Markets: Fixed Income
On Wednesday, there was quite some divergence between price action in the US and in EMU. The curves in both areas continued to steepen, a result of the combination of re-assessment of the economic prospects and expectations central banks will sustain their ultra-easy rate and liquidity policy. However, while in the US yields fell by 1-to 2 basis points with the exception of the 30- year that saw its yield up 1 basis point, German yields shot up by 6-to-9 basis points. The benchmark change was responsible for a rise of 21 basis points in the 2-year sector. In the euro zone, the intra-EMU sovereign spreads narrowed further, as the overall market sentiment remained bullish.In EMU, the Schatz auction went very well despite very low yield levels, probably due to abundant liquidity. However the overall market couldn’t profit as a bout of selling pushed the Bund below key support levels. Stronger equities played certainly a role, but it might have been due more to a lagged response on the economic improvement that has been apparent of recent. Indeed, in recent weeks the EMU market, more than the US one, had ignored the improved chances on a V-shaped recovery. The Bund stayed above the neckline of a bullish double top for longer (and contrary to the US Treasury), but couldn’t make headway which suggested that a correction was likely, something which occurred yesterday.
In the US, Treasuries initially were also under pressure ahead of the 10-year Note auction and because of equity strength, but a good 10-year auction and a reassuring Beige book (no inflation threat and soft on growth) pushed Treasuries to near unchanged levels for the day.
Technical picture Bund deteriorates
Today, the calendar contains the French industrial production data (July), US trade balance (July) and weekly claims. In France, industrial production is forecasted to show the third consecutive increase in July. In June, French industrial production rose by 0.3% M/M bolstered by strong gains in the auto sector. For July, the consensus is looking for an increase by 0.4% M/M. In the US, the trade deficit is expected to have widened slightly in July (-$27.3B from -$27.0B). Rather limited changes in both exports and imports are forecasted. In the week ended September 5, initial claims are forecasted to have dropped by 10 000 to 560 000, after showing a slight upward surprise in the previous week. Continuing claims, which are reported with an extra week lag, are expected to have dropped by 34 000 to a total number of 6 200 000. The developments in the claims should be monitored closely, as the claims are one of the timeliest indicators on the state of the US labour market.
Regarding monetary policy, there are a lot of ECB speeches scheduled, while Fed’s Lockhart will speak in the US. The ECB will also publish its monthly bulletin, which may provide further insight in the current thinking at the ECB. Although the ECB has stressed that it is too early to start withdrawing monetary stimulus, markets are looking for guidance on what will decide the timing of the exit strategy.
Yesterday, Chicago Fed Evans restated the current Fed mantra that it is too early to start reversing the accommodative stance in monetary policy. He dismissed both the deflation and inflation stories that are currently popping up in all media. The Fed has acted responsibly to prevent a potential deflation threat and in the same vein it will react timely to nip inflation in the bud when time is appropriate. The Fed’s independence is the guaranty for the fulfilment of its objective of price stability. We completely agree theoretically, but following the extraordinary measures it had to take, the chance that it will change cap on policy at the appropriate moment is very slim. Indeed, like Dallas Fed Fisher said yesterday, ‘given the lag between the time monetary policy is initiated and when it impacts the economy, that wind-down process needs to begin as soon as there are convincing signs that economic growth is gaining traction and that the lending capacity of the banking system is capable of expansion’. We fear the stakes on the timing of the exit are very high, as moving too early might cause the much-feared double-dip recession (and deflation), while moving too slowly might lead to more bubbles and inflation. Bets are open!!Accordingly, the Beige Book assessed the economy as still soft and activity often sluggish, but there were widespread reports talking of activity improving, firming or levelling off. So the report was consistent with an economy not yet in recovery but nevertheless poised to start growing soon. We think that the Book was deliberately not too optimistic. Central Banks worldwide are being very cautious and don’t want to derail the nascent recovery by tightening policy too early. To be successful they need to calm down market expectations about that recovery or they might be forced soon to reverse their ultra-soft policy.
On the supply front, yesterday evening’s $20B 10-year Note re-opening went very well mirroring a similar strong 3-year Note auction on Tuesday. The auction stopped at 3.512%, well through the WI bid of 3.526% at the moment of the stop. The bid/cover of 2.77 was also well above the average for re-openings. At the same time the indirect takedown was exceptionally strong. So the buy-side certainly showed up and the fact dealers got a record low takedown bodes well for secondary trading. Given these results, expectations for today’s $12B re-opening of the 30-year bond (4.5% August 2039) have improved, even if there is not always a strong relationship between the successes of various auctions. There will be a second re-opening in October. The auction will raise all new cash and the cash flows surrounding this week’s 3 auctions are unfavourable, as stated in our previous reports. However, at least already in the case of the 3- and 10-year Note auctions, this didn’t prevent the auctions to be successful. If the auction goes smoothly, we might see some relief in the market, especially should dealers once more take down only a small part of the auction.
Regarding trading, we have no strong opinion on the near term outlook for US Treasuries, but after the good run of the last month, it looks difficult for Treasuries to make much more headway. In yield terms, the market tested the necklines of potential double top formations, but at least for now without success. These necklines stand at 0.85% for the 2-year, 1.35% for the 3-year, 2.16% for the 5-year, 3.25% for the 10-year and 4.15% for the 30-year. Only a break below these levels would unclog the market and open perspectives for more gains. However, we think such a move is difficult to sustain given our positive outlook for the economy and the rather low levels reached.
In a daily perspective, the upward correction in yields might be over. Treasuries rebounded nicely yesterday following a strong auction and a reassuring Beige Book that will allow the Fed to restate that it is too early to start reversing the exceptional accommodative monetary policy.
Regarding European bond trading, yesterday’s sharp downward correction has deteriorated the technical outlook for the Bund, as it moved again below the neckline of a short-term double bottom formation at 120.84. Recently, we were already a bit disappointed as the break higher failed to generate much momentum. The reversal now suggests that more downside correction is becoming increasingly likely. At the short end of the curve, yesterday’s successful German Schatz auction indicates that the abundant liquidity provisions by the ECB are an important supportive factor for short-term bonds, even while yields have fallen to very low levels.
In the UK, the Bank of England will announce its monetary policy decisions, but following last month’s unexpected increase of the asset purchase facility from £125B to 175B no change is expected. Recently, there has been some discussion whether the Bank should lower the interest rate paid on bank reserves in an effort to encourage banks to step up lending. We however expect no decision on this subject today, as the monetary framework doesn’t facilitate such a move and as the Bank has recently indicated that it favours to take new decisions in inflation report months (Feb, Jun, Aug and Nov).
