Markets: Fixed Income
On Wednesday, global bonds traded at first sideways, before becoming victim to some profit taking in later US trading, as equities managed to avoid more losses. Profit taking should be seen against the juicy gains of late. Eco data had no noticeable impact and also the Obama plan on housing had surprisingly little impact. There was some talk about today’s announcement of the new Treasury issuance (2, 5- and 7-year). In a daily perspective, US yields rose by 7 to 14 basis points, the belly of the curve underperforming the wings. In EMU, yields increased by 2 to 8 basis points, the wings of the curve underperforming the belly. Intra- EMU government yield spreads narrowed slightly.
In the US, the eco data once more disappointed. Housing starts fell unexpectedly sharply, while industrial production was weak too and weaker-than-expected. In EMU, there were no important eco releases, but the UK industrial trends for February showed a dismal picture of the sector for which the weakness in sterling hasn’t brought any noticeable relief. In this respect, it wasn’t a big surprise that the Minutes of the BOE showed that the start of the quantitative easing policy is drawing closer.
The Obama housing plan, a very detailed one, couldn’t really push equities in a distinct direction. It isn’t in a first reading possible to determine whether it will have more success than some previous initiatives on the number of foreclosures going forward. However, we see several positive points in it and are disappointed by the initial reception it got in markets.
Obama Housing plan
The Obama administration unveiled its homeowner affordability and stability plan. It aims to help borrowers who can’t refinance and benefit from lower mortgage rates because of lower home values (negative equity of at least 20%) and tighter lending standards. The number of potential beneficiaries is 4 to 5 million. To be eligible, the original mortgage needs to have been owned or guaranteed by Fannie or Freddie and needs to be refinanced by Fannie or Freddie. The new loan can’t exceed 105% of the value of the property. There are no loan modifications involved. The plan also wants to help homeowners who need their mortgage payments reduced in order to avoid foreclosure. Here, the plan calls for significant loan modifications. This group is estimated to include 3 to 4 million homeowners. Only owner-occupied homes with conforming loans (eligible for GSE loans) will qualify. The plan targets borrowers with high mortgage debt-to-income ratios that are in worse shape than the first target group. Most will be delinquent, but it is no requirement. The goal is to reduce mortgage payments to 31% of household income. In a first step the lender will have to reduce interest rates enough to bring mortgage payments to 38%. Thereafter the interest rate is lowered enough to bring the payments down to 31% of income. The cost of this is shared between lender and the Treasury. Minimum interest rate is 2% and the new rate will remain in place for 5 years, after which it will be gradually raised to the conforming loan rate that prevailed when the loan was modified. Lenders have the option of lowering the mortgage debt-to-income ratio to 31% through principal reduction. If the cost of modification is greater than the cost of foreclosure the loan is not eligible for modification.
The plan offers lenders and borrowers a number of incentives to participate in the plan that remains voluntary. Servicers receive upfront fee of $1000 for each loan modification and receive an additionally $1000 a year for maximum 3 years as long as the borrower stays current on the loan. Borrowers who stay current on modified loans see their principal reduced by up to $1000 a year for 5 years. There is also an insurance fund (up to $10 B) created to guarantee payments. Fannie and Freddie are expected to play a key role in its implementation. The Treasury doubles the size of its financial commitment to the GSE’s to $200 B from $100 B before and raises the caps of their portfolios by $50 B to $900B.
The program looks attractive and may prevent a number of foreclosures, but is no panacea. The program is voluntary and only conforming loans are eligible, not private label MBS. Are the incentives high enough? Is the $50B growth of the portfolio of each GSE enough? We will have to wait until the mortgage industry has made up its mind on the merits of the plan. Whether it contains enough incentives to stop the avalanche of foreclosures and lay a bottom in the housing market.
