn’t be excluded. A sustained break would be highly relevant, also for Treasuries and it might signal that the markets start believing in a depression instead of a severe recession. While this should be positive for Treasuries, the technical pictures don’t make us confident enough to front-run such a break. Indeed, 10- and 30-year yields charts aren’t univocally bullish, while the 5-year yield (now 1.73%) tries to break again below the neckline of a bearish double bottom formation at 1.80%, which if confirmed would be a positive. So cautiousness remains warranted.
Exposure to Central Europe drives intra-EMU spreads wider
Today, the calendar contains the German ZEW survey (February) and euro zone trade balance (December). The German ZEW index is expected to extend its upward trend in February. The consensus is looking for its fourth consecutive improvement, with the headline expectation index rising from -31.0 to -25.0. The current situation, on the contrary, is forecasted to deteriorate further. Recently, the ZEW index lost much of its correlation with other confidence indicators and market impact is therefore likely to be limited. The euro zone trade deficit is expected to have widened (from 4.9B to 5.3B) in December. As traditional for periods of recession, both imports and exports are forecasted to have declined sharply.
Yesterday, the German bond market had another strong session on increased risk aversion. However rising concerns about the fiscal sustainability of several euro zone countries led to an impressive widening of the intra-EMU spreads. Indeed, the banking sector of several EMU member states is heavily exposed to Central and European economies and is now feeling the brunt of the sharp deterioration of the situation in that region. That is affecting the overall risk position of various EMU member states, as these may have to support their banking sector. Overnight, a report of Moody’s indicated that banks with subsidiaries in Eastern Europe may face rating downgrades, as the economies in the region deteriorate. The report warned that ‘the downturn in Eastern Europe will be more severe as a consequence of many countries’ dependence’ on capital flows from West European banks. Eastern European loans for example account for 75% of GDP in Austria, the highest ratio within the euro zone. In an article in today’s FT, the Austrian central bank governor Nowotny stepped up its campaign for the EU to aid struggling Eastern European economies saying that ‘I cannot imagine a policy of benign neglect will be the last word’ for countries of strategic importance such as the Ukraine. Yesterday, S&P put Ukraine on negative credit watch, as it waits for clarification of the country’s willingness and ability to fulfil the conditions of its IMF loan. Given its huge exposure to central Europe, the spread between German and Austrian 10-year widened dramatically over the past days and set highs at 120 basis points, while the other intra-EMU spreads are now again approaching the recent highs.
On the ECB front, ECB’s Stark already warned over the weekend that soaring public deficits in the euro zone were ‘alarming’ and added that politicians were in danger of creating a ‘crisis in public finances’ that risked ‘prolonging and aggravating the situation’. In his speech before EU parliament, ECB’s Trichet stressed that ‘it is of the utmost importance that policymakers do not merely focus on short-term solutions and instead adopt a longer-term perspective, with the objective of ensuring a sustained recovery’. Therefore, Trichet said that ‘credible exit strategies must be planned and promptly implemented once macroeconomic measures have had their desired effects’. Yesterday, the German Finance Minister Steinbrueck warned that ‘some countries are step by step approaching solvency difficulties’, but added ‘the other countries in the currency union would have to help states that face bankruptcy’.
Regarding trading, increased risk aversion is driving German yields ever lower. Yesterday, German 2-year yields extended their recent decline following the break to new cycle lows last week. At the longer end of the curve, German 10-year yields are now also approaching the cycle lows at around 2.9%-3%. These levels have already been tested three times over the past months and have failed to break until now. Therefore, we would consider at least partial profit-taking below the 3% level, as long as it isn’t clear that the ECB would indeed implement a quantitative easing policy and start buying longer-term government bonds or if risk aversion would soar even substantially further. Yesterday, the Greek governor of the central bank said that ‘the ECB hasn’t discussed buying government bonds in the secondary market’ and added that ‘the idea could constitute monetary financing which isn’t allowed under the bank’s charter’.
In the UK, the calendar contains the January CPI data. Inflation is forecasted to show its fourth straight monthly decline. On a yearly basis, CPI inflation is expected to come out at 2.7% Y/Y and might fall below the 2% target in the coming months.
