Markets: Fixed Income
On Friday, global bonds started the week with an outstanding performance, surfing on the waves of renewed risk aversion. Indeed, the rejection by the Obama administration of the carmakers restructuring plans and the bail out of the Spanish regional saving bank, Caja Castilla la Mancha, convinced equity investors to take profit on the strong rally of previous weeks.
In EMU, the eco data were dismal. Spanish building permits slumped 62% Y/Y and inflation dropped in negative territory (-0.1% Y/Y) for the first time in decades. This illustrates the enormous challenges for the Spanish economy hit by a busting real estate market. The EMU economic confidence index dropped in March to new historical low, contrasting with the slight uptick in the PMI sentiment reported last week. The US eco calendar was devoid of eco reports.
Intra-day, the price action was clear-cut. US Treasuries moved higher in the Asian session on weakening equities and the move up continued in early EMU dealings on the same factor. Afterwards the market slid in a sideways range near the intra-day highs where the EMU bonds lingered for the remainder of the day. In the US session, the price action was more volatile and the correlation with equities loosened, as the longer end was sold after the Fed bought only a small amount of very long Treasury securities in its third operation of Treasury purchases. The belly of the curve outperformed the wings in EMU, the opposite of Friday’s move. Yields fell between 3 and 7.7 basis points. In the US, the curve steepened in a bullish way with yields 8 to 1.4 basis points lower.
Intra-EMU yield spreads widened substantially on the risk aversion theme, even before S&P cut Ireland’s AAA rating to AA+ and held its negative outlook, which actually was announced after the cash market closed.
US Treasuries gain ground on risk aversion, but not convincingly
Today, the calendar contains the S&P Case Shiller house prices (January), Chicago PMI (March) and Conference Board’s consumer confidence (March). Last month, the Chicago PMI showed a slight increase (34.2 from 33.3) and for March, another marginal improvement (34.5) 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. Last month, Conference Board’s consumer confidence showed a sharp plunge (from 37.4 to 25.0) driven by the bleak outlook for the labour market. For March, a slight rebound is expected (28.0), which is in line with the Michigan consumer sentiment indicator and also ABC consumer confidence stabilized in March. S&P House prices are expected to have dropped by 18.6% Y/Y in January (from -18.55% Y/Y in December), according to the S&P Case Shiller survey. The OFHEO measure of house prices unexpectedly jumped in January. While the methodology and coverage of that index differs from the S&P one, we are curious to see whether also the S&P surprises.
Minneapolis Fed Stern speaks in Washington on “too big to fail”, one of his favourite themes. In the current crisis, that theme is certainly one of the key ones and it was subject of comments by Mr. Geithner when he presented his plans for a new architecture for the financial markets last week. Philly Fed governor Plosser speaks on regulatory reform. Plosser in H1 of 2008 voted at various occasions for a less easy policy, together with Dallas governor Fisher, but has since joined the majority of his colleagues in defending recent policy steps, as he doesn’t see inflation as a danger anymore. He favours the establishment of a clear exit strategy for the QE policy and believes the absence of it is causing uncertainty on the markets.
The Fed conducted its third round of purchases of Treasury securities this time in the 08/26 to 02/39 maturity sector. It bought only $2.499B for an offer/cover of 3.254, whereas it bought for approximately $7.5B in each of the first two auctions. The largest purchase was $891M in the 02/39 issue, which is the active 30-year bond, mirroring similar preference for the active issue in previous auctions. There was one other large purchase (6.125% of 11/27 for $419M) and in total it bought in 16 of the 17 issues in the sector. Tomorrow, the Fed will purchase Treasury securities in the 3 to 4.5 years maturity bucket.
Regarding trading, Treasuries had a relatively good run yesterday, but without being really convincing. There were no technical important levels broken and especially the long end closed well off the highs. Very interesting, the longer end sold off despite weakness in equities when the Fed limited its purchases of very long Treasury securities to $2.5B instead of the $7.5B in the first two operations at the short and medium sector of the curve. So the Fed seems indeed to concentrate on the 2-to-10-year maturity as they said when they announced their $300B program. However, the negative market reaction also shows how the market depends on these Fed purchases, which is no sign of strength. Looking at the graphs, the steep decline in yields following the Fed’s decision to start buying Treasury securities has partly been reversed and wasn’t able to push Treasuries distinctively above major resistance, making us think that more sideways trading is in the offering.
