Markets: Fixed Income
On Tuesday, global bonds continued their gradual rebound from the violent correction witnessed at the end of last week. There wasn’t one particular strong driver responsible for the bullish sentiment, but more a complex of elements that combined supported the market. The technicals played a role too. This resulted in a bull flattening in the US by 5.7 to 3 basis points, while a similar move occurred in EMU, with German yields down by 3-to-2 basis points, the 30-year lagging the movement (yield up 2.6 basis points) on supply concerns. Intra-EMU spreads with Germany widened a few basis points (see below).
Intra-day, the Bund opened unchanged and held a tight range until the release of the German ZEW economic sentiment survey. The latter pushed the Bund into positive territory. Importantly, technical-oriented traders were well aware that the Bund had tested key 121.74 level on Monday, but without success, keeping them on the buying side. Following the shift higher, the Bund traded again in a sideways fashion, as traders awaited the return of the US traders following their Columbus Day holiday. ECB Noyer sounded dovish, but without really bringing much new info, while the Dutch auction (2015) couldn’t impact the overall market. US Treasuries opened strongly, but soon reverted to unchanged levels. Later on, Treasuries rallied on a number of factors. Equities traded sideways, the US IBD Economic optimism index showed an unexpected decline to below 50 (overnight the ABC Consumer comfort index declined too) and the Fed purchased Treasuries in the 2016-2019 sector for an amount of $2.9B bringing the total amount of purchases at $297B, nearly completing the $300B scheme. On top of that, vice Fed chairman Kohn talked dovish, which contrasted sharply with some recent speeches of colleagues. So, Treasuries moved further north, only to drop just before the official closure, probably as a result of strong Intel results. The Bund more or less stabilized, albeit at the day highs in the US session, as the Bund had already rebounded strongly on Monday when US markets were closed.
New rally on the equity markets may hurt bonds
Today, the calendar contains the euro zone industrial production data (August) and US retail sales (September). In July, euro zone industrial production dropped by 0.3% M/M, led by declines in energy and capital goods. In August, the consensus is looking for an improvement by 1.2% M/M after German, French and Italian industrial production figures showed significant increases. A strong result would point to a robust growth of Q3 GDP. The US retail sales are a key indicator of the all important consumption that accounts for about 70% of US 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 and thus trimmed consumption. 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 headline retail sales. However, the market is eager to see whether underlying sales (excluding cars and gasoline sales) improved. If that’s the case, and we think it will, it would brighten the economic outlook, something which would be noticed in the market.
Following a strong Q3 earnings report of Philips on Monday, Johnson&Johnson’s earnings also topped analysts’ expectations, but investors reacted a bit disappointed as the company reported lower revenue on slowing sales of drugs and consumer items. After closing, Intel and this morning, ASML reported very strong earnings and revenues indicating that computer demand is returning to pre-recession levels. This should bolster equities in Europe and probably the US too, at least as the results of JPMorganChase (before opening) would be strong. Overall, we expect the banking sector to have benefited from the strong performance of the equity markets over the quarter and the further normalization in financial markets, reflected in the narrowing of the risk premia. Yesterday’s market reaction to the earnings of Johnson&Johnson however indicates that the market is already anticipating quite strong earnings and is increasingly looking to the underlying fundamentals. Ahead of the earnings of JPMorganChase and other US banks later on this week, the financials underperformed yesterday in the S&P after Goldman Sachs was downgraded by Meredith Whitney Advisors to a neutral rating from a buy. As such, the jury is still out whether the European and US equity markets will be able to break higher in a sustainable manner.
On the supply front, Germany, Italy and Portugal plan to tap the market today. Germany will tap its 2-year Schatz 1.25% Sep 2011 for an amount of €4B, while Italy will tap three different BTPs in the 5-, 15- and 30-year sector for respectively €2.25- 3B, 1.25-2B and 1-1.5B. Portugal plans to sell €0.75B of its 30-year benchmark 4.1% Apr 2037. Yesterday, the Netherlands sold only €1.835B of its 5-year benchmark, which was at the lower end of the pre-announced range. Overall, the intra-EMU sovereign spreads widened again yesterday. Since the low reached at the beginning of August, the sovereign spreads tend to widen again, despite the overall bullish sentiment on the equity markets. The move also contrasts with the narrowing trend in the corporate bond market, which is still intact. This may suggest that there are increasing doubts about the vigour of the governments to scale back their budget deficits. Last week, 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. Yesterday, a report from the Irish Economic and Social Research Institute painted a much bleaker picture of the outlook for Irish public finances, as it forecasted a deficit of 12.9% and 12.8% this and next year compared to the 10.7% deficit expected by the Irish central bank.
