Markets: Fixed Income
On Friday, global bonds were finally hit by a bout of profit taking in a technically overextended market. Especially, US Treasuries were sharply hit by a slightly better than expected Q2 GDP report and especially by the speech of Bernanke (see below). Equities moved swiftly higher after Bernanke’s comment creating more pressure on US Treasuries. Unsurprisingly, it was the longer end that led the correction, as investors decided to partially unwind the flattening curve that was massively set up during the August month. US 10- and 30-year T-Note yields rose by respectively 17 and 18 bps. In EMU, the moves were far more modest and technically insignificant. The belly of the German curve underperformed, pushing 5-and 10-year yields up 4-to-5 bps.
Regarding the intra-EMU bond market, investors still made more distinctions last week. The Greek case is obvious. Markets still doubt whether the country might default or avoid a restructuring of its debt. Greek 2- and 10-year yield spreads barely moved on Friday, but in a weekly perspective widened about 75-to-80 bps. Greek 10-year yields are 11.5% (spread 925 bps), clearly attaching a high chance on default. However, the interesting developments last week occurred in the other so-called peripherals. The case of Portugal and Ireland is more and more separated from the likes of Italy and Spain. The latter saw their yield spreads widen only slightly last week (flat on Friday) (7 and 13 bps for Spanish 10 and 2-year spreads, 9 and 6 bps for Italian 10 and 2-year in a weekly perspective). In the case of Ireland (hit by S&P downgrade) and Portugal, investors show ever more concerns about whether these countries won’t take the same road of Greece and at some point need support from the E(M)U €750B EFSF mechanism. The Irish 2- and 10-year yield spread widened 70 and 48 bps to respectively 281 and 352 bps, which is a record high for the 10-yearspread. The Irish 10-year yield stands at 5.72%, any substantial further increase might be difficult to carry, even if the Irish have some respite, as their financing needs are satisfied until Q2 of 2011. Of course, we suspect some prefunding of 2011 needs, maybe via the issuance of a new 5-year benchmark. The Portuguese situation is barely better. The 2 and 10-year yield spreads widened 35 bps to respectively 267 and 329 bps, which is in the case of the 10-year near the record high. However, also Portugal is well advanced in terms of 2010 bond issuance. We will eagerly look to the ECB statistics on its bond purchases to be released today. The ECB was in recent weeks barely in the market and various governors, including Trichet, suggested that the ECB program, hotly contested also by some inside the Council, had largely run its course. However, the deterioration of the situation in the Irish and Portuguese bond markets questions whether the ECB shouldn’t up its activity. However, with the EFSF operational, the ECB might feel that some countries should turn to the European political authorities and tap the program if they think it is needed. However, today we know whether the ECB did buy more bonds last week.
Fed chairman Bernanke gave a strong speech in Jackson Hole in which he addressed the economic outlook, explained the decision of the Fed in early August to re-invest the proceeds of the maturing MBS and agency paper in its portfolio and signalled that, if needed, the Fed was ready to employ more non-conventional tools to prevent a worsening of the economy or/and an increased risk on deflation
On the economy, Bernanke recognized the slowing in the economy that was more pronounced than expected by most Fed governors earlier this year and added that the task of recovery and repair from the global crisis is far from complete. However, Bernanke expects the economy to continue to expand in H2 2010 albeit at a relatively modest pace. Very interestingly, he added that the preconditions for a pickup in growth in 2011 appeared to remain in place. This was a first indication that Bernanke and the Fed are not ready yet to come up with more monetary stimulus. He also clearly said at the start of his comments that central banks alone cannot resolve all the problems. However, resource slack and unemployment seem likely to decline only slowly. On inflation, the chairman was brief. He sees inflation, that has recently declined to a level that is slightly below that which FOMC governors view as most conducive to a healthy economy in the long run, near current levels for some time before rising slowly towards levels more consistent with the FOMC’s objectives. Risk of either an undesirable rise in inflation or significant further disinflation seems low, suggesting that the markets are more spooked by deflation risks than Bernanke is.
