Markets: Fixed Income
On Wednesday, investors shrugged off weak eco data out of the US and Europe on hopes for a new stimulus package in China. This helped equities and commodities rebounding off the recent lows and pushed bonds materially lower. Hence, weak eco data, the record low euro zone services PMI and the huge drop in ADP employment, once again failed to support the bond markets. There, supply concerns are still very much in the focus following another weak Gilt auction in the UK and ahead of today’s announcement from the US Treasury Department on the amount of next week’s 3-, 10- and 30-year Note auctions.
In the US, the belly of the curve underperformed, as 2-year yields were up 6.4 basis points compared to 10.6 and 9.7 basis points in the 5- and 10-year sector and 6.5 basis points in the 30-year sector. As a result, US 10-year yields are again close to key resistance levels just above the 3% mark. In the euro zone, there was a huge steepening of the yield curve, as the short end outperformed ahead of today’s ECB meeting. 2-year yields were down 0.5 basis points, but 5-year yields were up 5.7 basis points, 10-year yields 8.8 basis points and 30-year yields 10.9 basis points. The improvement in risk appetite was also visible in a narrowing of the intra-EMU spreads with the notable exception of Ireland and Greece.
Government bonds fall, as equities and commodities rebound
Today, the euro zone calendar contains the first breakdown of the fourth quarter GDP and the French unemployment data, but all eyes will be on the ECB rate decision. According to the first estimate, euro zone GDP contracted by 1.5% Q/Q in the fourth quarter of 2008. The consensus expects to see an unchanged reading, but more important will be the breakdown. A significant negative contribution is expected from investments, while consumer spending might have had only a limited impact on fourth quarter GDP. Both imports and exports are forecasted to have dropped significantly. In the US, the calendar contains the weekly jobless claims and factory orders. In the week ended February 28, initial claims are expected to come out slightly lower (650 000 from 667 000). Continuing claims, which are reported with a one-week lag, are expected to have risen from 5 112 000 to 5 155 000. Factory orders are forecasted to have dropped by 3.5% M/M in January, but after the durables, the factory orders might contain only limited new information.
On the March monetary policy meeting, the ECB governing council is widely expected to cut interest rates by 50 basis points to 1.50%, which would be the lowest rate since the start of the EMU. As such, the pause in the easing cycle in February will prove very short-lived. The rate cut happens against the backdrop of a substantial worsening of the economic outlook, which will keep inflation low for the foreseeable future. This is likely to be reflected in the downward revision of the ECB staff growth and inflation projections. In December, the ECB staff projected growth to contract by only 0.5% Y/Y this year and to grow again by 1% Y/Y in 2010. It’s clear that these projections are completely outdated and far too optimistic. This implies that inflation, which was already projected to remain below the 2% level over the coming two years (1.4% Y/Y in 2009 and 1.8% Y/Y in 2010), to fall even further below this level. This wouldn’t be consistent with the ECB’s definition of price stability to keep inflation below, but close to 2%. Therefore, markets will focus during the press conference on hints from Trichet as to how far rates will fall and whether the ECB will take more unconventional measures. Regarding the first topic, some ECB governing council members, like Weber, have argued that the bottom for ECB rates is 1%, as the deposit rate would then hit the zero bottom. This is in line with our current target for ECB rates. Regarding the quantitative easing issue, it looks like there is no agreement reached yet inside the ECB governing council. Therefore, we expect Trichet to keep his options open, although some council members have suggested that the ECB is very unlikely to buy directly government bonds and is instead likely to focus on the Commercial Paper market as well as the corporate bond market.
Regarding trading, the rate decision itself shouldn’t have a large impact on the European bond market. Comments on the quantitative easing policy could be more interesting, but as Trichet is unlikely to provide details and eventual measures will focus on the CP or corporate bond market, the impact on government bonds may remain limited too. Yesterday’s trading session once again indicated that the underlying sentiment isn’t that bullish, especially not at the longer end of the curve. It’s quite disappointing that the Bund couldn’t break above the recent highs at 126.01/05 during the recent sell-off on the equity markets, but does fall sharply lower once equities rebound. This indicates that the risk on a break lower in the Bund (below 121.37) is currently larger than on a break higher, despite the very weak growth environment. We wouldn’t however go short, but look for signs sentiment is improving before installing new long positions. Therefore, we also keep a close eye on the US Treasury market, where US 10-year yields have come very close to the recent highs at 3.05%. A break above would heavily deteriorate the technical outlook for US Treasuries and would also have implications for the European bond market. In German 10-year yields, key resistance is seen at 3.40%.
On the supply front, Spain and France will tap the market. The auctions Spain shouldn’t pose a major problem, as Spain plans to tap two rather short-term bonds in the 3- and 4-year sector for an amount of €3-4B. France however will tap the longer end in the 7-, 10- and even 26-year sector for a substantial amount of €6-7B. French auctions have however gone rather well recently and we don’t have strong reasons why this shouldn’t be the case this time. Yesterday, Greece sold €7.5B of its new 10- year benchmark at a premium of 265 basis points over mid-swap.
In the UK, there was again a huge steepening of the yield curve, as the 30-year Gilt auction disappointed with a very low bid/cover and a large tail, while the short-end remained well-supported ahead of today’s Bank of England meeting. Markets count on a 50 basis points rate cut, but the risk may be for a smaller rate cut or even no cut at all. Some members within the MPC have voiced their concern that cutting rates too low could have an adverse impact on the willingness of banks to lend more as this may hurt their profitability via the compression of the margins between deposit and lending rates. Regarding quantitative easing, the consensus appears to be larger, but major uncertainty remains about which assets to buy and how much. We nevertheless expect that Gilts will be included in the range of assets that will be bought. Until now, the hints about a quantitative easing policy and the buying of longer-term Gilts have however failed to push longer-term yields materially lower. As a result, the spread between 2- and 10-year widened to new cycle highs yesterday.
