Markets: Fixed Income
On Friday, US and German bonds profited fully from risk aversion, as market fears on sovereign risk, especially in Europe continued to dominate trading. The headline US payrolls were weaker than expected, but the details showed multiple positive developments. So after an initial negative reaction on the equity markets and a positive one on the bond market, bonds lost the gains and equities recouped the losses. Thereafter the report was put aside and the market concentrated on the situation of government finances. In a daily perspective, US yields fell between 3 and 6 basis points, the 5-year leading Treasuries higher, while in EMU, the changes were a bit bigger, German yields dropping with 4 to 7.5 basis points, the wings outperforming the belly.
Intra-day, the Bund opened higher and moved further up, as European equities were again sold off. The technical break of the 123.76 resistance level in the Bund and of a similar resistance level in the Schatz was an additional positive. German industrial production dropped unexpectedly sharply in December, just like orders (released on last Thursday) stoking fears that the growth momentum is rapidly fading, but it got little attention in the market, as traders were looking at the peripheral bond trading and waiting on the payrolls. The headline figure of the payrolls report was weaker than expected and Treasuries spiked higher, while equities dipped lower. However, these moves were rapidly reversed as the details were encouraging. However, concerns about European sovereign debt persisted and accompanying risk aversion continued to drive bonds higher. A short squeeze at the end of the US session sent equities higher and even into a slight positive close, which incited long bond investors to trim their positions (after European closure). Apparently, the market was wary there might be possible a plan for Greece (other EMU sovereigns) assembled over the weekend, which in retrospect didn’t occur.
In the intra-EMU bond universe, tensions continued to put peripherals under pressure, widening their spreads to German yields, but some easing in tensions occurred in the later afternoon on hopes that some decisive plan may be discussed at the G7 meeting. There were some supporting comments for Greece from the finance ministers and ECB’s Trichet, but no overall plan. Trichet said he believed Greece would meet tough new targets to rein in its budget gap. “We are confident that the Greek government will take all the decisions that will permit it to reach that goal” he added. The French FM said that euro area countries would make sure the Greek plan was implemented, while Juncker dismissed the idea Greece would need money from the IMF. These comments summarize the current situation, but it remains unlikely that markets will calm down, as long as there is no clearer framework about debt and the relation to the EMU institutions. Is there a plan B, if countries cannot keep their debt obligations? In Portugal, the parliament passed a controversial bill on regional finances, against the will of the minority government that resisted the bill as it would enlarge the budget deficit. The government is now looking at ways to fight the bill before the Constitutional Court or otherwise. It isn’t obvious whether the bill will have material impact on the deficit, but the government’s stability plan was already unambitious and thus any further potential slippage might further unnerve markets that have already hesitations about the sustainability of the government finances. Strikes in Greece and Portugal are getting a lot of attention as markets fear that the implementation of deficit reducing budget will face popular protest and might eventually bring down governments. In a daily perspective, spreads versus Germany widened most for Spain, Italy (+4 bps) and Ireland (+8 bps).
The bond markets will be mainly influenced by the developments on public finances in the euro area and consequently its impact on risk aversion and equities. Beside this element, the US refunding auctions and EMU bond issuance are worth looking at too. The eco dataflow on the other hand is thin and only the US retail sales on Thursday and the euro area Q4 GDP data on Friday might have a potential impact on the market. Chairman Bernanke’s testimony on Wednesday is as usual a wild card.
Today, the eco calendar is rather uneventful as it only contains Bank of France’s business sentiment (January) and will only heat up at the end of the week with the US retail sales (Thursday), Michigan consumer confidence (Friday), euro zone industrial production (Friday) and fourth quarter GDP (Friday).
In December, US retail sales disappointed as they dropped for the first time in three months. Christmas sales seemed to have been soft, but also adverse weather conditions took its toll on sales. For January, the consensus is looking for an increase in retail sales by 0.3% M/M as industry reports looked strong. Michigan consumer confidence is expected to show a marginal increase in February. In the euro zone, industrial production is expected to show a slight increase in December (0.1% M/M). But after last Friday’s disappointment in the German production data, we believe that the risks are on the downside of expectations. On Friday, also the euro zone fourth quarter GDP data are scheduled for release. In the fourth quarter, growth is forecasted to have slowed in the euro zone. The consensus is looking for a GDP figure of 0.3% Q/Q (after 0.4% Q/Q in Q3) as especially German activity seems to have slowed in Q4. Nevertheless, a breakdown will only be available next month.
