Markets: Fixed Income
On Tuesday, US and EMU bonds lost some more ground following a batch of stronger-than-expected US eco data, but steadied later on, limiting the losses on a daily basis. The Irish Bond auction went well, but didn’t affect the overall market. Corporate supply was once more heavy, especially in the US. Fed Bernanke sounded dovish highlighting that the recovery would be slow. On a daily basis, US and German yields were up about 2-to-4 basis points.
Intra-day, EMU bonds opened slightly weaker, but held initially a sideways trading range. Later in the morning session, bonds started to fade again mirroring some stronger equity trading. The German ZEW economic sentiment index improved slightly in September, but somewhat less than expected. However, the market barely reacted. In the run-up to the US eco releases, prices both in EMU and US slid further down, as if the market anticipated stronger eco news. They were served on demand with the US retail sales for September coming in surprisingly strong and the NY Fed survey on manufacturing confirming a strengthening of the recovery in the industrial sector. Inflation surprised on the upside both in the US (PPI) as in UK (CPI) suggesting that there is currently no reason to be too concerned about deflation. So, bonds on both side of the Atlantic got another additional hit. However, it didn’t generate additional downside momentum and after the shift lower, bonds succeeded to move off the lows and hovered more sideways in the remainder of the session, helped by some Fed purchases in the 2020-2026 sector and by Bernanke saying that while the recession probably ended the recovery would be slow and the creation of new jobs would take much time.
ECB’s Stark warns on fiscal deficits
The calendar remains attractive today with the euro zone (final) and US CPI inflation data (August), US industrial production (August) and the NAHB house market index (September). According to the first estimate, euro zone CPI inflation rose from -0.7% Y/Y to -0.2% Y/Y, slightly above the consensus estimate. The final figure is forecasted to confirm this outcome. The core CPI, not yet published in a preliminary form, is expected to extend its downtrend. Also in the US, the annual inflation level is forecasted to have reached the trough in July. For August, the consensus is looking for an increase from -2.1% Y/Y to -1.7% Y/Y, mainly due to higher gasoline prices, but partially offset by declines in food prices. In the coming months, CPI inflation is expected to return into positive territory, both in the euro zone and US, partially due to the unwinding of oil price base effects. US industrial production is expected to show the second consecutive increase in August. If confirmed, this raises expectations that investments will show a positive contribution in the third quarter. Nevertheless, we believe the risks are on the downside of expectations due to the decline in the aggregate hours worked in manufacturing. The NAHB housing market index is expected to extend its rebound in September (19 from 18), providing further evidence that the US housing market has started to recover.
The market probably won’t react too much to the CPI data as these are still in negative territory. While the market sometimes reacts to the production data, these are in fact a bit outdated compared to the manufacturing surveys. The NAHB housing market index is probably the timeliest indicator for the housing market but is traditionally not a market mover. So, markets might look for drivers elsewhere.
On the supply front, Germany will tap its 10-year Bund 3.5% Jul19 for a total amount of €5B. It will be the last auction of the bond before Germany will issue a new benchmark at the beginning of November. Yesterday, there was solid demand for the Irish bond auctions. Ireland sold €0.3B of its 5-year benchmark and €0.7B of its 10-year benchmark, which was at the top end of the pre-announced range. Irish bonds outperformed the German bond market in the aftermath.
With regard to monetary policy, ECB executive board member Gonzalez-Paramo will participate at the Eurostat conference, where he will speak on the national accounts for policymaking. Yesterday, ECB’s Quaden said that ‘once we have the feeling that economic growth is back on track, there will have to be exit strategies of the monetary and budgetary policies’. He added that these exit strategies have to be ‘gradual, not brutal, and they must be explained clearly’, as he sounded still concerned about the employment outlook, the financial sector and the investment outlook. ECB’s Stark admitted that the time to exit has not come yet, but stressed the importance of a credible exit strategy for both monetary and fiscal policy, as he warned on the negative side effects if the stimulus measures are maintained for too long. While he sounded confident on the ECB’s exit strategy, he called on governments to develop and communicate ambitious and realistic fiscal exit and consolidation strategies as soon as possible. Otherwise, he warned ‘the effectiveness of the policy stimulus would be undermined and the gradual recovery jeopardized’. Stark’s comments reflect growing concerns at the ECB that their capability to raise rates may become compromised due to the precarious state of the public finances. As such, Stark cautions that the monetary exit will have asymmetric fiscal impacts on the respective euro zone countries, as an increase in market interest rates will have a much stronger impact on highly indebted countries, in particular on those with outstanding government bonds with short maturities. During the Q&A session, Stark said ‘he saw a risk of budget deficits getting out of control, as ‘he doubted whether in the euro area…there is really the political will to reduce deficits’. He also sounded concerned about ‘certain market developments’, as he saw a risk of new asset price bubbles emerging, but added that withdrawing fiscal stimulus and liquidity too early would lead to a collapse in the banking system.
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 looked 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. This week’s correction plays into our
view, but shouldn’t yet be considered as relevant from a longer term perspective. Technically, the Note future is still toying with the 117-19, neckline of a big double bottom formation with targets more than five points higher. Despite a few trips above this level (high even at 118-16+) the future didn’t really develop a strong momentum and is currently again below. Our fundamental analysis isn’t supported by the still bullish technical picture, suggesting that the market is not ready to embrace our analysis. In the cash market, key technical support levels (that would paint double tops if broken) 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. A fall below 116-18 would be such a first sign.
Regarding European bond trading, the Bund failed to build out recent gains and closed lower for the second consecutive day on Tuesday. As such, the Bund this time didn’t ignore the better than (US) eco data and reacted negatively. Hence, the technical break higher above the necklines of two double top formations at respectively 120.84 and 121.12 has failed to generate additional upward momentum and the technical picture looks still quite indecisive. Therefore, only a sustained break above the previous reaction highs at 121.70/74 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%. On the other hand, a break below last week’s lows would suggest that the upside is rejected and would open the door for more downward correction. For now, the appreciation of the euro hasn’t had much impact on the European bond market, but in case the euro would move closer to the record highs on a trade weighted basis, this would in first instance be a supportive factor for the short end of the curve.
In the UK, the short end of the Gilt market sharply outperformed the German bond market after BoE governor King repeated in a testimony before UK lawmakers that the Bank is considering a reduction in the remuneration of commercial bank reserves. King said that taking such a move might help to encourage banks to buy more assets, spreading the benefit of the quantitative easing policy to the broader economy. In response to his comments, the UK yield curve steepened sharply, as 2-year yields dropped to new record lows below 0.80%, while 10-year yields moved higher on the back of the better than expected US data.
Today, the calendar contains the labour market data. In August, UK jobless claims are expected to have risen by 25 000 after increasing by 24 900 in July. The ILO unemployment rate, which is reported with an extra month lag, is forecasted to have risen from 7.8% to 8.0%.