On monetary policy, Bernanke at length explained the August FOMC decision to keep the size of the Fed’s balance sheet stable by re-investing the proceeds of maturing MBS paper in Treasuries. The decision had caused quite a lot of uncertainty (and was seen as a precursor for additional, extra purchases of Treasury securities) and so some explanation was appropriate. Summarizing, the maturing of MBS paper and not reinvesting it, would lead to a slight reduction in policy accommodation over time. Slower growth might push longer term interest rates lower, accelerating the pace Fed’s MBS holdings are running off. Thus a weakening of the economy might act indirectly to increase the pace of passive policy tightening, a perverse outcome. To counteract it, the FOMC decided to re-invest the payments of Agency MBS into longer-term Treasuries. Bernanke also explained the impact of its policy of large scale purchases of assets on the economy by the so-called portfolio balance channel. These purchases change the quantity and mix of financial assets held by the public. So he concludes that the degree of accommodation delivered by the Fed’s purchase program is determinate primarily by the quantity and mix of the securities the Fed holds rather than by the current pace of new purchases.
Combining the fact that Bernanke believes the preconditions for stronger growth in 2011 remain in place and that the degree of accommodation of its purchases is determined by the quantity and mix of securities (that are now kept stable) instead of by the current pace of purchases makes us think that the Fed is not ready at this juncture to start a fresh program of additional asset purchases. This is also supported by the emphasize in the third part of its speech (see below) where he not only speaks about the benefits of additional stimulus by unconventional measures, but also about its costs. That might have also been one of the reasons for the correction in the bond market that had clearly anticipated a near term new Fed program.
In the third part of his speech, Bernanke made clear that if needed the Fed would not hesitate to provide additional monetary accommodation through unconventional measures, especially if the outlook were to deteriorate significantly. The issue is not whether we have the tools to help support economic activity and guard against disinflation, we have, but whether the benefits of each tool, in terms of additional stimulus, outweigh the associated risks and costs of using the tools. The chairman focussed on three tools notably additional purchases of longerterm securities, modifying the FOMC communication and reducing the interest paid on excess reserves. A fourth strategy, an increase in its inflation goals, was outright rejected. For the three other tools, the chairman gave some positives and drawbacks. However, it looks that the additional purchase of securities makes the biggest chance to be chosen, if needed. The reduction in interest paid on excess reserves would only make a small impact on financial conditions and risk to disrupt key financial markets and institutions. So it seems the FOMC is still discussing the pro and cons of the tools. Bernanke explicitly said that FOMC had not yet agreed on specific criteria or triggers for further action. However, he made two general observations.
First, while deflation is not a significant risk for the US at this time, the FOMC will strongly resist deviations from price stability in the downward direction. If these risks were to increase, the benefit/cost trade-offs of the policy tools would become significantly more favourable. Secondly, regardless of the risks of deflation, the FOMC will do all that it can do to ensure continuation of the economic recovery. A further significant weakening in the economic outlook would likely be associated with further disinflation and therefore there would be no conflict between supporting growth and maintaining price stability.
Concluding, the FOMC sees currently no reasons to implement without delay more unconventional measures to ease policy further (are we in a soft patch?), but should the economy weaken significantly further, the FOMC would not hesitate to implement more unconventional easing measures, presumably by a new additional program of asset purchases. We don’t expect any decision on a policy change at the September 21 FOMC meeting, but things may change at the November 2/3 or the December 14 meeting. At the November meeting, the Q3 GDP results are known, as are the September payrolls. The October payrolls are published on November 5, but the FOMC may have some preview of the report, which if true might give the FOMC a good take on the path of the economy going forward. However, the timing of the Congress elections on November 2 may be an impediment. At the December 14 FOMC meeting, there might be more certainty about the fate of the Bush tax cuts that expire at the end of December unless Congress decides otherwise (compromise between Republicans, expected to regain control of at least the House, and Democrats?). The markets will already assess chances on more Fed stimulus this week as the key ISM and payrolls figures are published.
ECB president Trichet also made an important speech in Jackson Home, on which we might return tomorrow. He emphasized the risk of high debt and the unprecedented uncertainties and underlined the difference between the two. The second one cannot be measured and thus incites economic actors to simply stand aside and do nothing.
Today, the eco calendar contains the European Commission confidence indicators and US personal income and spending data. European Commission’s economic confidence is expected to show a slight increase in August, mainly due to an improvement in services confidence. After the PMI’s, ZEW and IFO, the figure is rather outdated and therefore no market impact is expected. In the US, both personal income and spending are forecasted to have picked up in July after flat readings in June.
