Markets: Fixed Income
On Monday, global bonds started the week on a quiet note, as most investors remained sidelined ahead of the FOMC decision, key US data and developments in Greece. In the end, US yields were flat to 1 basis point lower, while changes in German yields varied between -0.5 and -1.7 basis points.
Intra-day, the Bund opened unchanged, showed some modest volatility early on and made one move higher in mid morning, after which the Bund hovered sideways in a very tight range until the close. In the US market, there was a small move down early in the session that was recouped later on. The US eco data didn’t affect the bond market and neither did the gyrations on the equity markets. The NY Fed manufacturing survey, the first regional survey for March, was very robust, while the late session release of the NAHB homebuilders’ survey for March was downbeat. In the intra- EMU market, German-Greek 10-year yield spreads initially narrowed, but as became clear that the Euro group would once more finish without a concrete support package for Greece, the spread re-widened to close the day unchanged at 305 basis points. For shorter maturities the spread narrowing continued, as the market downgrades the possibility for a near term default. In other weaker EMU government credits like Portugal, Spain and Ireland, the yield spread with German bunds widened modestly on a daily basis.
The Euro group devoted discussions on the Greek issue, but once more kept an ambiguous position on how Greece would be helped by stressing that Greece wouldn’t need any help after the courageous measures it had taken. The communiqué only said that the Ministers had agreed on the technicalities of the rescue efforts that could be activated swiftly if needed. The specifics of an eventual support package remain unclear though. Juncker suggested that if support was needed it would come in the form of bilateral help and not via guarantees and the objective would not be to provide financing at average euro zone interest rates, but to safeguard the financial stability as a whole. However, Juncker said that Greece had not asked for help and that the euro group taught the question of aid for Greece would not arise. A similar comment was given by the French Finance Minister. The Dutch Finance Minister said that any help would be tied to tough conditions of the kind the IMF applies. Juncker added that a decision on any aid for Greece would be for the EU leaders, which might be contradicted with fast action he promised if needed. Indeed, there would not only be 16 Finance Ministers of the euro group involved, but 27 EU leaders. It is brave of the Finance Ministers to try to convince the markets that Greece could do it on its own, but the strategy of voluntary ambiguity is dangerous and at least it tells the markets that the structural flaws in the euro construction, unified monetary policy/one currency, but national economic/fiscal policies remain unaddressed.
Today, the eco calendar is well-filled both in the US and euro zone with the US housing starts and permits, the final figure of euro zone CPI and the German ZEW. But most attention will probably go to the FOMC meeting and to the EU Commission report of the Greek’s new austerity package and the implementation of earlier packages. Ireland will come to the market and tap its 6- and 10-year bonds.
Although the snowstorms seem to have had less impact than expected on for example the retail sales and payrolls, the housing market may have been hit sharply. In February, both housing starts and permits are forecasted to have dropped by roughly 3.5% M/M. We believe that the risks might be on the upside of expectations for the building permits as they are less weather sensitive. In the euro zone, the final figure of February CPI inflation is forecasted to confirm the first estimate, which showed that inflation dropped from 1.0% Y/Y to 0.9% Y/Y. Core CPI, on the contrary, is expected to have dropped from 0.9% Y/Y to 0.8% Y/Y, a historical low level and while alarm bells on deflation are still not widely ringing, any downward surprise wouldn’t go by unnoticed. In Germany, the ZEW is expected to decline for the sixth consecutive month in March. The consensus is looking for a decline from 45.1 to 43.5.
The FOMC will convene for their 6-weekly meeting on monetary policy and publish its statement at 19.15 CET. In January, the FOMC statement didn’t contain too many surprises. The Fed upgraded its eco outlook and unwound its emergency policy measures further, but confirmed its intention to keep rates very low for an extended period of time. The dissent of Kansas Fed Hoenig certainly was a surprise. The statement said: “Voting against the policy action was Thomas M. Hoenig, who believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted.” The Minutes of the January FOMC specified that Hoenig was looking for more policy flexibility by not retaining the extended period of time language and suggesting the phrase that rates would be low for some time.
Another regional FOMC voter, St-Louis Fed Bullard later on showed overtly sympathy for the view of Hoenig and while less clearly also governors Lockhart and Evans seem to favour a change in the wording to give the Fed more flexibility going forward. Against these voices, most other governors seemed still comfortable by keeping this language in the statement. So, the debate on the language of the forward-looking rate guidance will be central at the FOMC meeting. We think there is a real chance that it will be changed or at least to appease hawks and doves a compromise is found to change it at the April 27-28 meeting. The January FOMC Minutes showed large divergences on the issue of potential asset sales. Most participants judged a future program of gradual asset sales could be helpful in shrinking the size of the balance sheet and interestingly, several thought it important to begin the program in the near future and shrink the balance more quickly than could be achieved by solely redeeming maturing securities.