Fed chairman Bernanke will testify Wednesday before the House Financial Services Committee, while later this month he will give its semi-annual testimony before both House and Senate Committees. Now, he has been sworn in, it is expected he will lay down the operational framework in which monetary policy will be conducted when the FOMC have finished its exit policy out of the emergency liquidity measures it took to fight the crisis. The finance facilities it created will have expired, but the Fed will still be confronted with an inflated QE purchased assets. It is unthinkable these assets might soon be sold in the market. Therefore, there will remain excess reserves that might keep rates near zero also when this shouldn’t be appropriate anymore. The Fed Funds rate, a bank rate, the Fed influences via open market transactions with primary dealers, isn’t in this context suitable to affect rates that banks charge to companies and consumers. The Fed has done some experiments whether it might use reverse repo-transactions or term deposit facility to absorb unwarranted liquidity. However, while the Fed will use these new instruments of monetary policy, it will probably use its authority to pay interest on excess reserves as the main instrument to influence market rates and demand for credit. Indeed, raising interest on excess reserves would raise the whole spectrum of market rates as no bank would lend out below the interest on excess reserves. However, there is a political sensitive feature on these payments. The Fed paying interest to the banking sector after having created itself the excess reserve, will probably meet quite a lot of public/political outrage. Another issue, brought forward in today’s WSJ is communication. In the past and also currently, the Fed tries to influence longer term rates by giving guidance that goes well beyond the next FOMC meeting. Some analysts say this predictability was one of the factors that fuelled the boom that led to the crisis. So there is enough stuff on which Bernanke may eventually surprise the markets.
The US Treasury will hold its 3-, 10 and 30-year refunding auctions. The Treasury held the size of all three auctions unchanged versus the previous refunding operation, contrary to our expectation for an increase of the size in the 10- and 30-year sector. So, the Treasury auctions a $40B 3-year note on Tuesday, a $25B 10-year note on Wednesday and a $16B 30-year bond on Thursday. The auctions will settle next week Tuesday. The steepening of the curve recently, might partly be due to upcoming supply at the longer end, partly a risk aversion phenomenon, might a positive element. While also the US CDS went up last week and Moody’s warned about the US AAA in the long run, the climate on the equity markets isn’t bad for the auctions. In EMU, issuance may be about €18B, but contrary to last week, there are no redemptions and only a modest coupon payment making the environment less generous for the auctions. While some of the weaker sovereign credits are waiting in the wing to come out with some syndicated issues, if there is an opportunity, it are mostly the stronger credits, Germany, the Netherlands and Austria that tap the markets this week. Only Italy on Friday (3% April 2025, 5% March 2025 and 3.75% August 2021) and Slovakia (4.5% 2026) today represent the weaker EMU sovereign credits. On Tuesday, Austria taps the July 2020 and March 2026 bonds and the Netherlands re-open its 2.75% Jan 2015, while on Wednesday Germany re-opens the OBL 2015. We will discuss them in more detail during the week.
Regarding trading, last week, German yields fell lower and the curve steepened as risk aversion became the main theme. Other sovereigns saw their yield spread with Germany widen, with especially Portugal and to a lesser extent also Spain, Ireland and Italy hit. Uncertainty about the sustainability of the finances of a number of mostly Southern countries spooked investors. The green light of the EC for the Greek stability plan (that included some extra measures) wasn’t able to restore calm. On the contrary, some clumsy comments of the Greek FM drew the attention to the situation of some other countries shifting speculation towards these credits. The flight-to-quality benefited German bonds mightily. The 2-year Bund yield dropped below 1% to the lowest level ever or at least in “modern times”. The 5- and 10-year yield at respectively 2.16% and 3.12% are still above historical lows, set in March 2009, but the situation looks a bit different too. In March 2009, depression looked to be the real risk. Currently, there is hope the situation is after all better now. So, we still think that the German bonds are too expensive, but in a short term perspective, it will be risk aversion that drives the action and other considerations are second tier. The technical picture of the Bund improved further by taking out the 124.06 high on the continuation charts. In yield terms, the 10-year is near tough support at 3.09%, which if broken would open the road for a return to the all time low at 2.849%. For the 5-year yield support stands at 2.146% and 2.03% (all time low)
