Markets: Fixed Income
On Tuesday, global bonds booked more, even juicy, gains as doom and gloom about the outlook of the (global) economy and about the state of the banking sector led to increased risk aversion and a sell-off in equities. In the US, Treasuries had some catching up to do and yields dropped by a massive 19 to 24 basis points for the 5-to-30-year sectors, while the 2-year yield dropped 10 basis points. In EMU, yield changes were more subdued but nevertheless dropped by 6 to 8 basis points in the 2-to-10-year maturity buckets and by 3 basis points at the longer end. For the 2- and 5-year, new all-time low yields were recorded. Intra-EMU yields spreads to Germany widened further, especially in Austria and Greece.
In the US, the NY Fed survey on manufacturing showed a renewed fall to a historic lows, but attention also went to problems in some states, like California, that are running out of cash. In EMU, the market shrugged off a better-than-expected ZEW survey and focussed on problems in Central Europe and its effect on the Western Europe banking sector after Moody’s published a critical report. In Japan, dismal GDP figures showed the extent of the problems also in Asia.
Commodities were sold sharply reversing some weeks of slightly better trading, suggesting that the market downgraded again its global growth forecasts, while equities hit the skids. The Dow is now very close to the cycle lows (7506), while the S&P has entered the crucial support area of 790 (50% from high), 768 (2002 low) and 741 (2008 low). A break of this area should be qualified as absolutely crucial and signalling that the market starts to discount not a deep recession, but a depression!!
In the US, St-Louis Fed Bullard suggested the Fed will wait with its decision to buy Treasuries until spring.
US Treasuries rally ebulient higher
Today, the calendar contains the weekly mortgage applications, January housing starts & building permits and industrial production data. In December, both the housing starts and permits plunged to a new record low and further declines are expected in January, despite the December rebound in existing and pending home sales. But the large inventories of unsold homes need to be worked off before we expect to see a significant improvement in housing starts and permits. Housing starts are forecasted to have dropped to 530 000 (from 550 000) in January and building permits are expected to come out at 525 000 (from 547 000). Industrial production is expected to have dropped by 1.5% M/M after falling by 2.0% M/M in December. Especially in the manufacturing sector, weak activity is forecasted.
St-Louis Fed Bullard said that the primary near-term risk for monetary policy is continued disinflation and a possible deflationary trap. He also added that in some ways, the current environment parallels the Japanese experience after 1990. He pointed that in the last three months of 2008, core CPI was near zero or slightly negative and while Y/Y readings were still firmly positive he said it would be unwise to focus solely to Y/Y measures at this stage. Bullard said that it was reasonable to say that core inflation is running at zero or slightly negative. To avoid deflation, he advocated increased emphasise on quantitative measures (something the Fed is doing), but in a more systematic way by offering a nominal anchor to the economy. He is in favour to set credible quantitative targets for monetary policy, starting with the growth rate of the monetary base. This has advantages like easy understanding and making communication less complicated. Rapid growth of the monetary base would also head off incipient deflationary threat. Bullard also warned that one shouldn’t expect changes in the Fed funds target rate soon.
Interesting for markets is the message that zero rate policy may be with us for an extended period and the Fed may set some targets for the growth of the monetary base. We understand his speech as the start of the Fed campaign to explain more clearly its quantitative easing policy, something announced by chairman Bernanke earlier this month. On the prospect the Fed may buy longer-dated Treasuries, Bullard said the Fed will monitor its lending program through spring before deciding on Treasury purchases. He sees no difference in buying Agencies or Treasuries. So, the decision may still be some way off and conditional on the success/ failure of its current lending programs including the still to be implemented TALF. Later today, Fed chairman Bernanke himself will speak on the Fed’s lending programs and its balance sheet. We will closely look to how he describes the Fed’s strategy and how it will be implemented. One key item remains of course whether/when the Fed might start buying longer-dated Treasuries, but following Bullard’s comments we don’t expect him to become more precise on the issue.
