Markets: Fixed Income
On Thursday, government bonds surged higher on plunging equities and the decision of the Bank of England to start its quantitative easing policy. Besides cutting interest rates by 50 basis points to 0.5%, the MPC announced that it will start buying medium- and long-term Gilts among other assets like corporate bonds for a total amount of £75B over the next three months, which may be upped to £150B later on. This resulted in a huge bull flattening of the UK yield curve, with 5-, 10- and 30-year yields all down more than 20 basis points.
The rate cut of the ECB to 1.5% and the measures of the Bank of England however failed to boost investor’s optimism, as equities continued their slide and fell sharply both in Europe and in the US.
Like in the UK, the US and euro zone yield curves flattened substantially on hopes that the Fed and the ECB will follow the Bank of England’s example. The announcement of the US Treasury that it will sell $34B in 3-year notes, $18B in 10-year notes and $11B in 30-year notes next week had no noticeable impact on trading. In the US, 2-year yields fell by 5.6 basis points, 5-year yields by 14.2 basis points, 10-year yields by 16.3 basis points and 30-year yields by 17.8 basis points. In the euro zone, 2-year yields were unchanged, but 5-, 10- and 30-year yields were down re-spectively 6, 11.9 and 12.7 basis points.
Bonds rally, as Bank of England will start its quantitative easing policy
Today, the euro zone calendar is empty, but in the US, the February payrolls report is scheduled for release. Last month, US employment dropped by 598 000 according to the official payrolls report. This was the third consecutive month showing a job loss of more than 500 000 and the sharpest drop since December 1974. For February, an improvement is not expected as the consensus is looking for a drop by 650 000. If confirmed, this will be the lowest reading since October 1949 when employment fell by 843 000. We believe the risks might be on the downside of expectations as all available evidence points to another horrific employment report. Earlier this week, the ADP employment showed a job loss of 697 000 in the private sector. Assuming that government payrolls are broadly unchanged, this would point to a drop of around 700 000 in the official payrolls report. In February continuing claims surged above 5 mil-lion, also temporary help agencies showed no improvement last month and labour market conditions deteriorated further in the manufacturing sector, according to the latest ISM survey.
On the supply front, Italy will detail which BTPs it plans to tap at their auction next week. Yesterday, the Spanish and French bond auctions went smoothly. Spain sold €4.013B of its two short-term bonds, while France sold in total €6.92B of its three longer-term OATs. After the auctions, French and especially Spanish government outperformed.
Yesterday, the ECB as expected cut its interest rates by 50 basis points to 1.5%. During the press conference, ECB’s president Trichet indicated that rates will decline further over the coming months, as the new ECB staff projections forecasted growth to remain very weak and inflation to remain well below the 2% level over the coming two years. As such, we still expect ECB rates to fall to 1%. Regarding quanti-tative easing, Trichet repeated that the ECB has already taken several unconven-tional measures in relation with the refinancing operations, which has led to a sub-stantial increase of the ECB’s balance sheet, which is some sort of quantitative eas-ing. Although no new measures were announced, Trichet indicated that the debate is ongoing and that nothing is excluded. He also announced that the governing council has decided to continue the fixed rate tender procedure with full allotment (which is already an unconventional measure) for all refinancing operations for as long as needed, and in any case beyond the end of 2009.
Regarding trading, yesterday’s session reconfirmed that this remains a buy-on-dips market, as bonds rebounded strongly off their recently lows on the back of the decision of the Bank of England to start buying government bonds and the plunge in equities. Hence, despite the recent rather disappointing performance of the govern-ment bond markets, we continue to trade with a bullish bias, but prefer a buy-on-dips strategy, as the recent highs in the Bund/lows in German 10-year yields have proved very difficult to break above/below. Yesterday’s session is however constructive and may indicate another test of the highs at 125.30 (Bund June contract) and 126.53 (historic highs) is in the making. The decision of the Bank of England to buy government bonds may indeed ease investors’ concerns about supply, which has been the major factor why bonds couldn’t gain further ground despite the worsening of the economic outlook and the sell-off in the equity markets.
In the UK, there was a huge bull flattening of the UK yield curve in response to the Bank of England announcement that it will buy £75B of assets over the next three months financed by central bank money. Although the Asset Purchase Fa-cility is intended to improve the functioning of the corporate credit markets, the MPC admitted that the majority of the overall purchases will likely be gilts and specified that it will also buy medium- and long-maturity conventional gilts. This means that al-most 10% of the total amount outstanding in Gilts (which was £478.8B at the end of 2008) will be in the hands of the Bank of England. As a result, the long end rallied and reversed Wednesday’s losses that occurred on the back of the very weak 30-year Gilt auction. Today, the UK calendar contains the February PPI data.
