Markets: Fixed Income
On Monday, government bonds fell off their recent highs, as equities rallied on better than expected earnings from Philips and an analyst upgrading of the banking sector ahead of a batch of quarterly results from the sector. These positive events offset worries related to CIT group, which provides financing to small and medium-sized companies. The rebound on the equity markets was however not reflected in the commodity markets, where the CRB index closed little changed. This may signal that the underlying sentiment is still rather cautious and helped bonds to limit their daily losses.
In the US, there was a bear steepening of the yield curve, as 2-year yields were unchanged compared to a rise by 4.8 basis points in 10-year yields. In the euro zone, the yield curve flattened slightly, as German 2-year yields were up by 1.3 basis points, while 30-year yields fell by 1.9 basis points. The intra-EMU sovereign spreads were stable on Friday amid a lack of supply.
Has the rebound in the Bund run out of steam?
Today, the calendar heats up both in the euro zone and in the US. In the euro zone, the May industrial production data and German ZEW (July) are scheduled for release. In the US, June retail sales, PPI data and business inventories (May) are on the agenda.
In April, euro zone industrial production disappointed markets falling by 1.9% M/M, while only a slight decline was expected. For May, the consensus is looking for an improvement (1.5% M/M) and we believe that the risks are on the upside of expectations after the better than expected national data. Last month, the German ZEW surprised again on the upside of expectations as it rose to the highest level since May 2006. The German ZEW is expected to extend its rebound in July as the headline index is forecasted to rise from 44.8 to 47.8. US retail sales are forecasted to show the second consecutive increase in June. Last month, retail sales rose by 0.5% M/M, which was partly driven by increasing crude oil prices. In June, retail sales are expected to have risen by 0.4% M/M, again partially related to the surge in oil prices. In June, US producer prices are forecasted to have risen by 0.9% M/M, but the yearly figure is forecasted to drop further (from -5.0% Y/Y to -5.2% Y/Y). US business inventories are expected to show the ninth consecutive decline.
A lot of attention will also go out to the equity markets where the earnings season is coming into full swing. Following yesterday’s better than expected earnings of Philips, the focus will shift towards the banking sector with Goldman Sachs, the tech sector with Intel and the pharma sector with Johnson & Johnson. The reaction of the equity markets over the coming weeks may into large extent decide what action policymakers will take next. In the US, there is currently some discussion going on whether a second stimulus package is needed, while in the euro zone the ECB is under increasing pressure to start purchasing corporate bonds in addition to their covered bond purchases. Yesterday, ECB president Trichet once again called on the banks ‘to continue to lend to firms and households at appropriate rates and in suitable volumes’. Regarding the huge amounts allotted at the ECB deposit facility, Trichet said that ‘it may take some time for the extra liquidity to be transformed into credit’. ‘Banks will have to gain experience in using the longer-term credit that they obtain … to expand their longer-term assets rather than increase the availability of short-term liquidity’. Although Trichet sounded quite relaxed, we still think that if the amounts deposited at the ECB remain sky-high, the ECB may still be forced to circumvent the banking sector and to provide direct credit to the real economy. Yesterday, Trichet however warned against such measures, as these involve a ‘significant transfer of credit risk from financial institutions to the taxpayer’, which does ‘fall within the realm of fiscal policy’. Therefore, we think it will take clear evidence of a credit crunch in the euro zone before the ECB may embark on such measures. As such, it will take at least until September before the ECB would come to such a conclusion.
On the supply front, Italy will tap three BTPs in the 5-, 7- and 9-year sector for a total amount of €4-5.75B. These shouldn’t pose a major problem, as there are a lot of redemptions scheduled this week.
Regarding trading, recent market activity has highlighted investors’ nervousness ahead of the earnings season. Compared to March, when investors had an overly pessimistic view on the economic outlook, the overall view is now much more balanced, which means that the risk on positive/negative surprises is much more even handed. This suggests that trading may be quite volatile over the next weeks, but lack any clear direction. This would also correspond well to the waitand- see stance from the policymakers. As such, we expect the downward correction in yields to run out of steam and anticipate more sideways trading, unless equities would still break decisively below the key 875 support zone in the S&P500.
In the UK, Gilts outperformed the German bond market, as they continued to rebound following Thursday’s sharp losses. This morning, the BRC retail sales monitor and RICS house price balance showed clear signs of improvement, which may weigh on the opening.
Later on today, consumer prices are expected to have risen by 0.3% M/M in June, while the yearly figure is forecasted to fall below the BoE target of 2.0% Y/Y. Regarding the BoE, Posen, who will join the MPC from September onwards, will testify on his appointment.
