Markets: Fixed Income
On Thursday, global bonds continued to correct lower and the curve steep-ened, again led by German bonds. We consider yesterday’s moves, follow through action on the correction that started on Wednesday and in which the surprisingly strong US ISM report played a key role. During the thinly traded Au-gust month, global bonds rallied relentlessly on the view that the US economy was sliding fast, eventually towards a double dip recession, even if that wasn’t already a consensus view. Talk about deflation became louder and the Fed added his contri-bution by suggesting at the FOMC meeting they might start a second QE program. Last Friday though Fed chairman Bernanke said the preconditions for stronger 2011 GDP growth were still in place and he never insinuated that deflation would be a problem. While he did leave the door open for more QE, if needed, there was no sign whatsoever that the conditions were fulfilled to start such a program anytime soon. The strong ISM on Tuesday was the final nail in the coffin of the bulls, as it seamed doubts about the possibility of a double dip and given the extreme position-ing of the market, a violent correction started. Yesterday, more investors apparently thought it smart to take a more neutral position, also ahead of the payrolls, giving the correction another leg. The correction yesterday started in the European session, shortly after the release of the details of Q2 GDP. These showed not only a big con-tribution of exports, but more surprisingly showed healthy domestic growth (con-sumption and investments), suggesting that the recovery in EMU is broader than ex-pected. Later on, global bonds remained under some, albeit more moderate down-ward pressure with the better-than-expected (unimportant) pending home sales a potential trigger. Equities traded reasonably strong in the US, despite the outsized gains on Wednesday, which was evidently an underlying negative for bonds. How-ever, the correction in the Bond market during the European session was not caused by equities. At the end of trading, German yields were flat (2-year) to 8.5 bps higher at the 30-year sector, while in the US the changes varied from +1 bps at the 2-year to +7 at the 30-year sector.
We will be brief on the ECB, but elaborate on the liquidity decisions. The ECB upgraded economic fore-casts, but Trichet remained ‘cautious and prudent’. It still sees a very different world than US Federal Reserve or Bank of Japan. The first interest rate increase still seems a very long distance away; perhaps late 2011 or early 2012.
Extensions of liquidity support are broadly as expected but some details were unexpected. Mr Trichet announced the extension of the time frame of excep-tional liquidity support to the Eurozone financial system. He said one week and one month refinancing operations would continue with full allotment (i.e. all demands for funds being met) at a fixed rate at least until mid January ‘for as long as necessary’. He also indicated that 3-month liquidity would be provided at end October, Novem-ber and December 2010 on the same full allotment basis. However, there was a slight change in the rate applicable to these operations. It would still be fixed, but at the average rate of the MROs over the lifetime of each 3 month LTRO. Mr. Trichet called the change completely technical in nature, but it also means that the ECB in theory is completely free to redesign its policy from early 2011 onwards, in-cluding eventual increases in its refi-rate. However, we don’t think this will actually happen.
Three additional fine-tuning operations offering twice 6-day and once 13 day liquidity on the same terms will be carried out on 30 September, on 11 Novem-ber and 23 December to meet any liquidity needs arising from the maturity of current 6 and 12 month offerings at end September, mid November and 23rd December. These operations will be conducted under the same procedure as the MRO opera-tions (fixed rate/full allotment). Similar fine-tuning operations were used when at the end of June 1-year LTRO matured.
This approach was broadly as expected but, at the margin, the “technical” change to the procedure for the 3-month LTRO means that the possibility of a new, ex-tra step in the exit policy may occur at the beginning of Q1 2011, whereas if the 3-month LTRO was conducted under the fixed, fixed variant, it would have been dif-ficult to take such a step before the last three month LTRO matured at the end of March. This might have been the concession Mr. Trichet had to make to the hawks inside the council to get the consensus on the policy. Note that while ECB’s Weber suggested a prolongation of the 3-month LTRO at full allotment, he limited it to the three month operation in September, that would carry the unlimited liquidity provision over the year end. Despite these comments, the ECB is still anxious to prevent any fears emerging that Eurozone banks could face increased funding difficulties in com-ing months. The market impact of the ECB decisions and press conference were minimal.
In the intra-EMU bond market, the sharp correction in the German market on Wednesday lessened pressures on the other core and peripheral bonds resulting in a spread narrowing across the board. This continued yesterday. Spain did well, addi-tionally helped by a 5-year bond auction that went reasonable well and so did France after an auction where investors were especially eager for the longer-dated OATs on offer. Only the Portuguese spread narrowing was a bit disappointing. We didn’t see a negative effect from the ECB reluctance to help peripheral bond mar-kets, as was clear from Trichet’s remarks and body language at yesterday’s com-ments.
Today, markets will focus on the US payrolls report, but also the euro zone retail sales, final figure of euro zone services PMI and US non-manufacturing ISM are on the agenda. Fed governor Lockhart and ECB Gonzalez-Paramo take the stage.
After another disappointment in July, the payrolls are expected to remain very weak in August. The consensus is looking for a decline by 100 000 in the head-line payrolls figure, but because of the distortions due to the Census 2010, more in-teresting are the private payrolls. After an 71 000 increase last month, private pay-rolls are expected to have risen by only 42 000 in August. The most recent data showed however a mixed picture as the ADP employment report showed a decline in private employment for the first time in seven months, while the employment com-ponent in the manufacturing ISM rose above 60 in August. If we compare the July outcome with the August expectation, the main swing factor will be the automotive sector. In July, GM kept 9 of its 11 assembly plants operating during the traditional shutdown, which provided a 21 000 lift to the automotive payrolls, which should be reversed in August (due to the seasonal adjustment factors). Nevertheless, worrying in the ADP report was the deterioration across small and medium size businesses, for which the ADP report provides normally an accurate forecast. Therefore, we be-lieve a downward surprise is not excluded. We also keep a close eye on the temporary help component, which turned negative last month, as it is a good fore-caster for the future development of the overall payrolls. A second consecutive de-cline will increase worries about the labour market weakness. Also in the US, the non-manufacturing ISM expected to show a decline in August (53.2 from 54.3), but after the manufacturing ISM, with which there is a good correlation, we believe the risks are on the upside of expectations. A downward surprise, eventually combined with payroll weakness may make investors conclude that the strong ISM was an out-lier. Despite these comments on the payrolls, we think the economy is in a soft patch and not sliding towards a double dip. In the euro zone, the retail sales are expected to have increased by 0.2% M/M in July after already a 0.2% M/M increase in June, while the final figure of services PMI is expected to confirm the first estimate (which showed a marginal decline from 55.8 to 55.6).
All eyes are today on the payrolls. There might be some risks on the down-side of expectations, but we have the impression that the market will look at the eco data (payrolls) through rosy glasses, just as it looked through dark glasses in Au-gust. So there are asymmetrical risks. A much worse-than-expected payrolls report might give the bulls another chance to push prices higher, but we ex-pect this move to fail, as we suspect a lot of longs are ready to offload bonds into rallies. A stronger-than-expected payrolls report (or even an as expected report) might convince more investors that the US economy won’t slide into recession and this reassessment of the outlook should continue to weigh on bonds. From a technical point of view, next major support levels for the Bund are 131.94 (38% retracement) and 131.77/73 (targets double top). On the upside, a sus-tained move above 133.25/32 would be a disappointment for the bears and delay a more pronounced correction, but even than we would consider the highs at 134.77 as difficult to take out in a longer perspective. So, we keep a sell-on-upticks strat-egy going into the payrolls.
