Markets: Fixed Income
On Friday, US and EMU bond markets showed some divergences. Volumes traded were very light in the US, while close to normal in EMU.
In EMU, the curve shifted lower with the belly underperforming and yields down 10 basis points at the wings and a more modest 3 to 4.4 basis points in the 5 and 10- year sectors. The sharply lower-than-expected German CPI galvanised hopes for a 50 basis points cut at the ECB meeting on Thursday and stimulated some in the market to speculate on hints that the ECB will go further in its non-standardized policy measures. Later today, in a separate flash report we will indeed argue that the ECB will announce some non-rate policy initiative.
In the US, yield changes were modest and limited to about 2-3 basis points with the exception of the 7- and 30-year. The former went up 7 basis points, but for a large part due to a benchmark change, while the latter fell 4 basis points due to positioning ahead of today’s Fed purchase in that sector. The daily curve movements seem to be driven by the Fed program of purchases of Treasury securities and more in particularly due to the specific sectors on the curve the Fed targets.
Intra-day, bonds were well supported in European trading, as equities were gradually sliding lower and the German CPI surprised on the downside. The market held well up in early US trading, as eco data were little eventful and ignored, and the Fed purchased in the 2-3 year sector of the curve. Profit taking in thin dealings later in the session pushed Treasuries (and Bunds) sharply down.
US Treasuries little changed in thin trading on Friday
The eco calendar is empty today, but later this week, the calendar heats up with some very important data, as the ISM and payrolls, scheduled for release. Besides the data, the Fed purchases of Treasuries will get attention too, as will the important G-20 meeting that starts on Thursday. The absence of new supply is a positive for the market.
Regarding the manufacturing sector, tomorrow, the Chicago PMI is scheduled for release. Last month, the Chicago PMI showed a slight increase (34.2 from 33.3) and for March, another marginal improvement (34.7) is expected. We believe a better than expected outcome is not excluded after the Philly and especially Richmond Fed surprised on the upside of expectations. However, the improvement was not generalized, as the NY Fed empire state manufacturing index showed a further deterioration. Later this week, the ISM manufacturing index is expected to stay unchanged (at 35.8) after the marginal improvement in February. The risks might be on the upside of expectations, but the outcome of the Chicago PMI may still affect our assessment. On Friday, the non-manufacturing ISM is scheduled for release. Last month, the non-manufacturing ISM lost somewhat of its gains from January and December, but for March, a slight increase is forecasted (42.0 from 41.6). Here, the outcome of the manufacturing sector, with which there is a strong correlation, may be decisive.
This week, we will receive some additional data from the housing market. All housing data released earlier this month for the month of February surprised on the upside of expectations, which raised hopes that the bottom in the housing market is behind us. Tomorrow, the S&P Case Shiller house prices are on the calendar and a slightly less negative outcome is expected (-18.50% Y/Y from -18.55% Y/Y). Pending home sales are forecasted to have dropped by 2.0% M/M in February (from -7.7% M/M). If an increase in sales would be the case, this will add to hopes that the worst in the housing market is behind us.
But this week’s eye-catcher will be the March payrolls. In the previous three months the payrolls reported each month a job loss of more than 650 000. For March, no improvement is expected as the consensus is looking for decline by 660 000 in employment. Especially the development in continuing claims raises fears that another awful labour market report is expected and also the initial claims remained at record high levels. Wednesday’s ADP report might give us a better indication, but also the ADP report is expected to remain extremely weak as the revised statistical underpinning is for a significant fraction based on the development of the claims. There are no T-Note auctions planned.
The event calendar is quite thin this week as compared to previous weeks with the noticeable exception of the G-20 meeting. There are no testimonies before Congress of which we are aware and the number of Fed speakers is limited. Minneapolis Fed Stern speaks on Tuesday in Washington on “too big to fail”, one of his favourite themes. In the current crisis, that theme is certainly one of the key themes and it was subject of comments by Mr. Geithner when he presented his plans for a new architecture for the financial markets. Philly Fed governor Plosser speaks on Tuesday on regulatory reform, while Cleveland Fed governor Pianalto speaks on Wednesday at the Ohio Bankers’ Day. On Thursday and Friday, the Richmond Fed organizes a credit markets conference on Thursday-Friday, at which chairman Bernanke gives the key-note closing address.