For today, the eco data may be slightly Treasury negative, but there may be still be some month end extension buying. The Fed governors should be neutral unless Fed Plosser emphasizes too much the need for the Fed to have a well-defined QE exit strategy. Equities are a wild card. Asian equities are trading mixed with the Nikkei gradually declining though. However, it doesn’t allow us to anticipate the equity trading pattern later out today. Attention might rapidly shift to the G-20 meeting and the key US data like the ISM tomorrow and the payrolls payrolls. Given these events, investors will probably remain cautious and often sidelined. Re-iterating our 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 occurred yesterday and while today Treasuries may have a more difficult time, we stick to our buy-on-dips strategy with the ideal entry levels (122-28+ June Note future).
Ireland loses AAA rating at S&P, holds negative outlook
Today, the eco calendar contains the first estimate of the euro zone CPI (March) and the German unemployment data. Last month, the euro zone CPI showed an unexpected uptick (1.2% Y/Y from 1.1% Y/Y), which might have been due to the unwinding of sharp discounts in January. For March, the consensus is looking for an outcome of 0.7% Y/Y, but the risks might be on the downside of expectations. After the sharper than expected decline in German inflation last week, Spanish inflation dropped into negative territory yesterday (-0.1% Y/Y from 0.7% Y/Y). Also the Belgian CPI dropped sharply and therefore we might see inflation falling below the consensus estimate. If inflation comes out significantly below the consensus, this will fuel talks about deflation. German unemployment is forecasted to have risen by 52 000 in March after rising by 40 000. The unemployment rate is expected to come out at 8.0%.
In conjunction with the general deterioration in sentiment on the equity markets and weak auctions from Italy and Slovakia, the intra-EMU sovereign spreads widened again yesterday. Italian and Greek bonds underperformed with the 10-year yield spread over German widening more than 10 basis points. Today, Greece will tap its 5-year benchmark 5.5% August 2014 for an unspecified amount. Price guidance is set at around 225-235 basis points over mid-swaps. Austrian bonds proved quite resilient yesterday, despite the downgrade of Hungary to BBB- by S&P and the negative outlook. Yesterday evening, S&P also downgraded Ireland from AAA to AA- and kept a negative outlook. This is will still have an impact on the spreads today.
On the ECB front, the testimony of ECB president Trichet before the Economic and Monetary Affairs Committee yesterday contained little new info, as Trichet respected the so-called ‘purdah’ or ‘black out‘-period ahead of the ECB monetary policy meeting this Thursday. The introductory remarks nevertheless showed some subtle changes compared to the introductory statement of the March policy meeting, which suggest that the ECB has further downgraded its assessment of the economic outlook. For instance, Trichet said that ‘the latest information suggests that economic activity has deteriorated further in the first quarter of 2009’ compared to ‘remained weak in early 2009’. Yesterday, German central bank governor Weber also sounded very downbeat on the economic outlook, as he indicated that ‘GDP could fall even more in first quarter than it did in the last quarter of 2008’, when it fell by 2.1% Q/Q and didn’t see the ‘potential for a slow pickup of the German economy before next year’. Despite the deteriorating growth outlook, Trichet sees the risks for deflation still low. ‘At the moment in the euro area … there is no international institution, certainly not the ECB, that would consider that the risk of deflation would be elevated and substantiated’. To tackle the mounting economic and financial crisis, we expect the ECB governing council not only to cut rates to 1% at its monthly policy meeting this Thursday, but to take more unconventional measures too. These will likely take the form of a further lengthening of the duration of its refinancing operations beyond the current maturity of 6 months. Recently, there is also more talk about purchasing private sector debt in the secondary market to improve the financing conditions of European companies. We however think it is still too early for such a move.
Ahead of Thursday’s ECB meeting, the debate on the potential unconventional measures the governing council may take will continue to support the German bond market. Yesterday, German bonds had a very strong day, although the rally already ran out of steam during the morning session and more sideways trading kicked in afterwards. This may indicate that the highs in the Bund may remain too tough 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, Gilts outperformed the German bond market, despite the slightly better than expected UK lending and housing data, as Gilts gained on the back on the back of the purchases from the Bank of England, that yesterday purchased £2.5B conventional Gilts in its reverse-auction.
Today, the Bank of England will hold its fourth reverse-auction of corporate bonds, as plans to buy £153M of high investment grade bonds. The previous auctions haven’t been a success raising calls for a more aggressive bidding or an extension of the auctions towards lower graded bonds. On the BoE front, BoE’s deputy governor responsible for financial markets, Tucker, will testify.
