Markets: Fixed Income
On Tuesday, US and German bond markets sold off on expectations that a rescue package for debt-stricken Greece is in the making, reversing the risk averse sentiment that had been building up in the past 10 days. Short covering was not only apparent in the intra-EMU weaker credits, but also in equity and even commodity markets. There had been forming a solid short basis that looked now ready to unwind their positions (partially). The other coin of the medal was core US and German bond market that played their traditional safe haven role and now witnessed the outflow of some of the safe-haven money. In a daily perspective, US yields were up 6.4 to 8.7 basis points, while German yields rose by 0.7 to 4 basis points, but after the official close yields went up further. Besides the Greek story, the US 3-year Note auction didn’t go well. Earlier in the day, Dutch and Austrian, strong credits that are used as substitute for benchmark German Bunds, auctions went very well.
Intra-day, two events marked trading. At first, there were rumours that Trichet cut short its trip to Sidney to participate at a key EU summit in Brussels on Thursday. A spokesman downplayed the news by saying that he simply took an earlier plane because of a too tight flight schedule. However, the market kept speculating that Trichet’s presence on Thursday meant that the 2020 summit on structural economic issues would also be a forum to discuss the difficult situation of some countries, Greece to start with, on the bond markets and maybe resolve the issue one way or another. Late in the European afternoon, Reuters came up with a story based on a senior official, saying that euro area governments had decided in principle to help Greece. No final decision had been taken, but the most likely decision was to offer bilateral help, the source said. It might take the form of guarantees, but there are of course still many difficult questions on the table. Any agreement should not incite other countries to profligacy and may not be constructed as a bail out. A solution too close to a bail-out may well be considered negative for the euro itself. So, we should expect all kind of rumours to infect the markets today in attendance of an EU official communication on the subject.
In the wake of the rumours, the 10-year Greek-German yield spread plunged 38 basis points to 324 basis points. Portugal saw its spread coming in 15 basis points (147 bps), but also Spain (-9 bps to 90 bps), Ireland (-9 bps to 169 bps) and Italy (-4 bps to 90 bps) profited from the Reuters report.
Today, all attention will be focussed on the issue of a rescue package for Greece. There will be multiple rumours and opinions ventilated, but most likely we will have to wait for a final decision after the EU summit on Thursday. Positioning ahead of the decision will be the dominating force behind trading today? The eco data and the German 5-year OBL and the US 10-year T-Note auction will get less attention than usual. Harsh weather conditions have prevented chairman Bernanke to testify and US data releases may be postponed too. The text of Bernanke should be available though.
The eco calendar contains the French industrial production data (December) and US trade balance (December). In December, French industrial production disappointed this morning, falling by 0.1% M/M, while an increase by 0.5% M/M was expected. In the US, the trade balance is forecasted to show a contraction in the deficit from $36.4B to $35.8B. Both imports and exports are expected to have increased in December. According to the Q4 GDP source data, the trade deficit expanded from $36.4B to $38.0B in December. Therefore, a smaller deficit would imply and upward revision to Q4 GDP, while a larger deficit would involve a downward adjustment.
Fed chairman Bernanke’s testimony before the House Financial Services Committee, is postponed due to the winter weather, but later this month he will give its semiannual 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 has finished its exit policy out of the emergency liquidity measures it took to fight the crisis. The liquidity facilities it created will have expired, but the Fed will still be confronted with purchased QE assets that have bloated its balance sheet. It is unthinkable the bulk of these assets might soon be sold in the market. St-Louis Fed governor Bullard argued earlier this week that these sales might start on a limited scale in H2 2010. Bullard, who advocated the sale of assets already for some time, also expressed his view that the sale of assets should precede rate increases. While we suspect that the latter suggestion has no majority inside the FOMC, we do think that asset sales will be put forward by Bernanke as one instrument in the FOMC arsenal. Bullard also said, in an interview to Dow Jones we didn’t capture immediately, that it would be logical, now the crisis has passed, that the discount rate would be incrementally raised, taking it eventually to 100 basis points above the Fed funds rate. The first step should come fairly soon. Indeed, the increase of the discount rate might be decided, maybe already at the March meeting.
