Markets: Fixed Income
On Monday, investors reacted positively on the details of Geithner’s plan to remove toxic assets off the banks balance sheets via public-private partnerships. As a result, equities surged higher fuelled by a rally in financial stocks, but also more cyclical stocks and commodities had a strong day. On the other side of the equation, safe assets like government bonds had a more difficult day, but overall the losses remained fairly limited, certainly when one takes into account the large gains of the equity markets.
In the US, yields rose between 1.8 and 4.3 basis points across the yield curve, with the 5-year segment hit the hardest. In the Europe, there was a slight bear steepening of the German yield curve with 2-year yields up 1.5 basis points and 10-year yields up 4.5 basis points after several ECB officials hinted at another rate cut, but signalled that the ECB is unlikely to buy government bonds anytime soon. The improvement in risk appetite was also reflected in a further narrowing of the intra-EMU sovereign spreads.
US Treasuries keep up quite well in the face of booming equities
Today, the calendar contains the Richmond Fed survey on manufacturing (March), the house price index (January) and weekly ABC consumer confidence. Last month, the Richmond Fed index dropped slightly (-51 from -49) after improving in January. For this month, the consensus is looking for an unchanged reading. We have no reason to distance ourselves from the consensus after last weeks’ regional business confidence indicators came out mixed. The NY Fed headline index deteriorated, while the Philly Fed painted a less negative picture, even if the details remained very weak. The house price index is expected to show a drop of 0.9% M/M in January after rising by 0.1% M/M in December.
The Treasury $1T program to help clean the bank’s balance sheet by removing toxic assets got a very good reception on the equity markets. It might go a long way in easing fears that banks would be nationalized and later on be considered as the start of the healing in financial markets. This is a necessary step for a turnaround in the economic downturn that risked ending up in a depression. We agree that a very high price will have been paid essentially via a draconian deterioration of the government finances reflected both in a sky-high deficit and in a sharp run-up in debt. In fact, debt is being transferred from the private sector, essentially banks, to the government sector. One cannot but conclude that the concessions made to private investors are very large and therefore the plan is sharply criticized as very onerous for taxpayers and beneficial for Wall Street. Nobel price winner Krugman called it a rehash of a “cash-for-trash” proposal the Bush proposal floated last fall. Also from Congress there were already critical voices. So, the big question going forward is whether the plan won’t be finished by some Congressional initiatives (see also lower).
The Treasury will issue auction today a $40B 2-year Note which is part of the $98B funding package that will be issued this week. A $34B and $24B 5- and 7-year Note auctions will take place tomorrow and on Thursday. The auctions settle on Tuesday 31 March. As only one 2-year Note matures ($18B), the total operation will raise another hefty $80B in fresh cash. The size of the 2-year Note auction has been kept unchanged at a record $40 B. The last two 2-year Note auctions went reasonable well with aggressive bidding (stop nearly 2 basis points below WI bid) and good participation of the buy-side (28.1% takedown, near average despite upped size). The 2-year yield is currently (0.90%) not far away from where it was at last auction (0.95%). The Fed’s decision to purchase up to $300B Treasury papers mostly in the 2- to-10-year maturity bucket is of course a support for the auctions, more for 5- and 7-year than for the 2 year, even if the $300B is not so huge when compared to the issuance of $98B this week. So, the auctions are another test for investors’ appetite in Treasury papers. Size matters and should be reflected in sloppier bidding (despite last month’s result).
Regarding Fed speakers, Chicago Fed governor Evans speaks on the economic outlook at the Czech National Bank, while St-Louis Bullard who spoke already on Friday speaks in London. More attention will go to the testimony of Fed chairman Bernanke and Treasury Secretary Geithner before a House panel on the government rescue of AIG. This is potentially an important event. Congress is enraged by the bonuses paid to AIG top managers at its financial unit, responsible for the demise of the firm and the $170B bail out. The House voted a tax law that will largely tax these bonuses. There is currently some fear in the financial sector that such retro-active legislation might be used in the future, for instance against those funds that eventually participate in the PPIF of Treasury Geithner. If that idea would generalize it might frighten the private sector and lead to a failure of the initiative. So we expect Bernanke and Geithner to show anger towards the way AIG acted reckless, but on the other hand to try to direct the House away from that kind of retro-active legislation that might be defendable on its own merits, but at the same time damage the more important general purpose of ending the financial crisis and remove the threat of a depression.
Atlanta Fed Lockhart explained why the Fed had decided to start purchasing US Treasury Notes. The worsening economic outlook was an important factor as was the success of a similar initiative by the BoE hat drove Gilt yields sharply lower. He called the first reaction of the market encouraging. He said that there were various opinions inside the FOMC on the subject (he preferred more support for the mortgage market) but in the end a very strong consensus emerged for a combination of various programs. Lockhart said he was fully in favour of the new initiative to buy toxic assets from the banks that might turn out to be a “real difference-maker.”
Late yesterday, the Fed and the Treasury issued a joint statement on the role of the Fed in preserving financial and monetary stability. Given the ever deeper involvement of the Fed in the credit markets, critic was mounting that the Fed might risk neglecting its role as guarantor of monetary stability (low inflation/strong growth). So the statement re-iterates its roles for maintaining financial stability and managing financial crisis on the one hand and for maintaining monetary stability. The statement treats amongst others the question of credit allocation and avoiding credit risk, the need to prevent measures of financial stability to constrain monetary policy. The Fed is also looking for additional tools to sterilize the effect of its actions on the supply of bank reserves. The statement shows that the Fed recognizes the fears about the effects of its actions for longer term price stability.
