Markets: Fixed Income
On Thursday, global bonds extended their decline for the second consecutive session amid supply concerns. Other traditionally bond-friendly drivers like weak eco data and falling equities (risk aversion) were unable to support bonds. At the end of dealing, the US curve had steepened in a bear fashion with yields up 3 to 12.5 basis points. In EMU, the curve bear flattened with yields up between 12 basis points for 2- and 5-year yields and 8 basis points for the 10- and 30-year yields.
In the case of German bonds, an additional element were signs that some peripheral countries might get help if they would encounter financing problems (see lower EMU bond part) leading to an easing of pressures on government bonds of Greece, Ireland and others (spread narrowing). German bonds as a consequence were victim of some selling.
The eco news was again disconcerting. The decline in the Philly Fed manufacturing index, following a similar decline in the NY Fed index smashed hopes raised after the January figures that the worst was over for the cyclical manufacturing sector. The initial claims holding at about 620 000 and continuing claims raising to about 5 million suggest that the February payrolls may again show losses in the vicinity of 600 000. However, these dismal numbers failed to support bonds, maybe partially counterbalanced by the surprise higher PPI and core PPI.
Regarding supply, the French and Spanish bond auctions didn’t go well, while the US Treasury announcement of new supply next week to the tune of $94 B was sobering too.
US Treasuries extend correction lower on supply concerns
Today, the calendar is thin and contains only the January CPI figures. Consumer price inflation is forecasted to show its first year-on-year decline since 1956, which might stoke fears of deflation. It shouldn’t however surprise most observers, as inflation will in the next months dive ever deeper in negative territory due to a base effect (energy prices). On a monthly basis however, inflation is expected to have risen by 0.3% M/M in January. In the previous months, the sharp decline in oil prices had a negative impact on inflation, but this might have come to an end in January as oil prices started to stabilize (or even increase somewhat). However, the risks might be on the upside of expectations as January is traditionally a month of price increases. This effect is mitigated by the seasonal adjustment factors, but is sometimes still visible. Also the significantly higher than expected PPI figures, released yesterday, might raise expectations for a higher outcome. 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 CPI figures might stabilize in the coming months, the yearly figure is expected to decline further.
The Treasury announced the details of three auctions to be conducted next week. The total amount of $94B new issuances is divided in a $40B 2-year, $32B 5-year and $22B 7-year Note. The size of the 2-year remains unchanged, the 5-year size is up $2B from the previous auction while the 7-year will be auctioned for the first time since April 1993. The auctions will be held on Tuesday, Wednesday and Thursday of next week and settle on Monday March 2. The announcement was probably not too far from expectations, but the huge amount of Treasury issuance remains of course an item.
Atlanta Fed governor Lockhart, a FOMC voter in 2009, expects growth to be restored this year, but added the Fed can still do more if recovery fails to appear. The Fed got the message about the need for aggressive action but cautioned that any additional measures ought to be measured and convincing. On inflation, he took a moderate position saying that what we have seen is disinflation, but nothing that suggests a real risk of deflation at the moment. Concluding Lockhart takes a middle of the road position inside the FOMC. He stands behind the Fed measures, but won’t be at the frontline to push the FOMC into a still more aggressive stance, also as he seems less concerned than some colleagues on the risk of deflation.
Regarding trading, Treasuries extended their decline amid more profit taking. Supply remains a concern with investors looking to next week’s 2-, 5-, and 7-year Note auctions for an amount of $94B. Eco weakness and declining equities brought little to no relief. However, we still think that in the end the fate of equities will be the key factor for Treasuries (in the next sessions). If equities drop below major support, Treasuries should rebound, but the fact Treasuries are well off the highs while equities test the bottom is a bit disconcerting. Should equities rebound, Treasuries may nose-dive. Therefore, we keep a cautious attitude and do not feel obliged to front-run an eventual major move in equities. Today, the CPI may “surprise” on the upside given the outcome of the PPI yesterday. We wouldn’t consider such an outcome as important for Treasuries, but it may allow us to gauge the current sentiment of the market. Will the market ignore it or push Treasuries a bit lower in case of a higher CPI? Whatever, the reaction will probably be short-lived, after which equities price action may take over as driver, even if the correlation between equities and Treasuries has considerably loosened of recent. .