US Treasuries cannot sustain rally
The calendar is well-filled today with the weekly claims, January PPI, leading indicators and Philly Fed (February). Earlier this week, the NY Fed showed a sharp decline in business confidence (February) after a slight improvement in January. In Philadelphia, business confidence is expected to show a marginal worsening (-25 from - 24.3) in February after improving in the month before. The risks might be on the downside of expectations following the downward surprise in the NY Fed. In the week ended February 14, initial claims are expected to come out at 620 000, broadly unchanged from the previous week’s reading (623 000). Continuing claims, which are reported with a one-week lag, are forecasted to have risen by 21 000 (to 4 831 000). The consensus forecasts producer prices to have risen by 0.3% M/M in January, while the yearly figure is forecasted to come out at -2.4% Y/Y (from -0.9% Y/Y).
Supply remains of course an issue and will get again quite some attention today with the Treasury announcement of the upcoming 2-, 5- and 7-year Note auctions that will be conducted next week. For the sake of completeness, Atlanta Fed Lockhart speaks on the US economy.
Fed chairman Bernanke discussed the various steps the Fed has taken in the implementation of its quantitative easing policy. He downplayed the inflation risks that may be triggered by the expansion of the Fed’s balance sheet. In this respect he noted that the sharp rise in the monetary base has only moderately raised M1 and M2 money supply, as banks leave the bulk of their excess reserves idle, in most cases on deposits with the Fed. He also announced that the Fed will release longer term (5-to-6 years) forecasts for growth and inflation. These growth and inflation projections may be considered as the rate of inflation FOMC participants see as consistent with the dual mandate given by Congress. So, there won’t be a formal inflation target, but nevertheless something close to such a target. Bernanke mentioned the purchase of longer-dated Treasuries not once in his speech, but this shouldn’t mean the issue is off the table.
The FOMC Minutes contained the new growth and inflation forecasts (“tendencies”). For 2009, the Fed became understandably more negative, putting growth between - 0.5% and -1.3%, down from -0.2% to +1.3% in October. The 2009 growth forecast still seems too optimist. Given the stimulus in the pipeline, 2010 growth forecast was upped slightly to 2.5% to 3.3% and the 2011 forecast to 3.8% to 5%. Unemployment rate outlook was revised higher to 8.5% to 8.8% in 2009, and to 8% to 8.3% in 2010. The inflation forecast for 2009 amounted to 0.3% to 1%, picking up to 1% to 1.5% in 2010 and to 0.9% to 1.7% in 2011. The longer term forecasts (see above) that might be considered as the long term objectives were put at 1.7% to 2% for inflation. While no big surprise, the forecast suggests that downside risks to inflation will dominate policymaking in the next 12 months. The Minutes showed broad agreement on the policy of quantitative easing. Specifically on the subject of the purchase of longerdated Treasuries there were various opinions, but all in all it seems there was broad agreement that the FOMC should first wait for the result of its recent measures before deciding whether additional steps were needed. Governor Lacker dissented because of doubts on a number of aspects of the Fed’s policy, even if he supported the expansion of the balance sheet.
Regarding trading, Treasuries couldn’t prolong Tuesday’s ebullient rally and fell a prey to some profit taking. Equities moving broadly sideways offered no trigger for more gains and the weak eco data were largely ignored. The eco data might be intrinsically supportive today, but at the end we think that the supply issue (announcement) and the risk appetite/aversion might be more influential. We are disappointed by the cool reception of Obama’s housing plan yesterday. Equities never could find a positive momentum and hovered in volatile trading up and down to close narrowly mixed. Following a sell-off on Tuesday and hovering near key support areas (Dow/S&P), equities should move quickly higher or the law of gravity will draw the indices below those key support levels. We still don’t leave the idea that some return of risk appetite is likely and this should prevent Treasuries from moving distinctly higher in the next sessions.
Re-iterating, technical the S&P index 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. Tuesday’s S&P price action looked a Marabodzu-like one, an exhaustion move that may be followed by some upward price action. However, yesterday’s inability to stage a recovery despite the housing plan is disconcerting.