The Fed conducted its second round of purchases of Treasury securities in the 03/11 to 04/12 maturity sector for an amount of $7.5B, a similar amount as in its first operation. It seems the Fed wants to frontload its program and warns investors not to fight the Fed. Investors submitted for $23.3B offers (offer/cover 3.09) versus $21.9B in its first operation. The NY Fed bought $5.625B or about 75% of total purchases of the active 3-year (03/12). Also in the first operation the active 7-year issue was bought the most, but not in the same big amount. The Fed purchased seven issues in the chosen sector and left 11 issues untouched. Today, the Fed conducts its third operation of Treasury purchases targeting now the very long end (17-to-30-year) of the curve. If the two previous operations are a good indication for today’s operation, the Fed may again buy about $7.5 worth of Treasuries and most likely most of it in the on-the-run 30-year. However, the Fed may lower the amount bought or it will finish its program in a few months instead of the intended 6 months. The Fed may also decide at some point not to target the on-the-run. It seems also that the Fed excludes the cheapest to deliver issues in its buyback operations.
Regarding trading, yields were modestly higher last week by 4 to 20 basis points, with the 5- and 7-year underperforming, due to benchmark changes and the 30-year outperforming with its yields down 5 basis points. The outperformance was due to the announcement that the Fed would this week purchase Treasuries at the very long end of the curve, whereas markets were more focussed on purchases in the 2-to-10- year maturity bucket and doubted whether there would be purchases at the very long end. Intra-week, Treasuries corrected lower until Thursday when a bottom was found and slight gains followed. However, on Friday, the market couldn’t prolong its upmove and closed little changed. The 2-, 5- and 7-year Note auctions went well with good demand and quite aggressive bidding. The Fed held its first two Treasury buyback operations for an amount of $15B. However, these intrinsically Treasury-positive factors were unable to prolong the huge post-FOMC rally on Wednesday of the week before. Indeed, risk appetite in overall markets improved due to better-than-expected eco data, the expansion of the Fed’s balance sheet and to the private public investment program (PPIP) that should allow banks to sell their toxic assets. It is the first time since the start of the crisis that the markets reacted positively to government plans. This might be an indication that markets feel that enough is done now to give the economy again traction further down the road. Many uncertainties and risks still exist, but the risk/reward balance might gradually tilt toward more risky assets. Equities (S&P) gained more than 6.5% last week and are up an impressive 23% from the March 6 low. There is of yet no convincing signal that the bear market is over. A sustained rise of the S&P above 943 is needed. However, we suspect that first a correction will occur and it will be interesting to see how this correction goes and where it stops. Eventually is even a re-test of the lows not excluded. The return of risk appetite was apparent in the swap spreads that narrowed substantially and in CDS and corporate bond spreads.
The better risk/reward balance in markets doesn’t automatically mean that Treasuries can only go lower. On the contrary, the climate is still rather Treasury positive. Eco climate remains challenging and renewed eco weakness will periodically remain an issue, maybe starting with this week’s payrolls report. Regarding equities, we suspect that following the recent strong rally, the market will get again enough bad news to drive equities from recent highs and even a retest of the lows shouldn’t yet be excluded. The Fed purchases of longer-date Treasuries is another positive and more in general the Fed is still expanding its balance sheet at the fast pace: there will be no sign or talk of turning policy around likely in many months. Bond yields also bottom in general well after equities. All these Treasury positive should not led us forget that the tsunami of new supply is not over. Regarding shorter term strategy, we think that the correction we witnessed following the post FOMC gains has run its course, as key support (122-28+ June Note future) held. Some upward price action at the start of the week wouldn’t surprise us. Besides end-of-month extension buying, the Fed will conduct two buy-back operations. Equities, as said, might be prone to more profit taking with the Obama administration refusal of the carmakers restructuring plan an item. Later in the week, it will be the G-20 and the payrolls that will drive the market. If the G-20 would come up with firm action to re-flate the global economy, it would be equity positive and Treasury negative. However, given the various, often contradictory views on that, from a risks/reward point of view, we wouldn’t bet on the G-20 to do more than agree on some kind of general framework, something that shouldn’t be enough for markets to get excited. On the payrolls, we have no elements to distance ourselves from consensus.
So, in the shorter term, we stick to our buy-on-dips strategy with the ideal entry levels (122-28+ June Note future). 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. Therefore, we play the range short term, buying around 122-28+ (June Note future) and selling around 126-04/24 (highs).
ECB’s unconventional measures in the focus this week
Today, the euro zone calendar contains the European Commission confidence indicators (March).
