Core bonds to correct somewhat higher?

Rates

No risk off after German election, but after N-K sabre rattling

The German election surprise didn't trigger safe haven flows on core bond markets and peripheral spreads barely widened. European equities traded stable while the decline of EUR/USD was technically irrelevant. ECB and Fed talk also failed to give distinct direction. However, in mid-US session, risk off sentiment flared up all of a sudden up after more war talk from North Korea (see news). Equities nosedived and core bonds jumped higher, while peripheral spreads widened. US equities made a partial comeback later in the session, but core bonds held on to good daily gains. In a daily perspective, US yields fell between 0.8 bp (2-yr) to 3 bps (10 yr), while German yields dropped between 2.7 bps (30-yr) and 4.7 bps (10-yr). On intra-EMU bond markets, 10-yr yield spreads versus Germany widened 5 bps (Spain/Italy) to 6 bps (Port./Greece).

 

Busy US calendar

Focus today will be on the US economic data , Fed speakers including Yellen, ECB speakers Praet and Liikanen and fresh supply.
US New Home sales surprised on the downside in July, dropping 9.4% M/M (571K annualised). They are notoriously volatile and consequently we expect a sharp rebound in August. Underlying housing demand is strong with a solid economy and lack of existing homes for sale. The market expects a rebound to 590K (3.3%), but risks are on the upside. Consumer confidence (Conference board) was near a cyclical high in August (122.9). However, the hurricanes and their effect on gasoline prices suggest a decline in September. That should be a temporary effect though as the labour market remains in healthy shape and equities are flirting with all-time highs. So, the market reaction on a weaker September figure (consensus 119.5) should be sanguine. Given the uncertainties about the impact of the hurricanes, it is difficult to assess the extent of the decline. The Richmond Fed survey is expected to show stable conditions.

Regarding central bankers, ECB Draghi and Coueré yesterday eve talked about the recovery, inflation and policy. We retain that they are optimist on the recovery and are increasingly confident that inflation will rebound. They are not afraid of the QE exit, but can't afford hasty moves on monetary policy and want to keep as much stimulus as needed. Regarding the future size of the ECB balance sheet, Draghi said it is hard to say now.

Today, ECB Praet and Liikanen take the stage, but after yesterday's speech of Draghi, we expect no new insights that are market moving. NY Fed Dudley defended yesterday the Fed's rate path including another rate hike in December as he sees low inflation as mainly due to temporary factors. Today, we hear the views of Fed Brainard (dove), Bostic (centr) and Mester (hawk), but the main attention goes to Yellen (after European close). She speaks on inflation, uncertainty and monetary policy. Interesting, but it is unlikely she comes to another conclusion on policy than last week when she gave her post-FOMC press conference.

 

Germany, Italy and the US to sell bonds

Today, the German Finanzagentur holds a €4B 2-yr Schatz auction (0% Sep2019). German auctions usually go sluggish, but the 2-yr Schatz auctions most of the time do okay. We expect the Schatz auction to be plain vanilla. The German election results and geopolitical concerns together with the natural interest of central banks should be positives for the auction. The US starts its end-of-month refinancing operation with a $26B 2-yr Note auction. It trades in the when issued market at 1.435%, which should be attractive after the recent rise, even as more rate hikes are on the horizon.

 

Core bonds to correct somewhat higher?

Overnight, risk sentiment improved cautiously. Asian equities are slightly negative, but not much different from WS closure. USD/JPY is little changed, but at yesterday's lows. Gold is strong, but additional gains are small and oil ekes out some more gains after yesterday's spike that broke key resistance. US Treasuries are little changed. So, risk sentiment is more neutral, but remains an issue. We expect the Bund to open neutral too.

Today's eco calendar contains US new home sales, consumer confidence and Richmond Fed business survey. The home sales may rebound, but risks are for a weaker consumer confidence and Richmond business confidence, albeit due to hurricane effects and higher gasoline prices. All in all markets shouldn't be driven by these releases. A plea of Fed speakers are wildcards (see above). Geopolitical issues like North-Korean threats & US verbal responses and the Kurdish independence referendum combined with the Turkish reaction may keep risk sentiment fragile. Higher oil prices aren't currently a main driver for core bonds. In such an environment, there might be room for some further profit on short positions in the German Bunds and US Treasuries. However, given the upcoming normalization of the ECB policy and the continuation of the Fed policy, the upside for core bonds may be limited and an easing of geopolitical tensions may turn the focus back to the central bankers, the economy and maybe oil prices.

After the FOMC meeting, we concluded that US Treasuries re-entered a sell-on-upticks phase after the Fed confirmed its view on 2017/2018 interest rate policy. A December rate hike isn't fully discounted yet. Short term though, we still expect some correction higher. We hold a sell-on-upticks view in the Bund as well as the ECB's normalisation process slowly takes off. From a technical point of view, both the Bund and the US Note future fell below uptrend lines (early September) since the start of summer, making the picture neutral from bullish.

 

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