Markets: Fixed Income
On Tuesday, global bonds extended Monday’s downward correction, although US Treasuries bounced late in the session when the Fed released the details of their first round of Treasury purchases. Overall, sentiment in global markets remained positive on the back of Geithner’s plan, as equities and commodities were able to hold on to most of Monday’s huge gains. The improvement in sentiment was also backed by better than expected business confidence surveys in the euro zone and the US.
As such, global bonds were under downward pressure for most of the day. In the euro zone, there was a huge bear steepening of the German yield curve with 2- year yields up 6.3 basis points compared to 13.2 basis points in 30-year yields. At the same time, the narrowing of the intra-EMU spreads continued benefiting from the improvement in risk appetite and the successful auctions from the Netherlands and Ireland. The spread between Irish and German 10-year yields fell by a huge 25 basis points.
In the US, bonds closed however off the day lows following a strong 2-year Note auction and the details of the Fed’s Treasury purchase programme. As a result, yields rose by less in the US, notably between 1.7 and 5.2 basis points and even declined by 5.3 basis points in the 30-year sector, as the Fed surprisingly included the long Bond in its plan to buy Treasury purchases.
US long bond surges as Fed announces buyback
Today, the calendar contains the durable goods orders (February), new home sales (February) and weekly mortgage applications. In February, the durables are forecasted to show their fifth consecutive monthly decline. The consensus is looking for a drop by 2.5% M/M after falling by a revised 4.5% M/M in January. Part of the decline is expected to come from weaker civilian aircraft orders, while orders for motor vehicles are forecasted to show a modest positive contribution. After the extremely weak orders in the previous four months, we believe the risks are for a less negative outcome. New home sales are expected to show their seventh straight monthly decline in February. After falling sharply in January (-10.2% M/M), the consensus is looking for a decline by 2.9% M/M (to 300 000) in February. The risks might be on the upside of expectations after the stronger than expected building starts and permits and also existing home sales, released earlier this week, came out better than expected. Fed speakers include Pianalto and Yellen, both will speak on the economy. Treasury Secretary Geithner gives a speech at the Council on foreign relations. The Treasury will auction $32B of 5-year T-Notes.
The $40B 2-year Note auction (coupon of 0.875%) went again very well with strong demand and aggressive bidding. The auction stopped at 0.949%, compared to the WI bid of 0.963% at the moment of the stop. The bid/cover of 2.71 compares to a 12 month average of 2.37, which taken the upped size into account, is very strong. The Indirect bid of $29B was the biggest ever and the hit ratio the highest since last December. Indirect bidders took away 53.1% of the total offer, well above the 34.9% average. Concluding, the buy-side showed up and wanted a big chunk of the issue. This means dealers will have little left to distribute in the next days.
The Treasury will issue auction today a $34B 5-year Note which is part of the $98B funding package that will be issued this week. The size of the auction is up $2B compared to last month. A 7-year Note auction will take place tomorrow. The auctions settle on Tuesday 31 March. The 5-year Note auction will raise all new cash upon settlement, but will pay $3.9B in coupon interest. Last month’s 5-year Note auction went very well, which wasn’t the case in previous months. The auction stopped below the WI bid, the bid/cover was solid and Indirect bidding aggressive. The strong 2-year Note auction yesterday is a plus, but not also a good precursor for the success of the 5-year Note auction. On the other hand, it is the first auction since the Fed announced its intention to purchase Treasuries, especially in the 2-to-10-year part of the curve. The 5-year traded around 1.88% last month, which compares to 1.74% currently, which is a slight negative. However, overall, the omens are good for a reasonable successful auction.
The Fed will hold its first Treasury coupon purchase today for settlement on Thursday and follows with more operations in the next days. Interestingly, the Treasury also plans to purchase the 30-year sector, something which was in some doubt until now, as the Fed said it would concentrate its operations in the 2-to-10-year sector of the curve. So, this announcement surprised the market and led to a rally with the 30-year sector outperforming. The Fed targets today issues between, February 29 2016 and February 15 2019, which may be a positive for tomorrow’s 7- year Note auction, but also for today’s 5-year Note auction. The Fed will buy the 5- year sector (September 30 2013 to February 15 2016) on April 2. However, other rounds of purchases are planned for Friday 27 March (03/11 to 04/12), Monday 30 (08/26 to 02/39) and on April 1 (05/12 to 08/13). The NY Fed will from now onwards regularly issue an operation schedule for the purchases of longer-dated Treasuries securities including maturity sector(s).
Regarding trading, the correction in Treasuries that started following the post-FOMC huge gains on Wednesday eve continued yesterday with losses however still contained. It looked as if the correction was gathering speed, but a very strong 2-year Note auction and the announcement that the Fed starts today with its plan to purchase longer term Treasury securities caused a late session rebound. Especially the 30-year sector outperformed, as markets thought the Fed may shun that sector. However, the announcement included a reverse auction for that sector next Monday.
Equities made a small step back yesterday, which was no big surprise following the huge gains on Monday. Monday’s move brought the S&P above a first key resistance of 804 and if the correction remains contained (765 is support), it might signal that the markets may be bottoming. Even a re-test of the lows wouldn’t be necessarily contradicting such an outlook. Indeed, the rally on the announcement of the government plans is an indication the market considers that enough stimulus and measures to heal financial markets is in place now. There are also signals that the Chinese economy may have bottomed and commodity markets move higher which nicely fits in the scenario of bottoming. In this respect, long term investors might now start using Treasury rallies to off load long positions. 10-year yields at around 2.5%, or 2% (lows) aren’t rewarding in a context of a healing world economy and governments that have put aggressive reflationary measures in place. The balance of risks may be turning towards inflation. Of course quantitative easing may artificially keep government yields low for some time, but at some point the market may decide to dump the Treasuries or the Fed may decide that it need to exit that experimental high-octane policy. The door might be too small for bond investors.