The excess reserves currently in the Fed system 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 elaborate and eventually surprise the markets.
Austria re-opened very successfully its 4.85% March 2026 RAGB and 3.9% July 2020 RAGB for a total of €1.65B, of which €150M allocated to the state. The bid/covers amounted to 3.02 and 1.96 respectively, confirming strong demand. Pricing was also quite aggressive with a small tail of respectively 1 and 0.5 basis point. Similarly, the Dutch Debt Agency sold €2.675B of its 2.75% January 2015 DSL benchmark at an average yield of 2.341%. The Agency has now already completed about 30% of its bond issuance for the year, which is comfortable. Austrian and Dutch bonds are trading strongly as the higher yield substitute for benchmark German bonds in a risk aversion environment. Today, Germany will re-open its 3.25% Jan 2020 for €6B. That will bring the total outstanding amount to €18B before a final re-opening in March will take place. The issue is not the CTD in the March Bund contract but is part of the basket. The rumour on Greece has cheapened the issue yesterday, which is positive, but receding risk aversion is of course a negative. Therefore, we aren’t quite sure whether investors will show up for this issue.
The $40B US 3-year T-Note auction was a bit mixed and sloppily bid. Indeed, the auction stopped at 1.377% with a 26.75% allocation at the high yield, well above the 1.363% bid in the WI trading at the moment of the stop. Usually the 3-year auction stops below the WI bid. The bid/cover of 2.83 was below last month’s 2.98, but above the 2.72 average. There was again a big, 12.4B direct bid this month but it wasn’t as aggressive as last month as direct bidders took down only 10.1% of the auction. Indirect bid improved on last month, but remained below average. The rumour about the EU agreeing on a plan to rescue Greece just before the auction may have played a negative role. Today, the Treasury will auction a $25B 10-year Note. It will be a new Note (15 Feb. 2020) to be re-opened in the next two months. The size is unchanged from November’s refunding auction and $4B larger than the re-openings in the previous two months. It will raise $6.545B upon settlement, while the three auctions of this week will raise together $32.657B in new cash. However, the Treasury will also payout a combined $21.57B coupon interest. So there remains a $11.08B gap that will need to be financed, which is less than the gap during the months the issues are reopened. The longer maturities are getting less demand from investors. It will also be the question whether uncertainty surrounding the Greek problems (and other sovereigns) will still affect the 10-year Note auction, like it may have the 3-year yesterday.
Regarding trading, the Bund opened slightly weaker than the after closure trading yesterday suggested. Above we elaborated on the possible Greek rescue package that drove the action and we suspect that the issue will remain a key driver going forward. The German market was too expensive on risk aversion and offered no value. So, we keep a negative attitude, even if near term volatility may remain high. Our expectation for a decline in Bunds was based on the belief that ultimately the EU cannot afford to let a member default. However, we are well aware that the current episode is a positive for bonds in general. It might incite governments to accelerate the implementation of bank liquidity regulations that oblige banks to keep more government bonds on board, which would be a support. Weaker economic growth forward may be a positive too. So, while we still expect yields to go up in the medium term, the increase should be more subdued.
Technically, the decline in the Bund is not yet very significantly. A first point of reference on the downside is 122.81 (28 Jan low), but a loss of the channel bottom at 123.28 today would be a warning, as was the loss of the medium term average at 123.52 today.
The flight-to-quality benefited German bonds mightily in recent weeks. The 2- year Bund yield dropped below 1% to the lowest level ever or at least in “modern times” and the 5- and 10-year yield had reached lows at respectively 2.14% and 3.09%, 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 think that the German bonds remain a bit too expensive after yesterday’s correction.
In the UK, the calendar contains the industrial production data (December) and the Bank of England will release its quarterly inflation report. In December, industrial production is expected to show a slight increase (0.2% M/M) as the cold snap might have pushed utility output up. Also manufacturing is forecasted to show a slight increase after staying unchanged in the previous two months, while mining and extraction are likely to act as a drag. After the Bank of England decided last week to pause its quantitative easing program, the inflation report is likely to show that growth will again undershoot previous forecasts, but medium-term inflation projections might show that inflation will top the 2% target, suggesting that a tightening of monetary policy in H2 2010 remains a possibility.
