Markets: Fixed Income
On Tuesday, global bonds held up rather well as risky assets, including equities, FX and commodities, rebounded after a few days of very modest profittaking. It was really the reflationary trade that struck the eye. Equities did well led by financials and basic materials, while the defensives (utilities, health care, telecom) lagged. Commodities rebounded across the board and the dollar was sold against the high yielders (and other currencies). In this environment, EMU bonds were able to avoid losses and US Treasuries even gained some modest ground. Technicals played a role, as did a successful US 2-year Note auction.
Intra-day, the Bund opened weaker and immediately tested extensively the downside (key support at 120.17), hitting a new ST low at 119.85 as equities started the session very strong. However, equities rapidly ran out of steam and stabilized at the high allowing bonds to struggle higher. Successful Dutch and Italian auctions might have been a positive factor, but at the onset of US trading, US Treasuries (and Bunds) faded again, as US traders were positioning for the 2-year Note. However, key support for the US T-Note future at 116-18 once more played its role and Treasuries and Bunds turned North helped by a technical bid. The US data, Richmond survey and house prices, were maybe at the margin Treasury supportive, but being no strong market movers their impact was limited. Bonds topped out soon after and faded again going into the US 2-year Note auction that went very well with strong demand and reasonable aggressive bidding. The auction stopped at 1.034%, below the 1.04% bid at the last WI trade and the 3.23 bid/cover exceeded easily the average of 2.60. The results led to some additional buying, leaving Treasuries with some modest gains in the close, while the German bonds were little changed on the day. The intra-EMU spreads stabilized.
No big changes expected at today’s FOMC meeting
Today, attention turns especially to the FOMC meeting and the statement that will however be published after the EMU markets closure. The eco calendar heats up in the euro zone with the first September business confidence surveys from France and Belgium, as well as the advance reading of the manufacturing and services PMI’s and the euro zone industrial new orders (July). There are no US eco data for release. The EMU manufacturing PMI is expected to approach the 50 boom/bust level, while the services PMI is forecasted to jump into expansionary territory. We put the risks on the upside of expectations. Overall, today’s eco data should confirm that the European economy has turned the corner and is again growing.
Yesterday, ECB governing council members Weber and Sramko however warned that the recovery could turn out ‘very sluggish’ and that questions remain on the sustainability of the recovery. Concerning the recent strength of the euro, Weber didn’t sound too concerned, as he called ‘the behaviour of the foreign-exchange markets not out of line with the developments over recent months’, given that ‘there were some stronger data coming from the euro zone compared to some other regions’. His comments are a bit odd, as we wouldn’t consider recent data out of the euro zone to be particularly stronger compared to the US or the UK. His comments could even be dangerous, as a further strengthening of the euro may threaten the recovery given the important role global demand traditionally plays during the first phase of a recovery in the euro zone. In this context, we wouldn’t be surprised if exporters would start to complain about the strength of the euro, as soon as it would come to a sustained break above the all-time highs in the euro trade weighted, which are currently under test. Such a development may lead to a delay in the timing of the ECB’s exit strategy and provide support to the short end of the yield curve.
On the supply front, both the US and Germany will issue a new 5-year benchmark today. The new 5-year Bobl 2.5% October 2014 will raise €7B. Yesterday, the Dutch and Italian auctions were again successful, as the intra-EMU spreads narrowed further. The $ 40 B US 5-year Note future will raise all new cash at settlement. The size was raised by $1 B to another record. Yesterday, the 2-year Note auction went extremely well, which is a good omen and offers reason for optimism for the 5-year Note auction today, even if there isn’t always a strong correlation between various auctions.
The FOMC meetings are always a highlight for markets, even if afterwards there is often some disappointment. Indeed, the FOMC most often doesn’t want to inject uncertainty and volatility into the markets. Will it be different this time? We don’t think so. The recovery is still too fragile and while conditions in financial markets have improved, they have not normalized yet. So, the FOMC will recognize that the economy is on the mend, but at the same time will add that slow growth is very likely for a longer period, unemployment will stay high and risks to the recovery have not dissipated. On inflation, we expect no changes in the wording of the statement, even if some governors like Yellen have recently repeated that downside risks to inflation are still prevalent. As a result, we expect the Fed to repeat that it will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability and that it will continue to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended time. Any substantial change in this part of the statement would cause fireworks in the markets and convince markets that the Fed might start taking back its accommodation earlier than the markets expect.
The big question surrounding this FOMC meeting is of course whether the Fed will unveil how it will manage its exit strategy. We think the statement may announce some minor changes in its quantitative easing programs. Already after the August 12 meeting, the FOMC announced that it would slow the pace of its Treasury securities purchases in such a way that the $300B program would be completed by the end of October (instead of the end of September). In the same vein, the FOMC may decide to stretch out in time its program to purchase $1.25T of agency MBS and $200B of agency debt well into 2010 to prevent abrupt changes in the markets. Earlier the Fed already announced an end of its MMIF facility, a reduction of the TSLF and TAF programs and an extension of the AMLF and the CPFF programs. Recently, there were also rumours about the Fed contemplating introducing reverse repos in its toolbox that might later on be used to withdraw excess liquidity.
In the UK, the Minutes of the Bank of England may indicate whether the MPC still considers raising the asset purchase facility any further and/or cutting the interest rate it pays on bank reserves.
Today, bond trading should be subdued ahead of the FOMC. Asian equities are trading with slight losses, but not enough to have a strong impact on bonds. In the morning, the PMI’s may be a slight negative, but probably compensated for by a strong Bobl auction. The US auction may cause some pre-positioning in early trading, but on the results we don’t expect a big move, as the FOMC decision draws closer and traders don’t want to get surprised. The FOMC is a wild card, but as overall we expect the Fed not to surprise, the impact on markets should be limited. Any suggestion that the FOMC would bring forward a tightening of policy would of course cause a sell-off especially at the short end.
Regarding US Treasury trading (unchanged), we were surprised by the strong run of Treasuries in August and early September in the face of stronger eco data, rallying equities and a weakening dollar and advocated a defensive attitude vis-à-vis Treasuries. We were quite well served last week as a correction occurred. However, the correction still has technically no meaningful significance, even if it brought the Note future near first support levels. While we remain moderately negative for Treasuries further out, it might be a bit early to see them selling off in a major way, as the FOMC probably doesn’t want to surprise markets. So we would sell Treasuries on upticks, if possible closer to the recent high at 118-16+ (10-year T-Note future). However, should Treasuries decisively drop below 116-18 we would jump the bandwagon. Should we be wrong and a powerful rally takes off, one needs to survey, in the cash market, the key technical support levels (that would paint double tops if broken) that 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. However, following the recent correction, it is now more likely to look for signs that the August-early September bull-run is over.
Regarding European bond trading, the Bund failed to build out recent gains and even tested extensively support levels (120.17). Indeed, the technical break higher above the necklines of two double top formations at respectively 120.84 and 121.12 earlier on has failed to generate additional upward momentum. A confirmed break below 120.17 (now neckline potential double top) would suggest that the upside is rejected and opens the door for more downward correction, also as the uptrendline from the 116.37 at 120.33 today would have been decisively broken (cf. graph). On the upside, 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%. While the current picture is one of indecisiveness, there are some prevailing risks on the downside for bonds though. However, as we expect the ECB to refrain from withdrawing its liquidity supportive policy in the next few weeks, as a 1-year tender at 1% will be held next week, it might be a bit too early to get a decisive break to the downside, which remains our view in a medium term perspective though.
