Markets: Fixed Income

On Friday, bond trading remained lacklustre leaving yields little changed in the end. The price action was mostly inspired by curve trades. In the US, traders and investors were happy as the refunding operation had ended and took some profit on steepeners that were (partially) initiated ahead of the refunding operation. On the contrary, in the EMU area, the steepening continued which brought the 2-to-10-year yield spread still a bit closer to cycle highs. The EMU eco data were a tad below consensus and thus disappointing, but didn’t cause an immediate reaction on the market. ECB talk wasn’t pretty eventful either. Some spillover effects on the curve may have come from rumours that Greek banks were advised to reduce bond holdings. It drove Greek spreads versus Germany 8 basis points wider. Other weaker credits like Ireland shed also ground, but the likes of France, Netherlands and Belgium were barely affected.

Intraday, the Bund traded listless in a tight 15 ticks range during the European morning session. EMU Q3 GDP figures were slightly below expectations, but the shortfall was compensated for by a slight upward revision of Q2 GDP growth. While it marked the official confirmation that the euro zone had come out of recession, there was no reason to be too excited. It fell well short of the US growth pace in Q3 for example. The market ignored the report completely. Bonds started to fall in the run-up to the US session and continued to do so immediately following the intrinsically (slight) bond positive US eco data. Import prices rose less than expected and the trade deficit was wider than expected, suggesting a small downward revision to Q3 GDP figures. However, the market found a bottom and rebounded going towards the Michigan consumer confidence release. The latter was a good deal weaker than expected, but couldn’t prevent Treasuries from dropping again as equities shrugged them off and moved north. However, the intra-day lows held and Treasuries managed to recoup the losses on short covering ahead of the weekend. EMU bonds on the contrary lingered around close to the intra-day lows, leaving longer-dated yields moderately up for the day.

This week starts already with an attractive calendar as the US retail sales (October), the NY Fed survey on manufacturing (November) and the euro zone CPI (November) are scheduled for release today. In September, US retail sales dropped by 1.5% M/M due to a sharp decline in motor vehicles and parts as the “Cash for Clunkers” program expired. Excluding oil autos and gas, retail sales rose by 0.4% M/M. In October, retail sales are forecasted to have risen again, by 0.9% M/M amongst others by car sales that rebounded in October. More important though will be the measure excluding cars and gasoline as a good gauge of underlying household spending. In recent months, the relative strength in these underlying sales surprised a lot of observers who taught that households would trim spending further to increase their savings and so deleverage. The longer term outlook for the economy surely depends on the attitude of households. They have the key to the sustainability of the recovery. The NY Empire State manufacturing index showed a massive improvement last month (34.57 from 18.88) driven by a significant rebound in production. The consensus is looking for a fall-back to 29.00 in November, but we see risks on the downside, as the October reading was indeed very strong. In the euro zone, the final figure of November CPI inflation is forecasted to confirm the first outcome of -0.1% Y/Y, but a downward surprise is not excluded after German CPI was revised from 0.0% Y/Y to - 0.1% Y/Y. The core CPI measure is gradually easing, something one should expect in the aftermath of a deep recession. Consensus expect a decline to 1.1% Y/Y (down from 1.2% Y/Y). A steeper decline would raise worries that deflation might become a problem, even if the headline figure should soon start to rise

During the remainder of the week, the euro zone calendar is thin, but in the US, we will receive the latest information on production, inflation and the housing market. Tomorrow, US industrial production is forecasted to show the fourth consecutive increase in October. Nevertheless, we believe that the risks might be on the downside of expectations as the production was very strong in September and some payback may kick in. The NAHB housing market index (November) and housing starts and permits (October) will give us an update on the latest developments in the US housing market. Last month, the expiration of the fiscal stimulus for the housing market coming closer had a mixed impact on the housing market data. Both the housing starts and permits showed an unexpected decline, but for October, a slight increase is forecasted. As it is difficult to guess the impact of the ending of the stimulus measures, we have no clear reasons to distance ourselves from the consensus. On Wednesday, CPI inflation is expected to show a significant increase in October (- 0.3% Y/Y from -1.3% Y/Y) due to a considerable increase in oil prices and base effects from last year’s sharp increase in energy prices. Both initial and continuing claims are forecasted to extend their downtrend, but initial claims might be distorted by the Veteran’s Day Holiday.

