Markets: Fixed Income
On Friday, US and EMU bonds had again a strong run, still profiting from the successful US auctions, but later on US Notes and bonds were hit by preweekend profit taking that left the US market mixed into the close, but with a steeper curvature. Indeed, US 2-year yields were up 2 basis points, while 30-year yields fell 2 basis points.
In the EMU, bonds did well from the start onwards, but the bigger gains were eked out during the US session. Market participants were bullish after Thursday surprisingly reversal day. Italian industrial production exceeded expectations and ECB members Bini Smaghi and Gonzalez-Paramo talked hawkish, but none of these were able to spoil the party. Neither did equities that closed up for the sixth consecutive session. Also here the curve flattened, but in an outright bullish fashion, as was the case for most of last week. German 2-year yields dropped by 2 and 30-year yields shed 8 basis points. Intra-EMU spreads to German bonds were stable to slightly lower.
Eurex to start trading its new 10-year BTP future today
Today, the US calendar is empty. In the euro zone, the industrial production data (July) and second quarter employment figures are scheduled for release, but these are no market movers. Euro zone industrial production showed an unexpected decline in June. For July, the consensus is looking for another (small) deterioration (- 0.2% M/M) as both German and French industrial production disappointed somewhat, but partially compensated by stronger-than-expected Italian production. Other items on the calendar are the EC growth forecasts, Fed governors Duke and Lacker who will speak on financial regulation and the Italian BTP auction.
Later this week, the US eco calendar is well packed with eco data that include PPI, CPI, retail sales, industrial production and the first manufacturing surveys for September, the inevitable initial claims and housing starts. This flood of eco data will allow the market to recalibrate its views on the strength of the eco recovery. We are especially interesting in the outcome of the retail sales and especially retail sales excluding cars to gauge the outlook for consumption; initial claims as a decline to lower levels is needed to bolster consumer propensity to consume and the manufacturing surveys to be certain that the turn in the inventory cycle is well entrenched. In EMU, the ZEW economic sentiment indicator and the final HICP inflation figure are scheduled for release.
Regarding monetary policy, there are again a number of interesting speeches scheduled this week, while the ECB will also hold its monthly non-monetary policy meeting on Thursday. Currently, the debate among central bankers is focussed on the right timing and implementation of the exit strategy from their unconventional and ultra-accommodative monetary policy. Although central bankers have well signalled this is not yet the time to start withdrawing monetary stimulus, markets will be looking for guidance on the principles that will influence their decision. On Friday, ECB’s Bini Smaghi singled out five issues that demand full attention. First, he stressed the importance of the timing, as actions are difficult to reverse. Secondly, he pointed to the uncertainties related to the analytical framework, but suggested that the cross checking between the economic and monetary analysis should help to reduce the uncertainty. Another issue that will influence the timing is the fiscal policy stance and warned that the more the fiscal exit is delayed, the more the monetary policy exit might have to be brought forward. On the subject of inflation expectations, he warned for too much complacency, as the private sector might not always be a good predictor of future developments. A final issue was related to financial stability, which may not compromise the primary objective: price stability. As such, it’s not the task of the central bank to continue providing liquidity to weak financial institutions, once the financial markets have normalized. Therefore, the exit from the nonstandard measures might take place independently from the interest rate policy decisions.
On the supply front, there are no auctions scheduled in the US, but on Thursday, the Treasury will announce the amounts of the 2-, 5- and 7-year Note auctions. In the euro zone, Italy, Ireland, Germany, France and Spain plan to tap the market this week. The net cash flows will be somewhat negative. Last week, both the US auctions and the German Schatz were very successful, which indicates there is still much real demand, despite the low yields and improvement in the economic outlook. Today, the new 10-year BTP future will start trading on Eurex. A successful introduction may mainly help longer-term Italian government bonds to outperform their counterparts. Overall, the new future should help investors to hedge their positions in non-core European government bonds after the strong correlation between the German and peripheral European government bonds broke down following the eruption of the financial crisis.
Regarding US Treasury trading, we were surprised by the strong run of Treasuries last week. Indeed, in the face of signs of stronger eco data, rallying equities and a weakening dollar, the rally looks a bit suspicious. Of course, the auctions went very well (also a bit surprisingly) and the Fed continues to signal its intention to keep policy easy for a prolonged period of time. However, the latter might eventually be considered as negative for the longer end. In these circumstances, we remain suspicious about the upside for the longer end of the curve. Cross checking with the technical picture, the Note future moved above the 117-19, neckline of a big double bottom formation with targets more than five points higher. However, a first venture above that level wasn’t sustained with a 118-04+ high. On Friday, the Note future set a new high at 118-16+ before settling at 117-31+. So our fundamental analysis isn’t supported by the technical picture, suggesting that the market is not ready to embrace our analysis. In that way, we stay on the sidelines at the onset of the week. While we have no strong opinion on equities, a correction wouldn’t surprise following last week’s strong rally. Would that be an argument for the market to push Treasuries further up? It might be, but the inverse relationship between equities and Treasuries was aborted recently. Will that also be the case when equities correct lower? In the cash market, corresponding levels (that would paint double tops) aren’t reached yet. These 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 really unclog the market and open perspectives for more gains. As the market is currently not on our side, we keep a neutral view on the longer end of the Treasury market, but keep looking for signs that the month long bull-run is over.
Regarding European bond trading, the Bund continued to perform strongly too, despite the dip on Wednesday. The losses were however rapidly recovered on Thursday and Friday and the Bund is currently again close to the previous highs and above the neckline of a double bottom formation at 120.84. We are not convinced yet that much more upside is available, as the first break above this level failed to generate much momentum. Therefore, only a sustained break above the previous reaction highs at 121.70 would suggest that a new up-leg is in the offering, as this would also correspond with a break below the recent lows in 10-year yields at 3.20%.
