Markets: Fixed Income
On Friday, global bonds sold off sharply. In the US, yields jumped 8 basis points in the 2-year sector and 13.3 basis points in the 10-year sector. In the EMU, 2-year yields rebounded even more sharply by 12.4 basis points, while 10-year yields moved 8.9 basis points higher. The European eco data with French and Italian industrial production were much stronger than expected, but weren’t the driver behind the sell-off, as bond prices rose at the time. In the US, the trade deficit was slightly smaller than expected, but also shouldn’t be considered as the trigger. US equities rebounded after a lower opening and may have had some negative impact, but overall the gains were too limited to explain the sell-off on the bond markets.
Some headline stories of news agencies brought about discussion in the market on the Fed’s exit strategy and might have been the trigger for a continuation of the profit taking that started on Thursday after a less well received 30-year bond auction. Firstly, the articles referred to the overnight speech of Fed chairman Bernanke on the Fed’s balance sheet, while the FT was running an article that the Fed was conducting small scale tests of reverse repo trades. Regarding the former, we think that the news agencies have read too much in his speech. The latter was very technical in nature, explaining the various posts on the Fed’s balance and how they had evolved since the crisis started. The chairman also spoke about the various tools it could use to diminish the excess reserves that have been deliberately created by the Fed in its fight of the financial crisis. Firstly, excess reserve will contract automatically as improving financial conditions lead to a reduced use of the special lending facilities. Secondly, the Fed can effectively put a floor under the money market rates by paying interest on the reserves, just like the ECB thus via its deposit facility. Thirdly, the Fed can use reverse repo with financial market participants, including banks, GSEs and other institutions (like money market funds) to prevent excess reserves to spill over in excess money and credit creation. Lastly, the Fed might offer term deposits to banks. So, the chairman, as he and other governors had done, continued to explain how the Fed might tighten once conditions are ready to tighten policy. There was one paragraph in the text that was interpreted by some as being hawkish, notably the following: “My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. Looking at the Federal Reserve's balance sheet is useful, once again, in helping to understand key elements of the Federal Reserve's exit strategy from its current policies”
The first sentence of that paragraph indeed is somewhat different from the key sentence in the FOMC statement that said “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” However, we doubt that Bernanke wanted to prepare the markets for a turn in policy. Firstly, Bernanke spoke after the US session whereas usually he speaks in prime time when he wants to convey an important message. Secondly, it was a theoretical speech with the key paragraph buried on the sixth page. Thirdly, Bernanke clearly said that its policy of buying MBS and Agency paper would continue going into 2010 (finish at end Q1 2010). It would be odd to start absorbing excess reserves ahead of the end of these purchases. So, overall, we don’t think that the Bernanke speech or the tests of reverse repos have any meaning for the timing of the exit. It is also difficult to interpret the market moves. In the US, the curve bear steepened instead of the more “logic” bear flattening that would be expected in case the exit policy was the real driver. Secondly, the correction started after the less well received 30-year bond auction. Thirdly, equities did well and ignored Bernanke’s comments. If they would have pointed to a near term tightening, the reaction should have been quite negative on the equity markets too, while the dollar should have rebounded more strongly after the huge losses of the previous weeks. Lastly, the short end of the EMU curve sold off (more sharply than the US one) despite Trichet repeating that it is no time for the exit strategy.
So, we tentatively think that the Bernanke comments and the reverse repo story were at best the trigger for more profit taking following the selling after the 30-year bond auction and the failed test of the post-Payrolls highs. It looks too early for the market to start already anticipating a tightening of monetary policy.
Intra-EMU government yield spreads versus Germany narrowed gently further, no signal of a dramatic change in perceptions about the direction of monetary policy.
Bund falls below short-term double top formation
This week’s calendar kicks off slowly, as today’s eco calendar is completely empty and US and Japanese markets are closed. Later this week, the eco calendar becomes busier and more interesting. We retain the following potential market moving releases. In the US, the retail sales on Wednesday and the CPI, initial claims and NY and Philly Fed manufacturing surveys on Thursday. In EMU, the eco calendar is thinner with only the German ZEW economic sentiment survey on Tuesday and CPI on Thursday worth mentioning.
