Markets: Fixed Income
On Monday, following two days of violent correction, global bonds found back their composure and closed with modest, albeit technically insignificant gains. In the EMU, German yields fell between 4 basis points in the two year sector, 2.2 basis points at the 10-year sector while the 30-year was nearly flat. The US bond future traded, but the cash market was closed in observance of Columbus Day.
We would qualify yesterday’s price action as essentially corrective in nature following a big two day sell-off that was partially attributed to hawkish comments of Bernanke, an interpretation we don’t share though. There were no eco data releases or other events behind the price action, but two stories underpinned the price action and might also have been behind the bull flattening of the curve. The Dutch National Bank took the DSB bank into custody after the bank was hit by a bank run. Also the CBER study on the UK economy had an impact. It concluded that rates would remain low for a long time, the sterling would lose more ground and the future government would implement a severe austerity program to correct the huge fiscal budget.
Intra-EMU government yield spreads versus Germany were little changed. The draft conclusions of a EU Fin Min meeting to take place next week show that Ministers are ready to announce the start of fiscal consolidation in 2011 on the condition the recovery is strengthening and becomes self-sustaining. This is interesting following remarks of ECB Trichet at his press conference that fiscal plans should be prepared urgently. However, the draft shouldn’t impress markets that would like to see more concrete initiatives and strong commitments to implement the consolidation plans.
Bonds rebound slightly, but jury is still out
Today, the eco calendar contains only second tier releases in the US, but in the euro zone, the October German ZEW economic sentiment indicator is worth looking at, even if the market reaction is often subdued and/or temporarily. The German ZEW index for October is expected to show some modest improvement. In September, it fell short of expectations, even if it still rose marginally. 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.
Following a strong Q3 earnings report of Philips that pushed equities substantially higher in Europe, attention now turns to the US with earnings reports of Intel and Johnson & Johnson, two bellwethers. While the correlation between bonds and equities was loose in recent months, especially when equities did well, bonds ignored equities, which was not the case when equities fell. However, this shouldn’t remain the case. If the S&P would break through key resistance and rally further, we might see a bigger negative reaction of bonds than recently. Risk appetite is clearly on the rise as evidenced also by an FT article (yesterday) that highlighted the upped optimism of Blackstone, the large buy-out firm that is planning to list 8 firms it owns and sell five others.
On the supply front, the Netherlands will tap its 5-year benchmark 2.75% Jan 2015 for an amount of €1.5-2.5B. Yesterday, Finland issued a new €3B 15-year benchmark via syndication. The new bond Jul 2025 was priced at 21 basis points above mid-swap. During the day, Finnish bonds underperformed slightly. Besides the overall bullish sentiment on the equity markets, this week’s auctions will also have to cope with very negative cash flows, as there are no redemptions. As such, 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. With regard to today’s Dutch auction, the problems with DSB Bank, which was placed under control of the central bank yesterday, may be an additional negative, as it may have negative implications for the Dutch budget.
With regard to monetary policy, Fed governors on duty are NY Fed Dudley on a notspecified theme at the Institute of International Bankers luncheon and vice chairman Kohn on the economic outlook. In EMU, the new Irish Central Banker, Mr. Honogan makes its maiden speech, while ECB Tumpel Gugerell speaks on payments systems. Following last week’s ECB press conference, we don’t expect them to move the market, but the Irish banker is known for his frankness. The further strengthening of the euro may however raise concerns in Frankfurt, after the euro yesterday rallied to its highest level in 6 months against sterling. The strengthening of the euro should be mainly supportive to the short end of the curve, as it may hurt the recovery and keep interest rates longer low than previously assumed.
Regarding today’s bond trading. Yesterday, bonds were able to recoup some ground following Friday’s steep losses. This however happened in very thin trading conditions, as US traders were absent in observance of Columbus Day. Last week, the downward correction was mainly triggered in the US after the 30-year bond auction results disappointed a bit and the speech of Bernanke was considered as hawkish. It will therefore be very interesting to see how US bond markets will evolve this afternoon. Yesterday, equities started the week in a positive mood following strong earnings from Philips. A sustained break above the highs may be a bond negative, but we wouldn’t overestimate the immediate impact as the correlation has been quite loose in recent months.
Regarding US Treasury market, early October Treasuries broke key resistance levels suggesting that another up-leg was in store. We didn’t fully embrace the move at the time as it was at odds with our fundamental view and advised to use the break and rally to offload long position, albeit at higher levels than we actually reached. Indeed, the improvement of the technicals suggested that more gains were likely. The correction at the end of last week was technically relevant (re-break of the key levels). At the start of the (US trading) week, we take a step back and want to see how traders react after the correction before drawing longer-term conclusions. Was it sim- ply a technical correction or has it a more fundamental meaning? In the next few days, some key eco data and the earnings season may give us an answer.
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%. Yesterday, the Bund fell to 121.76 and rebounded afterwards, which signals that the uptrend is still intact. We however still believe that the upside in prices is limited and are still looking for signs that sentiment is changing.
In the UK, Gilts reversed Friday’s steep losses on the back of a report from the Center for Economics and Business Research that forecasted UK interest rates to stay at record low levels until at least 2011. Overnight, the RICS house price index provided fresh evidence of the recovery in the housing market, as the index rose from 10.7 to 22, the highest since April 2007. According to the RICS, ‘a lack of supply is still underpinning the rise in house prices with new instructions to estate agents only edging up very gradually. This imbalance between demand and supply suggests that house prices will move higher in the near term’. Also overnight, the BRC retail sales monitor showed same store sales rising 2.8% in September compared to a year ago, when sales were hit by the Lehman debacle. Later today, CPI inflation is forecasted to have risen by 0.3% M/M, while the yearly figure is expected to extend its downtrend (from 1.6% Y/Y to 1.3% Y/Y) mainly due to favourable base effects. From next month onwards, however, base effects from crude oil are likely to see yearly inflation figure creep up again.
Besides the inflation data, the speech of BoE Bean on the economy may prove to be very interesting, as the MPC will have to decide in November whether to increase their asset purchase facility again or not. In August, Bean voted in line with the majority for an increase by £50B, whereas governor King, Besley (no MPC member anymore) and Miles supported a larger 75B increase. Yesterday, PM Brown said that he would support the Bank of England when it decides to halt its quantitative easing, but overnight, the BCC urged the Bank of England to expand its asset purchase facility by another £25B to £200B. Overall, it’s clear that the quantitative easing is nearing its end, which may prove a difficult hurdle for the bond market. Bean’s comments may also have an influence on sterling, which has come under increasing pressure from the Bank’s aggressive monetary policy. Yesterday, the report from the Center for Economics and Business Research led to a selling wave of sterling.
