Core bonds modestly down in follow through selling
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Core bonds hovered sideways during much of yesterday's session, nor eco data nor other items figured on the calendar. During the afternoon session, core bonds slid suddenly lower on some big orders. The Bund initially underperformed US Treasuries, but while Bunds soon travelled again sideways, the US Treasuries very gradually lost some more ground. Yesterday's price action was uneventful, given also the low volumes traded, but signalled that the downward correction in core bonds is not over yet. In a daily perspective, changes on the US yield curve ranged between +1.4 bps (2-yr) and +2.9 bps (30-yr), while German yields traded 0.8 bps (2-yr) to 3.2 bps (30-yr) higher, steepening the curves. On intra-EMU bond markets, 10-yr yield spreads narrowed across the board (3-4 bps for Italy and Spain). Portuguese bonds profited fully from the rating upgrade by S&P to investment grade (BBB-). The 10-yr yield spread versus Germany dived 39 bps.
Light calendar, before FOMC concludes tomorrow
September German ZEW economic confidence survey is expected little changed compared to August. As German equities recovered in September, we have no reasons to distance us from consensus. Anyway, market reactions on the release are mostly modest at best. In the US, housing starts and permits are expected respectively slightly higher and slightly lower in August, but no rebound from weak July figures. Sales look to have peaked, but no such sign yet from permits, which urges for caution in interpreting the housing market.
Regarding tomorrow's FOMC meeting, we expect the FOMC to announce the start of its balance sheet tapering (as of Oct. 1?). In June, the FOMC announced how the tapering would proceed. Monthly re-investments will initially decline by $6 bn of maturing US Treasuries and $4 bn of maturing MBS. These amounts will be raised "automatically" every quarter (by $6 bn and $4 bn) until they hit full pace after one year ($50 bn/month combined). We don't expect the decision to have a major impact on long term bonds, as it was extensively communicated to the markets. That may change when the programme gathers speed. Regarding the Fed's dot plot, we don't see changes in the median dot for 2017 (still one rate hike) and for 2018 (3 extra hikes). It would take four governors to lower their dot before the median dot drops. Of course, chances are high that some governors lower their dot which might be considered as dovish. Chances of a downward revision of the 2019 median dot (2.5 extra rate hikes) and the long run median dot (3%) are high. We think the FOMC has little incentive to signal now that its expected rate cycle will still be more shallow than recently indicated. Financial conditions have actually eased since the start of the year despite two rate increases. Long term yields dropped about 40 basis points, the dollar weakened about 10% and the equities are 11.7% (S&P) to 19.8% (Nasdaq) higher. Whether the Fed effectively raises rates in December remains uncertain. The debt ceiling issue will likely be again on the table and the economic data won't give a clear-cut picture with storm-related disruptions in September/October. Anyway, inflation should show signs of rising again.
Eyes remain on the Fed
Risk sentiment on Asia is slightly negative overnight with small losses for most equity indices and small gains for the US Note future. USD/JPY is the exception to the rule with more JPY losses. We expect a neutral to slightly higher opening for the Bund.
Today's EMU/US eco calendar remains thin with German ZEW and US housing starts & building permits. Those indicators mostly have little market moving potential and that's especially the case ahead of tomorrow's FOMC meeting. Since the beginning of last week, core bond markets lost significant ground, scaling back too dovish bets against monetary policy normalisation. With markets now positioned more neutral, we expect sideways trading ahead of the Fed. We expect the FOMC to hang on the 2017/2018 rate projections (1-3) while potentially lowering its neutral rate forecast. That would cause a flattening of the US yield curve.
From a technical point of view, US yields recaptured lost support levels and even broke out of their downward trend channels. Since last Friday, the market implied probability of a 2017 Fed rate hike trades back above 50% (first time since early July). Markets positioning remains too soft in the medium/long term, according to us. The FOMC will normally give the green light at its September meeting for balance sheet tapering in Q4 2017. That's negative for US T's long term. Speculation in the run-up to the October ECB meeting (slowdown in monthly purchases and extension APP; start policy normalisation) should cap the topside of the Bund which lost first support at 161.66, ending the uptrend since the start of summer.
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