In the shorter term, 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 (see higher). 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, 5- and 10-year yields are now at obvious resistance of 1.75% and 2.75% respectively. We are curious whether these will stop the correction. The calendar is interesting. Should new Home sales surprise on the upside and durable orders do the same, the correction might continue, but the damage may be contained if later on the 5-year Note auction replicates the success of yesterday’s 2-year. The results of the first reverse auction will get scrutinized closely.
Irish bonds outperform sharply after successful auction
Today, the calendar is thin as it only contains the German IFO indicator. In February, the German IFO business climate indicator plunged to a new record low due to a decline in the current assessment sub-index, while the expectations sub-index improved somewhat. For March, the consensus is looking for a slight drop in the headline index (82.2 from 82.6) due to a further weakening of the current assessment, while the expectations sub-index is forecasted to show a third consecutive increase. The risks might be on the upside of expectations after both the German and euro zone manufacturing PMI’s surprised on the upside yesterday. After the release of the PMI figures, the German IFO indicator might be less important for trading.
On the supply front, Germany will issue a new 5-year Bobl 2.25% April 2014 for an amount of €7B. Although German bonds have been outperforming on the European bond market over the past months, German bond auctions haven’t always gone that smooth. The bid/cover ratio was often very low, while the Bundesbank had to retain a substantial part of the amount offered. We have no strong opinion on today’s auction results, but yesterday’s auctions from Ireland and the Netherlands were well received by the market. As a result, the recent narrowing of the intra-EMU sovereign spreads continued. The Irish spread, which had been lagging the recent narrowing, plunged by 25 basis points in the 10-year sector. The sharp fall in the CDS of Ireland over the past weeks (see graph below) points to a further narrowing now that the auction has passed successfully.
On the money market, the ECB will hold a three-month refinancing operation. By providing liquidity up to six months at fixed rates and for unlimited amounts against an enlarged pool of collateral the ECB has in fact started its own form of quantitative easing last October, as this means that the ECB is providing liquidity to the banking sector beyond the amount what is actually needed. By doing so the ECB has eased the strains in the money market and lowered interest rates. The 3-month Euribor for example has fallen to 1.55%, which is very close to the current policy rate of 1.5%. Consequently, the liquidity spread has narrowed significantly and stands currently at its lowest level since September last year. The decline in the Euribors and the interest rates charged to households and corporations indicates that the transmission mechanism is working quite well in the euro zone and reduces the need for a direct intervention in the credit markets via the purchase of government and/or corporate bonds. A good functioning of the transmission mechanism is even more important in the euro zone, as 60% of the financing goes through commercial banks compared to only 30% in the US. Therefore, the ECB isn’t likely to follow the example of the Bank of England or the Fed anytime soon, but is working on a further expansion of its collateral and/or of the maturity of its operations. Such an easing or lengthening should also result in a lowering of the risk premia and/or longer-term interest rates in the euro zone and as such ease financing conditions. Yesterday, the Slovenian central bank governor Sramko indicated that there could be a ‘relatively fast decision’ on the subject. The Finnish central bank governor on his turn said that he sees ‘room for maneuvre’ on all interest rates, thereby hinting that also the deposit rate could be cut further from its current very low level of 0.5%. Earlier Weber has indicated that he favours to leave the deposit rate unchanged. The deposit rate has gained importance as the lower barrier for interbank interest rates, now that interbank rates have fallen below the main refinancing rate due to the ECB’s quantitative easing policy.
Outside the euro zone, the Norwegian central bank will decide on rates and is expected to cut rates again by 50 basis points from 2.5% to 2.0%, although the Bank sounded concerned about cutting rates too low at the last meeting. A quantitative easing policy is unlikely to be introduced, as Norway has very little government bonds outstanding and has plenty of room for more fiscal spending.
Regarding trading, there was a huge bear steepening of the German yield curve yesterday on the back of the better than expected PMI surveys and the general improvement in market sentiment. Today, the IFO is likely to confirm this slight improvement in business confidence. As such, we expect the German bond market to remain under downward pressure, 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 has also run out of steam, which should keep the upward impact on the European bond market limited.
In the UK, Gilts again underperformed following the upward surprise in the UK inflation rate and the comments of BoE’s King who warned on more fiscal stimulus. Today, the calendar contains the March CBI distributive trades report. Last month, the CBI distributive trades report showed an unexpected improvement in sales (-25 from -47). For March, we don’t exclude a slight relapse.
On the supply front, the DMO will sell £1.75B of its 40-year Gilt. It will be interesting to see how demand is for the issue, as the Bank of England is only purchasing Gilts between 5 and 25 years.
The Bank of England will today also hold its first purchase of corporate bonds within the framework of its quantitative easing policy. Yesterday, the Bank has announced that it will purchase up to 124 million pounds of corporate bonds. A detailed list of 29 bonds has been made available. Also today, the Bank will again purchase Gilts for an amount of £3.5B. The purchases form part of the central bank’s £75B asset purchase programme designed to kick-start the economy by increasing the amount of money in circulation.