German bonds hit by profit taking
In the euro zone, the eco calendar is again empty today, but on the supply front France and Spain will tap the market for an amount of respectively between €6.5- 8.3B and €2.5-3.5B. France will tap three of its BTANs in the 2, 4 and 5-year sector along with two longer-term inflation-linked OATs, while Spain will tap two of its longerterm Obligaciones in the 7- and 20-year sector. Ahead of today’s auction, the French and Spanish government haven’t really underperformed their peers and the yield spread compared to German bonds even narrowed slightly yesterday in line with the other intra-EMU yield spreads. A notable exception on this trend were however Austrian bonds, which continued their recent underperformance, as the exposure of its banking sector to the Central and Eastern economies continues to worry investors.
Hence, the EU Commission’s yearly assessment of the Stability programmes hasn’t really impacted the spreads, although the Commission started up an excessive deficit procedure against Ireland, Greece, Spain, France, Malta and Latvia for breaching the 3% budget-to-GDP limit in 2008. This means that none of these countries’ excessive deficits could be considered temporary, still close to the 3% threshold as well as due to exceptional circumstances. The Commission’s report is now addressed to the Economic and Financial Committee, which will formulate own opinions within a fortnight. Then, the Commission will, taking into account its report and the opinion of the Committee, decide whether to recommend to the Ecofin Council the existence of excessive deficits and a deadline for their correction. Whatever the outcome will be, it looks very implausible that any sanctions will be imposed. On the contrary, recent comments of German Finance Minister Steinbrück suggested that Germany would support emergency action to protect the euro zone if one of its member states would run into difficulty, notwithstanding the no bail-out clause of the EMU treaty.
Regarding trading, German bonds were hit by some profit-taking following the recent impressive rally higher. German 2-year yields rebounded strongly in a bullish engulfing pattern, which is a potential trend reversal signal that may suggest that the downtrend is over for now. At the longer end of the curve, German 10-year yields once again failed to break below the cycle lows at around 2.9% / 3% and rebounded too. This was also reflected in the Bund, which failed to break above the historic highs at 126.53. As long as it isn’t clear that the ECB will indeed implement more unconventional measures and start buying longer-term government bonds or equities break decisively lower and risk aversion soars again, we don’t expect such a break lower in yields/higher in the Bund to happen. Tomorrow, we also get the euro zone manufacturing and services PMI and like the German ZEW indicated earlier this week, a better than expected figure cannot be excluded, which could ease recent risk aversion and incite more profit-taking on the European bond market.
In the UK, there was a clear bear flattening of the yield curve, as the Minutes signalled that the MPC may prefer not to cut rates any/much further, but instead opt for a quantitative easing policy through the purchase of government and other securities financed by the creation of central bank reserves. As such, the MPC wants to avoid that interest rates close to zero would hit the bank’s profitability by decreasing their margin between deposit and lending rates. This might cause them to restrict their lending further with potentially adverse consequences for the rest of the economy. The MPC’s preference not to cut rates any/much further implies that UK 2-year yields may have entered a sideways trading range at around cycle lows. Yesterday, UK 2-year yields rose by 12.8 basis points, while the longer end fell by 2.7 basis points. The implications for the longer end of the curve are however less straightforward. The downward impact on yields from the quantitative easing policy must here be counterbalanced against the huge increase in supply and the increased concerns about fiscal sustainability of the UK. The latter is reflected in the sharp rise in the UK CDS over the past weeks, although there was a slight easing yesterday, and the ongoing debate about the possibility of a downgrade of the UK’s AAA rating. Today’s public finances figures for January will give further insight in the deterioration of the public finances. A decline of £7B in public sector net borrowing is expected, but the risks are clearly for a rise in borrowing given the huge capital injections of £17B in Lloyds Banking Group alone and the expected decline in income and corporate tax receipts. At the same time, we also keep a close eye on the results of the 3-year Gilt auction for an amount £3.35B.
Besides, the calendar also contains the M4 money supply and credit growth data. M4 money growth is expected to have fallen back to 1.2% M/M in January (from 1.4% M/M).
