Markets: Fixed Income
On Friday, global bonds continued their rally with the longer end of the curve up for the fourth consecutive day, as riskier markets continued to trade still somewhat heavier. The more mixed character of the incoming eco data in the US and the linked doubts on the strength of the global recovery were of course an important underlying reason for the market moves. The most interesting move though, which is a bit in contradiction with the above explanation was the tremendous curve flattening following some comments of Fed governor Warsh, who said that prudent risk management indicates that policy likely will need to begin normalisation before it is obvious that it is necessary, possibly with greater force than is customary. Coming a few days after the FOMC statement that suggested the Fed would keep policy ultra- easy for an extended period of time, it confused market participants who very well know that the shape of the curve is driven by Fed’s policy. Therefore the curve flattening, of which the long end profited (to the detriment of the short end) was very outspoken and the main event in Friday’s markets. Does this mean that this curve flattening will be the main theme for longer period? We think it might still be a bit early for that as the flattening in the US starts usually about 3 months before the actual tightening. It seems that the Fed, following the FOMC statement, found it necessary to prevent a one-way thinking and decided to inject some uncertainty about the timing of the monetary tightening. While the ECB should lag the Fed in an eventual tightening of policy, which still seems about 9 months away, the curve flattened too, but to a lesser extent. The 2-to-10-year yield spread flattening 11 basis points in the US and 7 basis points in EMU (Germany).
Intra-day, the Bund opened slightly weaker but soon traded listless slightly above Thursday’s closing lows, ignoring M3 money supply figures that were weaker than expected. Global bond markets sprung to live when US traders joined the action. The comments of Warsh (see higher) generated quite some curve activity with many traders taking profit on steepeners, a trade that was favoured during the financial crisis and the linked Fed accommodative stance. At the same time, the market reacted to the eco data, pushing bonds up after the disappointing durable orders and selling bonds following a stronger Michigan consumer sentiment. However, the drop was temporarily and when equities sagged, Treasuries and Bunds moved to new intraday highs, only marginally below key resistance levels (118-16+ T-Note future and 121.74 Bund). However, throughout these general market movements, the flattening was the eye-catcher, all day long.
Bund sets a new recovery high
Today, the market calendar is as good as empty. Some attention is warranted for the September German CPI, the Belgian OLO, the German Bubill and the Italian BTPei auctions, but they shouldn’t affect the overall bond markets. The quarterly testimony of ECB president Trichet before parliament might give some interesting headlines after Fed governor Warsh on Friday warned the US market that the Fed might start tightening earlier than is obvious and with more force. We don’t think that Trichet will be as blunt in his comments, but one should keep a close eye on Central Bankers these days.
Later this week, the eco calendar becomes more interesting. In the US, we look for the ADP employment and the Chicago PMI on Wednesday, the ISM and car sales on Thursday and especially the payrolls report on Friday. In EMU, the highlights are the EU Commission confidence data on Tuesday and the flash CPI on Wednesday. There are a number of Fed and ECB speeches scheduled of which Trichet’s today and Bernanke’s on Thursday should be singled out as potentially important. Ireland’s referendum on the new EU treaty might be important too, especially for intra-EMU government spreads. A potential no vote would of course inject uncertainty into the EMU markets of which German bonds usually profit. The electoral victory of CDU/CSU in and the liberal FDP in the weekend might cause a positive reaction in the stock market, but its impact on the bond market will at best be very temporarily (even the possible stock market rally should be limited in scope and duration).
Besides today’s auctions (cf. higher) Italy holds its BTP and CCT auctions on Tuesday, Germany taps the Schatz on Wednesday, while France and Spain hold their OAT and Bono auction on Thursday. Italy also decided to tap the dollar market with a 3-year bond via syndication, as did a number of other European governments to profit from a favourable basis swap constellation. In the US, the Treasury announces on Thursday the details of its 3-, 10- and 30-year Notes and Bonds and its 10-year TIPS, all to be held next week. The supply in the euro zone will mount to €29B in total compared to a redemption and coupon payments of around 16B, which means that the net cash flow will again be negative this week to the tune of €13B. This might be a hurdle for the EMU bond market. The ECB 1-year tender at fixed 1% and unlimited allotment is a positive, but given the current 1-year rate, it is unlikely to have much lasting effect on the market. On the contrary once it is over, the market may start anticipating a less generous 1-year tender in December.
Today’s bond markets: at the start of trading, the environment is intrinsically bond positive. Asian equities are lower, while also commodities are under some, modest pressure and the dollar is stronger. The calendar is neutral, at least if Trichet doesn’t surprise when he appears before parliament. Traders will look forward to an important US eco calendar further out and abundant supply in the EMU. On top of that, the Bund currently tests important resistance levels at 121.74 (3.20% 10-year yield) and the US T-Note future closes in on a similar 118-16+ resistance. The S&P approached on Friday the first support at 1039 (1041 intra-day low) as it posted its third consecutive daily loss. Should equities fall below this level and thus prolong its descent, risk aversion may be again a real theme that favours bonds. However, given these technicals, we suspect that there won’t be a neat break of these levels, at least not today.
Regarding US Treasury trading, since the start of September, Treasuries are in a sideways range, digesting the gains eked out since the turnaround on June 10. At the onset of trading, Treasuries are again at the top of this sideways range (118-16+ TNote Future) and thus markets are pondering whether another up-leg is in the offering. We don’t think such an up-leg is likely, because of our above consensus economic growth outlook. Of course, the accommodative Fed stance is still supportive, but it should be clear that the Fed is slowly coming closer to implementing its exit strategy. The remarks of Fed Warsh are a reminder of this. We wouldn’t draw too many conclusions from these comments and a tightening might still be well out in time, but the Treasuries should be in a bottoming out phase. Therefore, we don’t expect a break and if it would occur, we would look to build back still long positions. 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.
Regarding European bond trading. Last week, the Bund extensively tested the downside (120.17) with a new ST intra-day low at 119.85, but no sustained break occurred. The reversal on the equity markets accompanied by a decline in risk appetite helped the Bund to move again higher in its recent sideways range till the end of the week. This morning, the Bund even set a new short-term high at 121.91. For now, we don’t anticipate a sustained break higher and do expect recent sideways trading to continue.
