Markets: Fixed Income
On Tuesday, in the absence of eco releases, the market’s attention returned to the potential problems in the European bank sector partly due to their exposure to European government debt. It is a bit bizarre that it is only now that the market reacts negatively on the stress tests that were at first considered as successful. The awful situation in the Irish banking sector and more particularly Anglo Irish and its potential consequences for the Irish fiscal situation was again put in the picture in the past weeks. Yesterday, the Irish government decided to extent the guarantees for short-term banking liabilities, which the market picked up as a sign the Irish banking sector remains on a life-line of the government.
So, this return of risk aversion led to a renewed flight to the safety of German and US bonds. Of course, the moves should also been seen in the context of last week’s sell-off, which prepared the ground for a rebound. In the next few days it will become clearer whether the weakness of the European banking sector and the situation of the peripheral European bond markets will again be the dominant theme. Equities corrected lower, but only moderately (given recent gains) which makes us cautious for embracing yesterday’s correction as a sufficient reason to become outright bullish bonds at current levels. In a daily perspective, the bond gains were substantial. US bond yields fell between 3 and 12 bps, steepening the curve, while European yields fell by 6 to 11 bps, also steepening the curve. However, the strong performance of the European short end is interesting and may indicate that all recent ECB talk about the exit policy may once more have been premature. The US 3-year T-Note auction went well and had some additional positive impact during the session, while German factory orders disappointed, which wasn’t a negative for bonds either.
In the intra-EMU bond market, it shouldn’t be a surprise that spread widening was generalized. The three weakest credits, Greece, Ireland and Portugal, again stood out and saw their 10-year yield spreads widen by 20-to-30 bps. In the case of Portugal (354 bps) and Ireland (372 bps), these were new highs. The yields for both are now approaching 6%, which might be seen as critical as they question the ability of these countries to service their debt in a longer-term perspective. Luckily, both countries have nearly finished their 2010 financing needs. Portugal holds a small (€1.25B) auction today, which might be difficult. However, recently despite concerns about Portugal, the government succeeded in selling new debt paper. We suspect these results aren’t representative for the real sentiment about Portuguese bonds. Following the weakest EMU country group, there is a second group of Italy, Spain (the latter managed some time ago to escape the weakest group), that since a few days seems to have got Belgium as a new member, not so much with regard to the spread level which is much lower, but with regard to the dynamics. The problems of the latter are different from those of the former members and result from the collapse of the coalition negotiation talks on the institutional reform of the state. While the political situation is difficult, all parties are in favour of an austerity package to bring the deficit down below 3% in 2013. Note that while the Belgian debt is high (about 100%), its deficit has not blown out during the crisis as in most other countries. The debt dynamics are manageable. However, markets are nervous and we see news media, always looking for the next juicy story, turning more attention on Belgium, which might negatively affect Belgian debt. In a daily perspective, yield spreads of the second group widened 6, 7 bps to 74 bps (Belgium), 180 bps (Spain) and 154bps (Italy).
Today, the eco calendar remains thin with only the German industrial production data on the agenda besides some second tier data. The Fed will publish its Beige Book and Governor Kocherlakota speaks on the FOMC and ECB’s Weber on the banking crisis, while the Bank of Canada is expected to raise rates. Supply is heavy as Germany (Schatz and IL Bund), Portugal, Switzerland and the US will tap the market.
After a 0.6% M/M decline in June, German industrial production is expected to have risen by 1.0% M/M in July. We believe however that the risks might be on the downside of expectations after the weaker than expected factory orders yesterday. If German industrial production would decline for a second consecutive months, it will raise expectations about a slowdown in the second half of the year.
The US $33B 3-year Note auction went well. The auction stopped at 0.79%, below the WI of 0.795% at the moment of the stop. The bid/cover of 3.21 compared to last month’s 3.31 and an average of 3.03. Today, the Treasury will hold a re-opening of its 10-year T-Note (2.625% August 2020) for an amount of $21B. The size is unchanged from previous re-openings. It will raise all new cash upon settlement. Yesterday’s solid 3-year auction is a positive for today’s auction, even if in past auctions it wasn’t always a good precursor. The yield level of the 10-year is currently about 20 bps below where it traded ahead of the August auction, even if it is still up from the lows. The return of the safe haven demand should be positive too. In EMU, Portugal will auction its 5.45% Sept 2013 and its 3.85% April 2021 for an amount of €1.25B (see higher for comments). The German Debt Agency will tap its Sep 2012 Schatz for an amount of €6B and sell €2B of its 1.5% April 2016 IL. Regarding the Schatz, the yield decline of yesterday bought the yield to a two month low of about 0.55%, which is a negative that might however be compensated by the flight to safety motive that seems to have come back to the market. The German auctions quite often don’t go very well despite its success in the secondary market.
The Minutes of the last few Fed discount rate meetings showed that the Reserve Banks of Kansas and Dallas requested an increase to 1% from the current 0.75%, but the requests weren’t satisfied. The demand should be seen as the wish of some Reserve Banks to normalize the discount rate and especially by restoring a wider spread with the Fed Funds rate that was in “normal” times 100 basis points. Earlier, the Fed signalled that such normalization wouldn’t constitute a change in monetary policy.
Also in the UK, the industrial production data are on the agenda. After a 0.5% M/M drop in June, a rebound by 0.4% M/M is expected in July. The buy-side bid of 31.2 was up from recent bids, but the takedown of 54.1% was the lightest since May 2009. Buy-side demand was good but their bid was not aggressive, leaving a large chunk in the hands of the dealers, whose bid wasn’t particularly large.
Regarding bond trading today, Asian equities are trading relatively weak, but not weaker than Wall Street’s close would have suggested. European equities might open in the red as it still has to discount some losses of Wall Street after European closure, but it is unclear whether some autonomous decline will follow. We see little news that might give us a good clue on market’s direction. While we sensed yesterday morning that the risk theme might again be embraced, which occurred, we are surprised by the extent of the moves in German bonds and in the intra-EMU market. Was there much news in the WSJ story? Is there new info about the Irish banking sector? The situation was dire and still is. So, we are a bit sceptical that equities should plunge further and bonds recapture their highs anytime soon. We want to assess the market sentiment during the next few sessions before concluding. Technical, as long as the Bund doesn’t trade above the medium term moving average, the picture remains unchanged, despite the juicy gains eked out yesterday. Therefore, we still keep our weekly view and wait on more action to decide whether to amend that view.
Reiterating our weekly view, we expect that, after the steep correction, the violent sell-off will lose momentum and peter out, as markets wait for new info about the economy and central banks, info that is unlikely to become available this week. The technical picture of the Bund (Dec) shows a double top formation with neckline at 131.82 and targets at 130.39/35 reached on Friday. This might contain the sell-off for now, but a further correction towards 131.07 (50% retracement) shouldn’t be excluded. In this bottoming out phase, there might be rallies, but we would suspect these to meet renewed selling, as many investors might have been taken awry by the sell-off and wait on the sidelines for rallies to offload some long exposure. A move above 131.82/88 (neckline/MTMA) would be evidence the downside is better protected, but wouldn’t be enough to install again the outright bullish sentiment. The contract high will be a formidable hurdle difficult to take, unless the economic environment worsens considerably.