Later this week, both the US and euro zone eco calendar is well-filled with the US payrolls, manufacturing and non-manufacturing ISM, conference board’s consumer confidence, the first estimate of euro zone CPI, the second estimate of Q2 GDP and the retail sales. Attention will also go out to the ECB meeting and minutes of the latest Fed meeting.
After another disappointment in July, the payrolls are expected to remain very weak in August. The consensus is looking for a decline by 105 000 in the payrolls, but because of the distortions due to the Census 2010, more interesting are the private payrolls. After a 71 000 increase last month, private payrolls are expected to have risen by only 46 000 in August. We have no reasons to distance ourselves from the (weak) consensus after the elevated claims in the previous weeks. We keep a close eye on the temporary help component, which turned negative last month, as it is a good forecaster for the future development of the overall payrolls. A second consecutive decline will raise fears about a double dip. The manufacturing ISM is expected to decline for a fourth consecutive month in August. The consensus is looking for a decline from 55.5 to 53.5, which would be the lowest level in almost one year and provide further evidence that the US economy is cooling down. The nonmanufacturing ISM is forecasted to show a more moderate deterioration in August. After two consecutive declines, Conference Board’s consumer confidence is expected to show a slight uptick in August, which would be in line with the recent developments in the ABC and Michigan consumer confidence indicators. Nevertheless, consumer sentiment remains very fragile due to high unemployment, low wages and the weak economic outlook. After a significant increase in July, euro zone CPI inflation is forecasted drop back in August. The consensus is looking for a decline from 1.7% Y/Y to 1.5% Y/Y, but after the German inflation data last Friday, a downward surprise is not excluded, which might spark increase doubts about the low level of inflation. The preliminary estimate of euro zone Q2 GDP is expected to confirm the first estimate, which showed that the euro zone economy grew by a much better than expected 1.0% Q/Q. It will be interesting to see whether the breakdown show the same (encouraging) picture as the German details. Euro zone retail sales are expected to have risen by 0.2% M/M in July after a flat outcome in June. The German retail sales on Wednesday might give some indication about the euro zone reading. The breakdown of the German Q2 GDP data showed consumer started to spend again, which is expected to continue at the start of the third quarter and is an encouraging sign as it is an important condition for sustained growth.
Other events this week are the ECB meeting on Thursday and the August FOMC Minutes on Wednesday. Regarding the ECB, markets will focus on the decisions on the liquidity exit policy, the new ECB forecasts and eventual comments on the ECB Securities Market Program (bond purchases). We will publish a preview flash on Tuesday. The FOMC Minutes might be interesting literature, especially given press articles about the heated discussions at the meeting on the nonconventional monetary policy measures, but Bernanke’s comments in Jackson Hole make these Minutes less interesting from a market point of view.
Regarding supply, Italy will issue today a new 10-year BTP (3.75% March 2021; €4-5B) and tap the June 2013 BTP (€2-3B), while France holds its OAT auction and Spain its Bono auction on Thursday. The US Treasury will announce the details of its 3, 10 and 30-year auctions on Thursday.
Regarding bond markets, there was a profit taking movement on Friday, as Bernanke didn’t signal any immediate easing of policy, which the market had anticipated. The question for the markets is now whether the US activity data will soften further to the point the Fed will be convinced it has to step in with additional measures or whether the data will be more in line with what one might expect in a soft patch. In the latter case, hopes on more QE might be disappointed and in time bond yield may have to go higher. After the correction, we are again more neutral on US Treasuries at the start of the new trading week. In EMU, the ECB meeting takes the centre stage, but we agree with consensus that the ECB will prolong its emergency liquidity measures into Q1 2011, as signalled by ECB’s Weber.
However, we have increased our monitoring of the intra-EMU bond market, after the renewed spread widening of late of Irish and Portuguese bonds. The absence of buyers makes these peripheral markets vulnerable to some bouts of selling. The absence of the ECB as a buyer of last resort is disturbing. Could the ECB re-enter the fray, to re-install a more normal market functioning? It will be interesting to see how the spreads evolve if German yields would rise a bit, which was in the past often a positive for peripherals. Regarding the Bund market, Friday’s correction was modest and one shouldn’t yet be taken as an important turnaround, even if it may signal the end of the relentless bull-run. The technical picture hasn’t been seriously damaged, but the break below the, albeit steep, uptrendline should not be ignored. We suggest that investors will try to find out whether the bull run is indeed over and only at the end of the week after the payrolls, the outcome should be clearer.