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.
Intra-EMU yield spreads narrow, as Germany and France signal help in case of financial trouble
Today, the economic calendar contains the euro zone PMI figures (February). Last month, manufacturing PMI showed a slight improvement, the headline index rose from 33.9 to 34.4, still far below the historical average of 50.9 and only marginally above the current low. For February, another marginal increase (35.0) is expected. Earlier this week, the German ZEW index showed a sharper than expected rebound, but much of the ZEW’s correlation with other confidence indicators has disappeared recently. As such, a slight deterioration is not excluded. Also Services PMI is forecasted to show a marginal improvement (42.5 from 42.2).
On the ECB front, ECB President Trichet will speak this morning at the European American Press Club, while ECB’s Vice-President Papademos will participate this evening in a panel on Financial Regulation in New York. The ECB is currently under increasing pressure to announce more unconventional measures to support the economy, now that rates are coming close to zero and the Fed, Bank of England and BoJ have already taken further steps in that direction. Yesterday evening, ECB’s Liikanen again indicated that the ECB ‘has not exhausted its creativity and its capacity to take initiatives’. He pointed out that ‘we are facing the worst financial crisis of our time’ and added that ‘when price stability is anchored’ the ECB ‘can support other economic policy goals of the union’. Therefore, ‘we have to make sure we are able to act possibly in even more difficult circumstances than we are now in’. These comments indicate that the debate on more quantitative and qualitative easing is more than ever ongoing within the ECB and should continue to provide support to the European bond market. However, as long as no more details are known on what specific action the ECB plans to take, it won’t however be enough to push the Bund above the contract high.
Yesterday, German bonds declined for the second consecutive day on supply concerns (weak auctions from Spain and France) and profit taking following its recent outperformance compared to the other peripheral EMU government bonds. This resulted in a substantial narrowing of the intra-EMU yield spreads in the 10-year sector, especially compared Greece (-23 basis points), Ireland and Italy (- 10 basis points) and Austria and Portugal (-8 basis points). The profit taking came on the back of more signs that Germany and France would help other EMU member states if they would face financial troubles, despite the no-bail out clause in the EU treaty. Indeed, following comments of German Finance Minister Steinbrueck on Monday that ‘other countries in the currency union would have to help states that face bankruptcy’, French Finance Minister Largarde yesterday said that the she ‘hoped that each member of the euro zone, with its own responsibility and accountability to the others, will do their utmost to avoid severe difficulties of the kind that would require involvement of the IMF.’ And although German Chancellor Merkel didn’t want to speculate on the issue, she appeared to support the idea.
Regarding trading, we remain bullish on the European bond market, even though a break higher in the Schatz and Bund looks difficult for now. Nevertheless, as long as the ECB is discussing more unconventional measures and equities are testing the sell-off lows any uptrend in German yields looks unsustainable. Therefore, we expect German yields to remain close to the recent lows and look for a buy bonds on dips approach.
In contrast to the bear flattening on the European bond market, there was a bear steepening of the UK yield curve. While the short end of the curve benefited from the well received 3-year Gilt auction, the longer end suffered from the worse than expected public finance data for the month of January. These data indicate that the Chancellor’s public sector net borrowing forecasts for this year of £77.6B will prove too optimistic and that he will have to revise up an already shockingly large £118B public deficit or 8% of GDP. At the same time, the ONS announced that it will treat Royal Bank of Scotland Group and Lloyds Banking Group as public sector entities and estimated that as a result of this decision public sector net debt will increase by between £1-1.5T. This will cause the debt-to-GDP ratio to explode to around 120- 150%. At the end of January, the debt-to-GDP ratio stood at 47.8% compared to 42.2% a year earlier. The rapid deterioration of the UK public finances is also likely to keep the debate ongoing whether the UK will be able to retain its AAA rating. This may counterbalance the downward influence on longer-term yields stemming from the intention of the Bank of England to start buying longer-term Gilts.
Today, the calendar contains the January retail sales. Recently, consumption expenditure held up rather well in the UK. In December, retail sales surprised on the upside rising by 1.6% M/M, while a decline by 0.7% M/M was expected. For January, the consensus is looking for a slight drop (-1.0% M/M). We have no clear view on the outcome as retail sales constantly surprised on the upside in the previous months.
