Markets: Fixed Income
On Wednesday, government bonds proved again very resilient despite another batch of stronger than expected eco data out of the euro zone and the US. In the euro zone, the German IFO posted its sharpest gain since July 1996, while in the US, both the durable orders and the new home sales surprised on the upside. The impact on the bond markets was however very limited, probably due to the less bullish sentiment on the equity markets, where most European equity indices closed slightly lower and US equities were unchanged. Another well-received 5-year Note auction also supported the bond market.
In a daily perspective, US 2-year yields were 3.9 basis points higher due to a benchmark change, while 10- and 30-year yields declined by respectively 0.1 and 2.8 basis points. In the euro zone, German yields fell around 3.5 basis points across the yield curve, except for 30-year yields which declined by 1.8 basis points. Consequently, German 10-year yields fell below first key support at 3.25%, which if confirmed would further improve the technical outlook for bonds. The slight correction on the equity markets was also reflected in the intra-EMU sovereign spreads, which widened slightly, as risk appetite waned a bit.
German 10-yr yields fall below first key support at 3.25%
Today, the calendar is well-filled both in the euro zone and US with the euro zone M3 money supply and credit growth data (July), German CPI (August), the preliminary figure of US Q2 GDP and the weekly claims.
In June, M3 money supply growth slowed from 3.5% Y/Y to 3.7% Y/Y and the three-month moving average fell below the ECB’s reference value of 4.5% Y/Y. For July, the consensus is looking for a further slowing in M3 money supply to 3.2% Y/Y. This should reassure the ECB governing council that medium inflationary pressures remain limited, despite the unprecedented liquidity injections. At the same time, credit growth will also be closely monitored given the latent concerns about a credit squeeze in the euro zone, which may still pose a threat to the euro zone’s economic recovery. On a monthly basis, German inflation is expected to come out flat in August. Annual inflation is however expected to have reached its trough in July and is expected to rebound in August. The first regional inflation data out of North Rhine- Westphalia showed a larger than expected increase, which puts the risks on the upside. The preliminary figure of US second quarter GDP is expected to show a downward revision from -1.0% Q/Q to -1.5% Q/Q (annualized). Downward revisions are expected to come from inventories as well as a sharper decline in business investment and a limited downward revision in personal consumption. A further narrowing in the net export deficit might partially offset these negative adjustments. In the week ended August 22, initial claims are expected to have dropped from 576 000 to 565 000, while continuing claims are forecasted to stay broadly unchanged.
On the supply front, the US Treasury will hold a $28B 7-year Note auction, which will complete this week’s auctions. Just like yesterday’s 5-year Note auction, the auction will raise all new cash. Both the 2- and 5-year Note auctions went well this week, but this is no guarantee that this will also be the case for today’s auction.
This afternoon, Richmond Fed president Lacker, a FOMC voting member, will speak on the US economy. Yesterday, Atlanta Fed president Lockhart supported the Fed’s current wait-and-see stance, as he said that although ‘the US economy is improving, it is still fragile’. He also explicitly agreed that policy interest rates will have to be kept low for an extended period. Lacker, a hawk, however warned in June that the Fed must avoid the risks of ‘waiting too long or moving too slowly’ to shrink the balance sheet and tighten policy when the recovery emerges to prevent rising inflation. Similar comments today may hurt the short end of the US yield curve. In the euro zone, ECB’s Draghi yesterday echoed recent comments from his colleagues when he said that ‘strong uncertainties’ remain even though the global economy appears to be recovering from its first recession since World War II. These comments suggest that no big change should be expected at next week’s ECB meeting, despite the recent better than expected eco data.
On the money market, the three-month dollar libor fell for the first time since 1993 below the yen libor, which does indicate that investors believe US interest rates could indeed stay low for a prolonged period.
Regarding trading, over the past month, government bond markets have performed strongly despite the general improvement in the economic outlook. Indeed, despite the rally on the equity, commodity and credit markets, yields are still well below the year highs set at the beginning of June. The improvement in risk appetite has nevertheless led to a significant tightening in the credit spreads, which has even pushed several EMU countries’ yields to new cycle lows. It appears that the outlook for central bank policy rates to remain low for extended period of time has set a new liquidity driven rally on all asset markets into motion, which should also keep longer-term yields rather low. This week’s trading action indeed confirmed that the upside pressure on yields is currently quite limited, as yields continue to ignore the better than expected eco data. From a technical point of view, US 10-year yields failed to retest the 4% level in August and fell below their uptrend line recently. Next important support is seen at around 3.25%, which is the neckline of a potential double top formation. In Germany, similar support is seen at around 3.25%, which was broken yesterday. A sustained break below would bring the cycle lows again in the picture (see graph above).
In the UK, the calendar contains the CBI distributive trades report (monthly and quarterly). On a monthly basis, sales are forecasted to have declined in August, while the quarterly figure is expected to have increased.
