Markets: Fixed Income
On Tuesday, better than expected manufacturing surveys out of China, Europe and the US failed to boost market optimism, as a buy the rumour sell the fact reaction pushed equities and commodities sharply lower and helped government bonds to rebound off the intra-day lows set immediately after the release of the ISM. The ISM showed the US manufacturing sector expanding for the first time since January 2008.
As a result, the rise in US yields was reversed by the end of the day. US 2-year yields fell by 6.3 basis points, while 5-year yields dropped by 7 basis points and 10- year yields by 3.5 basis points. 30-year yields bucked the downtrend and rose slightly by 1.4 basis points ahead of next week’s longer-term auctions. In the euro zone, the German yield curve steepened too with German 2-year yields down by 5.1 basis points, 10-year yields by 1.6 basis points and 30-year yields by 0.7 basis points. The decrease in risk appetite was also reflected in the intra-EMU sovereign spreads, where the spreads widened again.
Both US T-Note and Bund future at key technical levels
Today, the calendar contains the preliminary estimate of euro zone’s second quarter GDP, the US ADP employment report (August) and July factory orders.
According to the advance estimate, euro zone GDP contracted by 0.1% Q/Q, while a deeper contraction was expected (-0.5% Q/Q). The preliminary estimate is forecasted to confirm this outcome and will provide us the breakdown. The biggest drag is expected to come from inventory liquidation, but also investments are likely to show a negative contribution. Net exports, household consumption and government expenditure are forecasted to have mitigated the contraction. Recently, the correlation between the ADP employment report and official payrolls loosened somewhat as the ADP report overestimated the number of official job losses. For August however, the consensus is looking for a significant improvement in ADP employment (-250 000 from -371 000), which would bring both surveys more in line with each other. Nevertheless, we believe that the risks are still for a weaker ADP report. In July, US factory orders are expected to show the fourth straight increase. The consensus is looking for an improvement by 2.2% M/M, but an upward surprise is not excluded after the durables.
This evening, the Fed will also release of the Minutes of the August FOMC meeting. The statement issued after the meeting showed very little changes compared to the previous. Indeed, in the statement, the Fed repeated that it believed the federal funds rate will have to be maintained at exceptionally low levels for an extended period and also restated its intention to purchase a total of up to $1.25 trillion of mortgage- backed securities, $200B of agency debt and $300B of Treasury securities. The only material change in the report was that the purchase of the Treasuries would be slowed down so that the purchases would only be completed by the end of October. Since, most Fed governors have confirmed that it’s too early to withdraw monetary stimulus, although some (Lacker and Bullard) questioned whether the full amount of mortgage-backed securities should be still be purchased. Overall, we expect the Minutes to confirm that monetary policy will remain ultra-accommodative for the time being.
Ahead of Thursday’s ECB meeting, Austrian ECB governor Nowotny once again suggested that it’s much too early to remove monetary stimulus, as he sees ‘a danger of very low rates of positive growth for some time’. Hence, he warned ‘against calling an end to difficult times’ and called fighting unemployment a ‘priority’, as inflation is ‘no immediate concern’. His comments again indicate that the ECB remains very cautious despite the recent improvement in the economic outlook. This suggests that monetary policy will remain ultra-accommodative for quite some time and that no big changes should be expected this Thursday.
Regarding trading. Over the past two months, 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 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 succeeded in bringing also longer-term yields lower. Yesterday’s market reaction on the better than expected ISM manufacturing now suggests that the recent rally on the equity, commodity and credit markets has gone far enough. A further substantial correction on these markets should continue to support the bond markets, which are currently testing key resistance levels both in the Bund (123.02) as well as the US T-Note future (117-19). A sustained break above would materially improve the technical outlook for bonds, certainly if the break would also be confirmed in yields, where important support is seen at around 3.25% both in German and US 10-year yields. While we are testing these yield levels in Germany, US yields are still some distance away.
In the UK, the calendar is empty today. On the supply front, the DMO will tap a 3-year Gilt for an amount of £5B.
