Markets: Fixed Income
On Monday, government bonds benefited from the pull-back in risk appetite, as the sell-off on the Chinese equity markets dented recent bullish global equity and commodity sentiment. During the day, European bonds opened sharply higher on the back of the losses on the Asian equity markets, where the Shanghai composite closed almost 7% lower. European bonds however couldn’t hold on to the opening gains and even fell into negative territory following a stronger than expected Chicago PMI, which rose to 50, the highest level since September 2008. A late bid in the US Treasury market however reversed the losses and European bonds closed unchanged and tracked US Treasuries higher after the official closing.
In a daily perspective, US yields were moderately lower, as 2-year yields fell by 4.8 basis points, 5-year yields by 6 basis points and 10- and 30-year yields by respectively 4.8 and 2.2 basis points. In the euro zone, German yields were mixed, mainly due to the early closing of the cash market. The decline in risk appetite was also visible in the intra-EMU sovereign spreads, where the spreads widened slightly yesterday.
Still no sustained break higher in the Bund
Today, the calendar contains the final figure of the euro zone manufacturing PMI (August), the euro zone unemployment rate (July), German retail sales (July) as well as the US manufacturing ISM (August) and pending home sales (July).
According to the first estimate, the euro zone manufacturing PMI rose from 46.3 to 47.9, slightly above the consensus estimate. Today, the final figure is forecasted to confirm this outcome, but the risks might still be on the upside of expectations after the better than expected IFO and European Commission confidence indicators. Last month, the euro zone unemployment rate rose from a downwardly revised 9.3% to 9.4%, significantly lower than expected (9.7%). In July, the unemployment rate is forecasted to have risen from 9.4% to 9.5% and we have no reasons to distance ourselves from the consensus. German retail sales are forecasted to have risen by 0.7% M/M in July. In the US, the ISM manufacturing index is expected to rise from 48.9 to 50.5 in August, the first above-50 reading since January 2008, indicating that the manufacturing sector is expanding again. We believe that an upward surprise is not excluded after the Chicago PMI, which has been lagging the ISM recently, rose back to 50. US pending home sales are expected to show the sixth consecutive increase in July (by 1.6% M/M), adding to recent signs that the worst for the US housing market is behind us.
On the supply front, Austria will tap the market today, as it plans to sell €1.75B of its 10-year benchmark and 0.825B of its 5-year benchmark. In the absence of redemption payments, the net cash flows will be highly negative.
Yesterday, NY Fed president Dudley said that it’s ‘premature’ to start withdrawing monetary policy stimulus, as the ‘economy still isn’t growing very fast’ and ‘we do have a very high unemployment rate’. In a similar vein, he suggested that the Fed will buy the full amount of mortgage-backed securities that has been authorized by year end. The latter is a bit at odds with last week’s comments of regional Fed members Lacker and Bullard, who both questioned whether the full amount is still necessary. We however tend to give more weight to the comments from the Board, as these usually have a larger influence on policy decisions. As such, we still believe the Fed will buy the full amount of assets.
Regarding trading. Over the past two months, government bond markets have continued to perform 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 this year highs set at the beginning of June. The improvement in risk appetite has also led to a significant tightening in the sovereign credit spreads, which has even pushed yields of several EMU member countries to new cycle lows. This suggests 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 does also support the government bond markets. Last week’s trading indeed confirmed that the upside pressure on yields is currently quite limited, as yields continued 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 even fell below their uptrend line. First important support is now seen at around 3.25%, which is the neckline of a potential double top formation. In US 30- year yields, the similar neckline is already under test at 4.15%. In Germany, 10-year yields are also testing the neckline of a double top formation at around 3.25/20%. A sustained break below would bring the cycle lows again in the picture. In the Bund, these levels correspond with 122.50/85.
Also in the UK, the calendar contains the August manufacturing PMI. Last month, UK manufacturing PMI jumped already into expansionary territory and is expected to extend its rebound in August. The consensus is looking for an improvement to 51.5 (from 50.8). Mortgage approvals are expected to rise again in July, however they remain at low levels (half the long-term average), which suggests that activity in the housing market remains lacklustre. Overall, the lending data require close monitoring, as tight lending conditions were an important factor behind recent decisions from the Bank of England. Continued weak lending may convince the BoE to take further steps to discourage banks from depositing money at the central bank, for example by following the Swedish example and set the interest rates on bank reserves into negative territory.