Regarding trading, the sentiment has turned completely over the last few days, effectively starting after Tuesday’s Geithner speech on the banking plan that disappointed friend and foe by its absence of specifics. Investors have again downgraded their views on the economy and the financial sector. The S&P financial sub-index dropped yesterday to new cycle lows and the overall S&P index dropped about 4.5% and has now entered a critical support area (790-741) which if lost, would signal the market is making itself up for a depression. We have always put this support area as the line in the sand that when passed over would have also a very supportive impact on Treasuries. So, we are closely waiting to the outcome of the test. In the past, authorities tried to prevent a collapse by announcing a kind of support plan, maybe this time the mortgage support plan, Geithner talked about. However, the government may start running out of plans. From a technical point of view, yesterday’s S&P price action looked like a Marabodzu-like one, an exhaustion move that may be followed by some upward price action. Despite the gains, the technical pictures of the 10- and 30-year bonds (yields) haven’t improved decisively. For that to happen, the 10-year yield should fall below 2.60% (now 2.66%) and the 30-year yield below 3.41% (now 3.46%). Similarly, the March Note contract should break above 124-30 (previous high) and still better 125-25+ (bull flag top). The pictures of the 2- and 5- year yields are bullish with the 2-year however in a sideways trading range between 0.60% and 1%. While the underlying sentiment has become apparently bullish for Treasuries and the eco data should be weak again (but this is already expected and the outcome maybe mixed to expectations), following yesterday’s stellar gains there may be some profit taking if equities could find their composure. If this isn’t the case and Treasury yields drop below the levels mentioned higher, we become again fully bullish on Treasuries.
Austrian government bonds hit, as concerns about Central Europe mount
Today, the economic data calendar is empty, but on the ECB front Bini Smaghi is scheduled to speak on the outlook for the euro zone. This may be very interesting given the recent increased tensions between the euro zone member states, reflected in the widening of the intra-EMU yield spreads, and between the euro zone member states and the Central and Eastern European economies, reflected in the sharp fall of their local currencies compared to the euro.
Yesterday, the report of Moody’s highlighted again the vulnerability of the central and eastern European economies in the current economic and financial crisis, but also warned on the potential backlash of these problems towards the banking sector of several EMU member states who are heavily exposed to the Central and Eastern European economies. That is affecting the overall risk position of various EMU member states, as these may have to support their banking sector. Last week, ECB’s Bini Smaghi already warned that the mistrust that there is today in financial markets’ is ‘transformed into mistrust in states’. As a result, the intra-EMU yield spreads widened further with Austrian and Greek government bonds underperforming the most compared to German government bonds.
Over the past months, the IMF has already offered aid to Latvia, Hungary, Serbia, Belarus and Ukraine. Yesterday, EU Monetary Affairs Commissioner Almunia admitted that also ‘Romania is discussing publicly if they need support’. Almunia added that ‘there is an increased concern not only of Romania or Hungary, but the situation of all countries in the southeast part of Europe, both EU member states and non-EU member states, because of the financing of their growth’. This brings the question of how such help must be financed more than ever on the table. Earlier this week, German Finance Minister Steinbrueck already indicated that ‘other countries in the currency union would have to help states that face bankruptcy’ but didn’t elaborate on the financing issue or whether this should also be the case for countries outside the monetary union. This could bring the idea of a sovereign bond issue jointly issued by several euro zone countries again on the forefront. Yesterday evening a top S&P expert however indicated that such a joint bond ‘would automatically be rated at the level of the lowest-rated nation’ participating in the issue.
Regarding trading, German bonds continued to benefit from the increased risk aversion related to the concerns in Central Europe and the sell-off on the equity markets. Following the break to new lows in German 2-year yields last week, 5-year yields now also confirmed the break lower, while 10-year yields fell again below the 3% level and are now approaching the lows at 2.9%. 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 at around 2.9%, as long as it isn’t clear that the ECB would indeed implement a quantitative easing policy and start buying longerterm government bonds. Yesterday, ECB’s Nowotny indicated that ‘there is, as we are going down with interest rates, the discussion on whether there are additional, more unconventional measures needed’. But also if equities would fall decisively below the cycle lows, risk aversion is likely to soar again, which would again benefit the German bond market.
In the UK, the calendar contains the Bank of England Minutes and CBI industrial trends survey (February). On the 5th of February, the BoE cut rates by 50 basis points to 1%. We expect to see another split decision with Blanchflower voting for a larger rate cut. It will be interesting to see whether there was also a discussion to maintain rates unchanged.