Regarding the US eco data, the retail sales are a key indicator of the all important consumption that accounts for about 70% of GDP. The debt burden of US households has increased sharply in recent years and the collapse of the asset markets has left the households overleveraged. Since the crisis started, households have saved again more. To get a more sustainable recovery, consumption needs to revive. In August, retail sales were unexpectedly stronger, also outside the car sector that profited from the cash for clunkers incentives. At the end of September the latter program expired and car sales collapsed. This will be reflected in a steep decline of the retail sales. However, the market is eager to see whether underlying sales (excluding cars) improved. If that’s the case, it would brighten the economic outlook, something which would be noticed in the market. The inflation rate probably remained subdued in September with 0.2% M/M and 0.1% M/M increases expected for headline and core CPI measures. The October NY and Philly fed manufacturing surveys are as important as the retail sales. In October, the headline figures of both surveys were reasonable good, but the underlying picture showed some weaknesses. Manufacturing is the most cyclical sector and therefore we would like to see no repetition of these weaknesses. The initial claims are a weekly and thus volatile indicator. However, it is the timeliest indicator for the labour market. Last week, claims dropped substantially to a new low for the new cycle that started in March 2009 when claims peaked. Another drop (not expected by consensus) would be important and get noticed. In EMU, the German ZEW economic sentiment index for October is expected to show some modest improvement. In September, it fell short of expectations. The index has already reached a high level of 57.7 which has to be compared with peak values of 70 to 80 in previous cycles. If another disappointment occurs, we wouldn’t take it too serious, but wait for the more reliable IFO index to be published next week. The CPI flash estimate put inflation at -0.3% Y/Y in September. Follow- ing the downward revision to the German results, we put the risks on a downward revision of the EMU HICP to -0.4% Y/Y.
Alongside the eco data, the Q3 earnings season will attract much attention. Last week, Alcoa printed stronger than expected results, but couldn’t really benefit from them. Both in the US and in Europe, most equity indices are close to the mid- September highs. Although we expect the Q3 earnings to be generally stronger than expected, based on the extensive cost cutting by companies earlier in the year, it remains to be seen whether this will be sufficient to continue the recent rally higher.
As usual, many ECB and two Fed central bankers take the floor. However, coming just after the ECB meeting, we don’t expect ECB members to be very influential in the markets. The Fed governors on duty are NY Fed Dudley tomorrow on a not-specified theme and Tarullo on Wednesday about the state of the banking industry. We will preview these speeches later on this week if we think they may be relevant for markets.
On the supply front, the US Treasury will settle the auctions it held last week. Further out, the US Treasury will absent from tapping the Treasury Note market. In EMU, there is a lot of supply coming from the Netherlands, Germany, Italy, Portugal, Spain and France. Due to the exemption of any redemption this week, the net cash flow will be highly negative. It will be interesting to see whether this will influence demand at the auctions after the previous auctions from Spain and France two weeks ago disappointed a bit. This will be even more important following last week’s ECB press conference, during which ECB president Trichet called it increasingly pressing that governments come up with ambitious and realistic fiscal exit and consolidation strategies in order to ensure the sustainability of public finances. On Friday, the intra- EMU sovereign spreads narrowed slightly despite the sell-off seen on the bond markets.
Regarding today’s bond trading. Following Friday’s surprisingly steep sell-off, it will be interesting to see whether there is more follow through selling or whether bonds are able to regain some ground. Today, the calendar is devoid of market moving data and the US markets are closed. This suggests that trading may be rather quiet today and that we will have to wait until US markets open again to get more feeling of the underlying sentiment. The earnings of Philips this morning were again better than expected, which may add to the positive sentiment on the equity markets following Friday’s higher closing in the US. Asian equity markets trade mixed this morning. Shortterm, the Bund has fallen below the neckline of a short-term double top formation at 122.31 with the targets at 121.65/58.
Regarding European bond market, the longer-term technical picture of the Bund is still bullish, despite Friday’s sell-off. A sustained fall below 121.74 would be a first warning signal that the underlying sentiment is deteriorating. In German 10-year yields, this would correspond with a rebound above 3.25%. Such a move would support our view that the upside in prices is limited and that more downward correction is likely given the economic recovery and the talk about exit strategies.
