Volatile trading of bonds and equities ahead of Yellen

Rates

Yesterday, global core bonds had a very volatile session, mirroring the moves of riskier equities. The upcoming semi-annual testimony of Yellen might have been at play. At the end, equities were marginally lower, US Treasuries slightly higher and German bonds narrowly mixed. Core bonds were initially hit by some profit taking as overbought conditions had to be worked off and as European equities held up rather well following Monday’s crash. However, during the afternoon session core bonds climbed higher again, as equities slid suffered and oil prices dropped significantly. However US equities erased most losses despite the renewed oil downleg. On a daily basis , German yields rose up to 1.6/1.4 bps (10-30-yr), while yields at the short end of the curve (2-5 yr) were fractionally lower. The US bond curve outperformed at the longer end (2.2 to 2.7 bps lower for the 10s and 30s), but was little changed at the short end.

On intra-EMU bond markets, peripherals couldn’t recoup Monday’s big losses, but, on a positive note, the rout paused at least for Italian and Spanish bonds. Spanish and Italian 10-yr yield spreads versus Germany fell 2-3 bps. Greek and Portuguese yield spreads on the contrary continued to widen by 60 and 27 bps respectively. Yields reached 15 month highs. Portuguese FM Centeno defended the 2016 budget as balanced, responsible, but Eurogroup will review the budget and give its opinion today. A statement may be released. Earlier this month, the EU Commission didn’t reject the Portuguese draft budget, but called for further measures to ensure compliance the with Stability and Growth pact. So, there is scope for a conflict with EU and Eurogroup finance ministers. Under the new Socialist government, Portugal is considered a weak link inside the euro area.

The eco calendar remains thin today with only some national EMU production data. The focus will be on Yellen’s testimony to Congress. Yellen should bolster optimism in markets after the renewed turmoil. Markets have now fully priced out rate hikes for 2016 and sharply lowered expectations for rate hikes further out. The first doom prophets are speaking about cutting rates and the debate of negative rates (if needed) has started, with former Fed governor Kocherlakota reiterating his call to cut rates into negative territory. The Fed’s December dot plot of 4 hikes in 2016 and a lot more in 2017/18 looks outlandish. However, Yellen cannot completely capitulate. She will recognize that the Fed should be more cautious on tightening and take its time to evaluate the impact of the turmoil on the US economy before deciding to continue its tightening cycle. On the other hand, she will point to the robust national fundamentals and more specifically to the vibrant labour market. It is a delicate task and any wrong word may hit riskier markets hard.

Germany and US tap the market

The German Finanzagentur launches a new 2-yr Schatz (€5B 0% Mar2018). On the grey market, the new Schatz trades with a 2.1 bps pick-up in ASW-spread terms against the previous benchmark (0% Dec2017). That corresponds with a 2 bps pick-up in yield terms. The record low absolute yield (-0.52%) is totally unattractive. Despite reigning negative risk sentiment, we fear that demand could be subdued. The US Treasury started its mid-month refinancing operation with a terrible $24B 3-yr Note auction. The bid cover was the smallest since July 2009, and the auction stopped with a tail for the first time since June 2014. It was the largest tail since July 2010. Bidding details showed particularly small direct and indirect bids, while the dealer bid was good. Today, the US Treasury continues with a $23B 10-yr Note auction. Currently, the WI trades around 1.71%.

Today: Risk sentiment and Yellen

Overnight, most Asian equity markets remain closed (including China). Other indices trade around 1% lower with Japan underperforming (-3%) on the back of JPY strength. The Nikkei loses more than 5%. The US Note future trades marginally higher suggesting a slightly stronger opening for the Bund.

Today’s eco calendar contains only central bank speakers. Focus goes to Yellen’s testimony. She will likely confirm the strong domestic economy, but highlight risks stemming from the “external” world. Such balanced message shouldn’t really frighten markets. ECB Praet (talk down EUR?) and Fed Williams also speak Risk sentiment and technical factors will continue drive trading ahead of Yellen. European equity markets lost another important support level, suggesting more downside (risk off, positive core bonds). The S&P 500 is still testing crucial support. Oil prices are back in tail spin and support the Bund. So longer term sentiment remains positive for core bonds (also taking into account the technical picture), but both the Bund and the US Note future are heavily overbought, which make them vulnerable for bouts of short term profit taking is risk sentiment improves.

Technically, the German 10-yr yield fell below final support (0.42%).
Weakness in equity market/oil prices and the dovish turn of global central banks (ECB, BoE, BoJ and Fed) pulled yields lower since the start of the year. The break lower opens the way for a complete retracement towards the all-time low at 0.05%. The US 10-yr yield dropped below 1.9%. From a technical point of view, this also suggests more downside towards 1.64%.

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