Following the FOMC and ECB meetings in early November, governors from both central banks came out to explain the decisions and give their personal take on the economy, inflation and policy. From the ECB, we learnt that the discussions about the exit strategy have heated up in the run-up to the key December meeting when some decisions on the non-conventional policy measures need to be taken. The Frankfurt Executive board members took the initiative and brought the message that gradualism is the key. They don’t want to surprise markets and seem ready to let the market itself decide on the pace of unwinding of these measures. Especially, Trichet’s comments that they don’t intent to change the current relationship between eonia and deposit rate was important in pushing expectations for higher very short rates downward and further out in time. This was a main factor also in the steepening of the curve, which has probably run its course by now. ECB Gonzalez–Paramo didn’t add that much on the debate Friday, but two of his comments are nevertheless worth citing. Firstly, he said that the ECB would decide in December whether to add a premium on its “final” 12-month tender and secondly, he could imagine the ECB tightening policy even if one or two countries were still in recession. In the US, central bank talk was much focussed around the problems in the commercial real estate market, highlighted by several governors, but on Friday NY Fed Dudley said that they don’t pose a systemic risk. Governor Yellen stressed the deflationary risks, but some other governors like Bullard and Hoenig showed some unease by the prospect policy would remain too accommodative for too long. All governors, including the hawks, were however still of the view that there was no reason yet to change the accommodative policy (for an extended period of time). This week, several Fed and ECB governors will add their views to the debate. Of course the speech of Fed chairman Bernanke today stands out as the eye-catcher.

In EMU, the issuance calendar is interesting. The cash flows are unsupportive as no redemptions take place. Governments will issue bonds worth about €17B. On Tuesday, the Irish Debt Agency taps the 4% Jun 2014 and the Oct 2019 for a small amount of €0.74 to 1B. The eye-catcher will be on Wednesday with Germany auctioning a new Dec 2011 Schatz (€5B), the second last auction of the year for Germany that will only have to tap the 5-year Bobl next week. Spain re-opens its 4.8% Jan 2024 (€1.5-2.5B) on Thursday, when France holds its BTAN and OAT(e)i auctions (€6.5-to-7.5B). In the UK, there are no Gilt auctions, but the BoE will hold its reverse Gilt auction targeting the very long end (Mar 2036 and beyond). In the US, there is no fresh coupon supply this week.

The Belgian debt agency announced on Friday it may introduce new 30-year bonds in 2010 after assessment of demand. If not, 15-year bonds are another option. It might also consider selling its first inflation-linked bond through a private placement, a novelty for Belgian debt. According to Bloomberg, Belgium would protect itself via a swap as it doesn’t want to assume inflation risk. However, we have some reservations about the idea and think that it might still be subject to further deliberations.

Regarding trading, Asian equities started the week on a strong footing as APEC said Asian countries should maintain stimulus for now and Friday‘s advance in Wall Street was encouraging too following Thursday’s correction. Equities might be a key factor driver for other markets as the S&P looks likely to retest the cycle highs for a second time. We have the impression that the uptrend in equities is transforming in a more sideways trend, as the nine month rally shows signs of fatigue. Should we be wrong though and equities take decisively out the highs, it should weigh on bonds. The avalanche of eco data may be the trigger for such a movement. While we have a rather optimistic view on global growth for the next quarter, we might get some disappointments (compared to expectations) in the US data this week. The housing data may be negatively influenced by the tax incentive for first home buyers that was planned to expire. The regional manufacturing surveys that were outstanding last month, especially the NY one, may correct a bit more than expected, while the retail sales are a bit of a wild card. Central bank talk should be intrinsically bond friendly, but the market probably has already discounted this enough, as evidenced by the rally in the e.g. 2-year sector. US yields of 0.80% and German yields at about 1.20% are vulnerable for some profit taking. The longer end is less stretched than the shorter one and may benefit from profit taking on steepeners, but the technical pictures show that complacency is unwarranted and stop loss protection looks appropriate. The German 10-year yield (3.38%) is near neckline of sort of inverted head and shoulder formation with neckline at 3.39%.

Regarding the European bond market, the longer-term bullish technical picture of the Bund started to deteriorate after the Bund fell off the highs at around 123.00 and broke below its long-standing uptrend channel. It didn’t however come yet to a real test of the September lows at 119.85 (which if broken would violate the higher low higher high configuration), but a break through 120.51 would already be an omen that such a test might be in the cards. The broken uptrend at 122.14 is the first point of reference. The longer end of the bond market seems to be in a wait-and-see period from which we don’t see it exit in the near future. Sideways trading in the 120.51/119.85 to 122.44 range is likely.

Regarding the US Treasury market, the technical picture of the US T-Note future is still quite similar to the Bund future, as the T-Note future has also fallen off the highs (119-29) since early October and rebounded before a test of the September lows (116-18) occurred, the US T-Note tested but yet failed to break above the neckline of a potential double bottom formation at 118-28+/119-01, but kept the Note future still a good distance off the crucial 116-18 support level (more than the Bund). With the refunding operation finished, supply faded into the background, making us curious whether it will be enough to lead the T-Note future break the 118-28+/119-01 resistance. At least on Friday, the future showed little momentum, even if it closed at 118- 30+. A neat break might brighten the short term outlook and open the way for a test of 119-29 (October 2 high) level, probably difficult to sustain above though.