Last month, economic confidence plunged to a new record low with all sub-indices (except construction confidence) also hitting new record lows. The headline index dropped from 67.2 to 65.4 and is expected to show a marginal increase in March (to 65.8). The improvement is expected to come from business sentiment, while consumer confidence is expected to remain unchanged at the record low. We believe the risks might be on the upside of expectations after the recent (but also slight) improvement in the PMI’s. Tomorrow, we will receive the first estimate of euro zone CPI. In line with German inflation data, euro zone consumer price inflation is expected to come out below 1% (at 0.7% Y/Y), after the slight uptick in February. Today, the Belgian and Spanish CPI data are scheduled for release. Later this week, we will receive the final PMI figures, which are expected to confirm the first estimate.
On the supply front, Italy and Slovakia (today), France and Spain (Thursday) will tap the market this week for a total amount of up to €20B. Supply is quite well spread across the yield curve. Last week, supply concerns flared up again following a failed 40-year Gilt auction in the UK, but overall the intra-EMU spreads narrowed further benefiting from the general improvement in risk appetite on the global financial markets. Today, Italy will tap 2 BTPs in the 3- and 10-year sector for an amount of €3-3.5B as well as 2 CCTs in the 5- and 6-year sector for an amount of €3- 3.5B. On Friday, the Italian 10-year inflation-linked BTPei auction was well received with a strong bid/cover of 2.45 compared to 1.48 at the previous auction. Slovakia on the other hand will tap a 2-year zero-coupon bond for an unspecified amount. On Friday, Moody’s has lowered the outlook for Slovakia from positive to stable. Regarding today’s auctions, the 10-year BTP auction will be most closely monitored, as longerterm auctions would be the first to fail if investors would grow more concerned about the state of the public finances or about the longer-term prospects for inflation. Ahead of today’s auction, Italian government bonds underperformed slightly on Friday.
Over the weekend, the Spanish government had to bail out its first bank, as it will take our management of regional savings bank Caja de Ahorros Castilla La Mancha and provide liquidity guarantees of up to €9B to keep the bank afloat.
On the ECB front, ECB president Trichet will give its quarterly testimony before EU parliament, while ECB’s Bini Smaghi will speak on the European economic outlook. Both speeches come just ahead of this Thursday’s important ECB monetary policy meeting. Although the ECB governing council members usually don’t speak about monetary policy in the week of the meeting, the testimony of Trichet will likely be an exception. Market attention will particularly go out to comments about additional unconventional measures the ECB governing council could take at this week’s meeting after several governors hinted at an extension of the refinancing operations beyond the current six months and vice president Papademos on Friday even mentioned the purchasing of private debt securities. These measures should further ease liquidity and credit strains and as such lowers the financing costs for European companies and consumers, now that the room for more interest rate cuts is running rapidly dry. Indeed, following this Thursday’s expected rate cut to 1%, the deposit rate will fall to almost zero, which means that the rate cut cycle has probably ended. Based on recent ECB comments and the importance of the banking sector in the euro zone’s financial landscape, we expect the ECB first to focus on a restoring of the monetary transmission mechanism via the banking channel through the extension of its refinancing operations before purchasing corporate bonds. Such an extension would not only lower short-term market interest rates but would also have a downward impact on longer-term yields.
Regarding trading, German bonds tried to extend their rebound on Friday, but fell prey to profit taking late in the session despite the losses in the equity markets. Ahead of the ECB meeting on Thursday, we remain quite bullish on the outlook for German bonds. This morning’s heavy equity losses in Asia and rebound in the US Treasury market support this view. From a technical point of view, the highs in the Bund will however remain very difficult to break above. Therefore, we stick to our buy-on-dips approach and favour profit-taking on longs in case of a test of the highs in the 124.71-125.63 area.
In the UK, the hometrack house price index this morning showed prices falling at their slowest pace in 10 months in March by 0.6% M/M and 10.3% Y/Y. The property website sounded more optimistic about the outlook as it stated that ‘while market conditions remain extremely tough, and the economic outlook is far from rosy, agents are currently marking down prices less aggressively than they were in the autumn’. ‘Still, prices will probably keep falling the rest of the year’. On Friday, BoE’s chief economist Dale already pointed to some signs of stabilization in the housing market. In another survey this morning, the CBI was however very downbeat on the financial sector, as they expect financial-services companies to cut as many as 15 000 jobs in the second quarter.
Today, lending data will be released and Bank of England’s director for financial stability Jenkinson (no MPC member) will speak at the Annual Liquidity Management Conference.