With regard to monetary policy, ECB Bini Smaghi will speak on monetary policy and asset prices. We expect the speech to be very interesting from a theoretical point of view, but of little immediate interest for the markets. The speech will probably stress the advantages of the ECB’s two pillar strategy, whereby the money supply and credit growth data contain valuable additional information on top of the economic analysis about the longer-term risks for price stability, mainly stemming form asset price developments. In recent comments, the ECB has already indicated that its December 2005 decision to start hiking interest rates in the previous cycle has been a good decision, which was mainly based on the pick-up in money supply and credit growth at the time. This suggests that also during this cycle the timing of the first rate hike will again be very dependent on the developments in money supply and credit growth.
The current very low levels suggest that it still much too early to start raising rates. Yesterday, ECB’s Noyer sounded very cautious on the economic recovery, as he said that ‘the risks of a new collapse aren’t negligible’ and singled out unemployment and a lack of investment financing as the biggest risks. As such, Noyer concluded that ‘the day when we will have to withdraw monetary support hasn’t yet come’. Yesterday, the speech of NY Fed Dudley on the financial sector was interesting for the sector, but didn’t contain messages for the overall markets. Vice chairman Kohn’s remarks on the economic outlook however need to be commented. We qualify his remarks as distinctively dovish, compared to speeches of the likes of Bullard and Warsh. Kohn sees the economy growing at a modest pace, slightly strengthening in 2010, because the situation on the labour market will restrain household income and thus consumption. He clearly is no believer of a V-shaped recovery. As a consequence, inflation will be subdued for some time. He even sees the downside risk to inflation as dominant. “If inflation expectations were to begin to ratchet down towards the actual inflation levels we have experienced recently, inflation could move appreciably lower”. He also refers to the wide output gap as an element why downside inflation risks prevail and refutes the arguments of some other governors that the output gap may be much smaller than generally presumed. Given these different views on the role of the output gap and earlier reported differences on the impact of QE on the economy and its future, the Minutes of the September FOMC meeting might be interesting.
Regarding today’s bond trading. Over the past two days, bonds were able to recoup some ground following the steep losses at the end of last week. Hence, there was no follow-through selling in the US after trading resumed following Monday’s Columbus Day Holiday. At the same time, the rebound didn’t convince us yet that the correction is over. The short-term outlook for bonds will mainly depend on the equity markets and the US retail sales. A sustained break higher on the equity markets would be a bond negative and could again trigger a correction, even if the correlation between equities and bonds has been quite loose over the previous months. This morning, Asian equity markets performed strongly, putting bonds already under some pressure. However, contrary to the US T-Note future, the Bund is still well above the key support (at 121.74) and may profit from the strength of the euro, as the euro trade weighted reached its highest level since December last year, even if this strength may help the shorter end somewhat more than the longer end. So, the fight between bond bulls and bears may resume today, which incite us to closely watch the fate of the technical important support level for the Bund.
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 simply a technical correction or has it a more fundamental meaning? The reaction on the retail sales and on an eventual break higher of equities may learn us more about the underlying sentiment.
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%. On Monday, the Bund fell to 121.76, but 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, jobless claims are forecasted to have risen by 24 500 in September after increasing by 24 400 in August. This will be the eighteenth consecutive month that unemployment rose in the UK, but the rate of increase slowed already.
On the supply front, the DMO will tap its 4.75% Mar 2020 Gilt for an amount of £3.5B. It will be a first test for investors’ appetite, after the DMO announced it will issue a new ultra-long 50-year Gilt via syndication next week. The uncertainty about the asset purchase facility may also weigh on demand after BoE Bean’s speech on QE gave little indication on whether he would support a further extension of the program in November.