Regarding trading, US Treasuries once more corrected only mildly lower despite a return of risk appetite as reflected in huge equity gains. So, most of the post-FOMC gains are safeguarded. The eco releases are second tier and probably unable to set the direction in the Treasury market. The testimony of Bernanke/Geithner and the debate about the merits and costs of the toxic assets plan will be more influential via the direction of equities. It is still early days, but it is the first time since the crisis started that the equity market reacted positively on a government plan to redress the situation in the financial sector and the economy. The rise of the S&P above 804 is a first step that might lead to the perception the bottom is reached and the economy might escape a depression-like development. Some correction in equities today on profit taking wouldn’t be a major setback, but the eventual correction shouldn’t go too far. The 2-year Note auction is a second key driver today. Improved risk appetite is traditionally a negative for the short end of the curve, but given Fed insistence that rates will be at rock bottom levels for an extended period of time and the prospect that Fed purchases of Treasuries might include some action in the 2-year sector too, it isn’t clear whether investors will be eagerly snap up another $40B of 2-year Notes.
In such a context, we stick to our buy-on-dips strategy. The general MT outlook for Treasuries is bullish (technicals), but there are risks longer term preventing us to become wildly enthusiast for Treasuries at current levels (aggressive Fed policy points to potential inflation problems down the road, potential return of risk appetite and a sharply increased supply). Therefore, we play the range short term, buying around 122-28+ (June Note future) and selling around 126-04/24 (last week high/contract high). In yield terms, from a technical point of view, the recent (modest) back up in yields is slightly deteriorating the picture as 5- and 10-year yields are again above 1.60 and 2.60% respectively. However, we wouldn’t yet be too concerned about it.
European bonds underperform
Today, the eco calendar heats up with the March PMI surveys. Last month, manufacturing PMI dropped to a new cyclical low (33.5) removing hopes, which had been raised after the slight uptick in January, that the worst might be over. The consensus expects an unchanged reading for March. Indeed, we might see some stabilization at these very low levels, but we have no clear view on the risks surrounding consensus. Also, services PMI dropped to a new cyclical low last month (39.2), with all subindices showing a further deterioration. For March, the consensus is looking for a stable outcome in the services sector too.
Echoing comments from ECB president Trichet and Weber over the weekend, the governor of the central bank of Cyprus Orphanides yesterday indicated that he sees room for a further reduction in interest rates and a further expansion of the nonconventional measures taken so far. Orphanides said that the ECB’s current measures ‘can be extended within the present framework’. This suggests that he also favours to continue working via the banking channel instead of following the example of the Bank of England and the Fed and buying directly government and/or corporate bonds in the financial markets. Today, ECB’s Liikanen will present the economic forecasts for the Finnish economy. Earlier this month, Liikanen already indicated that the ECB has room to move if needed. As such, a 50 basis points rate cut to 1% at the April meeting looks increasingly likely. At the same time, the ECB is expected to reduce the corridor between the main refinancing rate and the deposit facility, which would otherwise fall to zero.
On the supply front, Flanders, the most important autonomous region in Belgium, yesterday announced its intention to issue up to €2.5B bonds in the 3- and 5-year sector. The price guidance of the bonds is set at respectively 60 and 95 basis points over mid-swap, which would result in an interesting yield pick-up of 43 and 47 basis points over the comparable Belgian OLO’s. There were no negative spill-over from the supply towards the Belgian government bond market. Today, Ireland will tap the 3- and 10-year sector for an amount of €0.75-1B, while the Netherlands will tap three bonds in the 5-year sector for an amount of €0-2B. Over the past weeks, Ireland has lagged the narrowing of the intra-EMU spreads. A successful auction today could therefore result in a strong outperformance of Irish bonds.
Regarding trading, the European data calendar looks interesting with the first business sentiment surveys of March scheduled for release. The general improvement in sentiment is however likely to prove more important and is likely to weigh further on the European bond market today, especially at the longer end of the curve, as the ECB has signalled that it is unlikely to buy government bonds anytime soon. Also from a technical point of view, the inability to recoup the 124.70 level in the Bund following last week’s Fed announcement indicates that the highs are still too tough to break above. Therefore, we stick to out buy on dips approach and look towards last week’s lows at around 122.11 and at the February lows at 120.37 before installing new long positions. Besides, the rally in the euro also appears to be capped at around the 1.37 level, which should keep the upward impact on the European bond market limited.
In the UK, Gilts underperformed the European bond market after the Bank of England bought £2.5B of long-term Gilts at lower than expected prices. The wings however outperformed on speculation that the Bank will also start to buy more short-term and ultra-long Gilts.
Today, the calendar contains the February CPI figures. On a monthly basis, consumer prices are expected to show an uptick (0.3% M/M) after four consecutive monthly declines. The yearly figure is forecasted to drop to 2.6% Y/Y (from 3.0% Y/Y) in February, while core CPI is forecasted to remain unchanged at 1.3% Y/Y. Several MPC members are also scheduled to speak today, but we don’t expect them to rock the boat and to support the quantitative easing policy, as the Minutes showed a unanimous vote in favour of the measures.
Yesterday evening, BoE’s Blanchflower sounded again pessimistic on the UK economic outlook, as he warned that the number of unemployed people could rise to above 3 million and called for more fiscal stimulus. He will speak again this evening, but we don’t expect him to move the market, as he is known as a dove and will leave the MPC at the end of May.