No decisions were taken though. In the mean time, officials of the influential NY Fed suggested that the Fed shouldn’t actively sell the assets it purchased as an emergency support measure during the crisis. Maturing assets wouldn’t be replaced, shrinking the pool of assets gradually. We think that the Washington-based Board is of the same opinion, contrary to a number of regional Fed presidents who want to start selling assets quite fast. We think that the NY Fed opinion will prevail. Selling assets might unsettle the mortgage market that is still very weak. The question of selling assets is not a theoretical one. Indeed, if the Fed doesn’t sell assets, it will have to conduct its policy via its rates (FF, interest paid on excess reserves). If it does sell assets, the tightening will happen via the longer end of the curve, allowing the Fed to keep official rates very low for longer. The Fed asset purchase programme nears completion (end of March) and given the uncertainty surrounding it, we don’t expect the Fed to add to the uncertainty by introducing the perspective of asset sales.
Concluding, a change in the wording of the FOMC statement might be a further step in the normalization of policy. It gives the Fed more flexibility and keeps the outlook on rate hikes in H2 alive, on condition that the economy improves further and the recovery becomes broad-based and self-supportive. If the change does occur, we expect the money market and the short end of the bond market to correct, flattening the bond curve. There have already been some moves towards a faster tightening in recent weeks. The implied Dec FF rate stands at 0.53% currently versus 0.44% at the start of the month.
The EU Commission will publish its report on the Greek austerity package and the implementation of previous announced measures. We suppose that also the most recent budget results will be commented. Overall though, we think, given recent upbeat support for Greece from EU Commissioner Rehn, euro group president Juncker and ECB Trichet, that the report will be supportive for Greece. If not, it would be very odd and disturbing.
Yesterday ECB Gonzalez-Paramo stressed the necessity to reinforce the coordination of economic policies, adding that the Growth and Stability pact needs teeth that really bite. In other comments, he warned that low interest rates can create problems and pointed to the bubbles in the past as the result of inappropriate low rates for too long. We don’t see these comments as indicating that the ECB will raise rates anytime soon, but they show the opinion that current rates are at exceptional levels and the ECB has the natural tendency to raise them, on the condition that the economy and the situation in financial markets allow them to do, which isn’t the case currently. Gonzalez declined to answer the question whether the ECB was studying the possibility of maintaining for longer the current relaxed collateral requirements for the use of ECB liquidity, but said that just as important as collateral is the ECB’s system for controlling risk associated with the collateral. This might indicate that the ECB is thinking about adapting hair cuts as a possibility to keep the relaxed collateral framework into place.
Regarding markets (unchanged view), risk appetite has in recent weeks made a comeback, reflected in equities near cycle highs and bond spreads near the lows of the year. The yen weakened, but so did the dollar to some extent. The global data flow has been encouraging and while the Greek situation isn’t solved, at least tensions abated somewhat. Rating action in emerging markets was positive with upward revisions in Indonesia and Ukraine. However, at the same time US and especially German bond yields barely rose. This sets the stage for a possible interesting week. Will the market continue to trade on the reflationary theme and thus equities move to new cycle highs or will hesitation creep into the minds? In the former case, bonds should be under pressure, while in the latter they may stay strong. After having pondered the various factors in play this week, we keep our bearish view on the government bonds. The FOMC might change its wording in a sense that reminds markets that the days of absolutely low rates are counted. Supply is a modestly negative factor for European government bonds, while the data is a question mark, given the snowstorms that may have affected some data. However, our bearish view for the week is conditional as no major technical signals appeared. The Bund tested the downside on Friday, but managed to recoup the losses later on. First support level stands at 122.20 (neckline double bottom) but a sustained drop below the uptrendline at 121.96 today would be a clearer signal. Therefore, our advice is to take profit on rallies, preferable near the contract high of 123.05.
In the UK only some second-tier data are on the agenda today. Gilts outperformed Bunds yesterday, as yields fell by 1.5 to 3.6 basis points on the day, maybe on dovish comments of BoE Barker or Moody’s comments that they had confidence the future UK government would take the necessary fiscal measures to address its bloated finances.
