Markets: Fixed Income
On Friday, global bonds sold off, as a better than expected US Payrolls report raised hopes that the US recession is coming to an end. Indeed, while the unemployment rate surged to 9.4%, the US employment report showed that payrolls had fallen by 345 000, the smallest amount for eight months, and well below the expected drop of about 520 000. Remarkably, it was mainly the short end of the curve that was sold off, which resulted in a sharp bear flattening of both the US and the German yield curve.
In the US, 2-year yields rose by more than 30 basis points compared to 24.3, 11.8 and 5.4 basis points in 5, 10 and 30-year yields. Comments of Fed’s Lockhart contributed to the sell-off at the short end, as he was quoted in a MNI article saying that ‘he could envision the Fed eventually raising US benchmark interest rates while continuing to run an expansionary monetary policy’.
A similar move was seen on the European bond market, where German 2-year yields rose by 15.7 basis points compared to 14.5, 8.4 and 2.4 basis points in 5, 10 and 30- year yields. The intra-EMU sovereign spreads narrowed, as investors’ risk appetite improved in the wake of the better than expected Payrolls report.
Sell-off shifts to short end of the curve
Today, the eco calendar is thin with only German factory orders (April) scheduled for release. In March, German factory orders showed an unexpected and wide-spread rebound (3.3% M/M) after six months of steep declines. For April however, the consensus is looking for a flat outcome, while the year-on-year figure is forecasted to show an awful 33.2% Y/Y drop. Later this week, the calendar remains rather thin in the euro zone with only the industrial production data (April) released on Friday. In April, euro zone industrial production is forecasted to show its eighth consecutive decline. The consensus is looking for a drop by 0.4% M/M, but some national indicators, released earlier this week, might give us a better indication.
In the US, the calendar heats up in the second part of the week with the trade balance (Wednesday), retail sales (Thursday) and Michigan Consumer Confidence (Friday). In March, the trade deficit widened again after reaching its lowest level in nine years in February. For April, the consensus is looking for another widening of the deficit from -$26.7B to -$28.7. It is also interesting to keep an eye on the developments in imports and exports. Last month, US retail sales showed an unexpected decline, but for this month, markets expect to see an improvement in retail sales. Another disappointing figure could raise questions about the sustainability of the current recovery. Michigan consumer confidence on Friday is forecasted to show a marginal improvement in May (69.2 from 68.7).
The supply calendar is very heavy this week both in the euro zone and the US. In the euro zone, Slovakia (2-year), the Netherlands (10-year), Austria (6- and 10- year), Germany (5-year and new 10-year inflation-linked), Portugal (10-year) and Italy (new 5-year, 12- and 14-year) will all tap the market, while in the US, the Treasury will raise $65B via 3-, 10- and 30-year auctions. In the US, the auctions will raise all new cash, while in the euro zone the redemption of a German Schatz (€14B) won’t be sufficient to meet the amount on offer. The heavy supply calendar may lead to a widening of the intra-EMU sovereign spreads, as risk aversion has risen again due to the devaluation speculation in Latvia.
On the ECB front, last week’s ECB policy meeting has signalled that the governing council has entered a wait-and-see stance. Despite the downward revision of the growth outlook in the new staff projections and the undershooting of the inflation target, Trichet’s comments suggested that the ECB feels it has done enough and will now await the impact of its recent decisions on the real economy. As such, we don’t expect them to change policy until at least after the summer. This evening, ECB executive board member Stark will speak on monetary policy.
On Friday, the sharp rise in 2-year yields, both in the US and in the euro zone, indicates that investors are becoming more nervous about the outlook for monetary policy now that the green shoots are being confirmed. Until Friday, the upward pressure in yields had only been evident in longer-term yields, as investors expected monetary policy to remain very loose for the foreseeable future. This has resulted in a sharp steepening of the US and European yield curves since mid-2008, with the spread between 2- and 10-year yields rising to around the highs seen in previous cycles (see graph below).
Regarding trading, Friday’s sell-off has deteriorated the technical outlook for bonds. This has not only been the case at the longer end of the curve, but also at the short end. At the longer end of the curve, German 10-year yields are currently above the neckline of a major double top formation seen at around 3.70%. A confirmation of this break would signal that the era of low long-term yields is over. But surprisingly, German 2-year yields rose even more strongly than 10-year yields on Friday and are currently testing the January highs at around 1.70%. The strong rise in government bond yields also dampened the positive sentiment on the equity markets, where the S&P failed to break above the January highs and even closed slightly lower despite the better than expected US Payrolls report. This indicates that yields have risen to levels where investors become worried about. In a short-term perspective, we fear that a lot of investors still have to adapt their positions towards the improved macro economic outlook, which may result in a further correction on the recent steepening and push short-term yields still higher.
In the UK, the eco calendar is empty today, but the Bank of England will hold a reverse auction for an amount of £3.5B.
