Markets: Fixed Income
On Thursday, global bond markets calmed down as the economic dataflow was thin and equities/commodities kept a more sideways trading profile, at least until the latter part of the US session.
In this context, European yield changes were limited to a rise of 1 to 2.8 basis points, the shape of the curve showing no distinct trend and the Bund future closed around opening levels. The German bond market once more ignored the economic news that was again quite encouraging (but close to expectations). German consumer confidence rose further in August and money and lending data eased concerns about deflation while UK retail sales were brisk.
In the US, Treasuries (and Bund) were hit by lower-than-expected initial claims that lifted equities. However, stocks couldn’t hold on to their gains, allowing bonds to recoup the initial losses. Later on, the longer end outperformed, also helped by the strong 7-year Note auction, leaving the 2- and 5-year yield little changed on the day, but the 10- and 30-year yield dropped about 6 basis points. The Fed buying $1.42B of Treasury debt in the Nov 2021 to November 2039 sector was a marginal positive factor for the longer end.
In the EMU bond markets, tensions eased in lockstep with the calming down of the Bund market. The 10-year yield spreads of the various peripherals marginally widened (1-to-2 basis points). Ireland, whose bonds had been badly hit in previous days, successfully sold 0.6B of T-bills. The average yield of the 6-month bills dropped to 1.978% from 2.458% some weeks ago. Demand was strong, but the size of the auction was small (and reduced). While it is of course better than a weakly bid auction, we don’t draw conclusions from T-bills auctions for the Irish bonds. Indeed, the short maturity and the “high” yield are attractive as the credit risk on these maturities is very small.
Today, the first estimate of German CPI inflation, the second estimate of US Q2 GDP and final figure of University of Michigan consumer confidence are scheduled for release. But more attention will go out to the Fed’s annual symposium at Jackson Hole, where Bernanke will speak on the economic outlook and the Fed’s policy response. A CNBC interview with ECB Weber in late afternoon and Trichet’s speech in Jackson Hole are other key events that might be interesting to gauge how the ECB will model its liquidity (exit) policy going further. Formal announcement on the liquidity policy are scheduled for the September ECB meeting (next week).
After an upward surprise in July, German CPI inflation is forecasted to decline slightly in August. The consensus is looking for a drop from 1.2% Y/Y to 1.1% Y/Y. We have no reasons to distance ourselves from the consensus, but a downward surprise might increase talks about too low inflation. In the US, the second estimate of Q2 GDP is expected to show a significant downward revision compared to the first estimate. The consensus is looking for a downward revision from 2.4% Q/Q to 1.4% Q/Q, mainly due to a lower contribution from inventories and net-exports, but an even weaker figure is not excluded. The final figure of U. of Michigan consumer confidence is expected to confirm the first estimate, which showed an increase from 67.8 to 69.6.
The US $29B 7-year T-Note auction turned out to be the best of this week’s auctions, confirming that investors are looking for duration and yield. The curve flattening thus continued yesterday. The 7-year T-Note auction stopped at 1.989%, well below the bid in the WI at the moment of the stop (1.997%). The bid/cover of 2.98 exceeded both July’s 2.78 and the year average of 2.80. The buyside participation was up from last month and the takedown of 65% strong as the buy-side bid was reasonably aggressive too.
The yearly Fed conference in Jackson Hole at the end of August draws traditionally a lot of attention and this is not different this time. Indeed, US economic growth has slowed unexpectedly sharply in recent months, a fact that was explicitly recognized by the Fed in its FOMC statement that showed a more downbeat mood on the economy. Markets were also surprised that the Fed decided to re-invest its maturing MBS paper into longer-dated Treasuries. Later on, Fed members explained that this decision was meant to show markets that the Fed wouldn’t allow a (tacit) tightening of monetary policy while the economy was weakening. A NY Fed report showing that the lower yields were accelerating the prepayments of mortgages and bringing forward the maturing of MBS paper, played a role too. Markets saw the FOMC decision as the precursor of more QE (via purchases of Treasuries, not of MBS this time) and acted accordingly, driving the curve flatter. However, newspaper articles suggested that the FOMC was divided on the issue and some governors believed that the decision would confuse markets and could unduly stimulate economic pessimism. Against this background, the Jackson Hole conference gives Bernanke and other central bankers the opportunity to clarify the Fed’s views on the economic outlook, on the risks of deflation and on the potential monetary policy responses.
Bernanke is a specialist on the Great Depression and was a very active researcher on the Japanese deflation on which he gave in 2002/03 a number of well-publicized speeches. He is in favour of bold and decisive action to pre-empt deflation from infecting the economy and making monetary policy (less) or (in)effective. He is often referred to as “helicopter Ben”, as he suggested once (ironically) that eventually the Fed should print dollar bills, hire helicopters and throw them out above the cities. However, as a chairman of the Fed, he has to avoid a divisive rift in his FOMC, which may affect his actions. So, Bernanke has the difficult task to explain the Fed’s eco outlook, while assuring markets that in case of a renewed downturn/ recession and deflation the Fed still has ammunition left to fight it. Indeed, doubts are rising that monetary policy has still the ability to turn the economy around in case of a double dip. Indeed, if the US is in a liquidity trap, monetary policy might be ineffective and QE would be no panacea. The Japanese are already for years in deflation despite QE. Or does that teach the Fed that it should use the “bazooka” and not wait on a further weakening of the economy before announcing a major additional QE program.
So, it is obvious that Bernanke’s speech has the potential to move the markets substantially. However, given the strong rally in the bond markets and the decline in yields, the Fed may think that its objective has already been reached and the lower yields may help the economy recover. In that case, Bernanke may choose not to go further in his comments on how the Fed will model its monetary policy going forward. In that case, a downward correction of bonds looks likely. We have no strong feeling about how far Bernanke will go in his comments on the possibilities for policy to address the recent economic weakness and the still modest risks on deflation.
Regarding bond markets, we think markets will wait for Bernanke before choosing a distinct direction. The German CPI will probably be ignored, while the US Q2 GDP (revision) might set the sentiment by which the market will go into the speech of Bernanke. From last Tuesday onward, we feel that after the tremendous rally the bonds might be ready for a correction. There has been increased volatility on Wednesday/Thursday, but no real correction worth that name. The Bernanke’s speech may decide though whether indeed a correction will take place or whether bonds will simply steam further ahead with the 2% an eye-catching target for both German and US 10-year yields. (Psych. level for German bonds and the level (2.03%) reached by the 10-year US T-Note yield at the end of 2008 after QE was announced).
In the UK, the eco calendar contains the preliminary estimate of Q2 GDP, which is expected to confirm the advance estimate of 1.1% Q/Q. Also interesting will be the breakdown.
