US Non-manufacturing ISM, but Italian referendum key

Rates

Short covering after plain vanilla US payrolls

On Friday, global core bonds corrected higher after the US payrolls turned out a mixed bag. The headline payroll number missed consensus by a whisker (178k vs 180k). The unemployment rate unexpectedly declined from 4.9% to 4.6%, the lowest level since 2007 and below the Fed’s (current) NAIRU. Average hourly earnings disappointed though at -0.1% M/M and 2.5% Y/Y (from 2.8% Y/Y in October). Immediately after the US payrolls release some short-covering gains followed, but investors sold into the “rally” sending core bonds back to prepayrolls levels. However, there was no follow through selling which brought a stronger bout of short covering and more substantial gains. The upcoming referendum might have been of some additional help, but the Italian spread narrowing suggest that it wasn’t the main factor. The change in the US curve, with the belly outperforming, suggests that markets scaled back their expectations for the (2017) Fed rate path, probably due to the disappointing decline of AHE (earnings). Equity markets initially gained some ground, but closed nearly unchanged. The oil price remained upwardly oriented, following some modest initial profit taking.

In a daily perspective, changes on the US yield curve ranged between -4.7 bps (30-yr) and -7.7 bps (5-yr), the belly of the curve outperforming. The German yield curve bull flattened with yields down between 0.5 bps and 9.8 bps. On intra-EMU bond markets, the Italian 10-yr yield spreads versus Germany narrowed up to 6 bps, as optimism on the referendum was still high (see below for the cold shower that followed). Spanish, Portuguese and Greek spreads widened by 2 to 8 bps.

US Non-manufacturing ISM, but Italian referendum key

In the euro area, the final Markit business surveys for November shouldn’t stir markets while the EMU retail sales for October are outdated and not very reliable. The UK services PMI (54.3 from 54.5) may have a marginal effect if the outcome deviates from consensus. In the US, the Non-manufacturing ISM is more interesting. It is expected to have marginally increased in November to 55.5 from 54.8 previously. We have no reasons to distance us from the consensus. Speeches of Fed Dudley, Evans and Bullard, three doves, shouldn’t bring fireworks either, as a rate hike next week is a near certainty.

Italian PM Renzi resigns after referendum defeat

Italy rejected constitutional reforms proposed by PM Renzi in a referendum with a very clear 60% majority and a high turnout of about 70%. PM Renzi announced his resignation. The outcome is the worst possible for markets as it could be interpreted as rejecting Mr. Renzi’s reform plans, but also as supporting opposition parties. According to a recent poll, outsider 5SM (Grillo’s Five Stary Party), would be first in eventual parliamentary elections. The outcome also raises uncertainty about the outcome of the Dutch and French elections in H1 2017 and about the tail risk of EMU disintegration (5 Star party promised EU referendum). The Italian president will now launch a round of talks on the formation of a new government. Snap elections aren’t excluded given the clear outcome by high turnout, but are unlikely even if it would probably be the most democratic way of action. The political instability could jeopardize BMPS’s plans to raise up to €5B by the end of the year (eg if sentiment towards the Italian financial sector gets a new snap). The bank and its advisers are expected to meet this morning. On markets, we expect last week Italian spread narrowing to be undo. Risk-off favors the Bund at the expense of swaps and other, especially peripheral, bonds. The euro pays the price with EUR/USD back towards 1.0550. As Thursday’s ECB meeting looms, we don’t expect the risk-off moves to be extreme.

How long will risk-off last this time?

Overnight, Asian stock markets lose around 1% in the global risk-off move following the Italian referendum outcome. China underperforms despite an improving Caixin Services PMI, probably because of Trump’s policy (see headlines). The US Note future gains ground, suggesting a stronger opening for the Bund.

Today, markets will have to digest the Italian referendum outcome. We think that the initial market reaction will be risk-off, but in line with the Brexit-vote and US elections, it shouldn’t last long. Investors selling peripheral bonds risk being “countered” by a possible ECB decision to extend the current end date of the QE-programme when they meet on Thursday. The US non-manufacturing ISM is expected to remain strong, but risks being overshadowed by this weekend’s events. Overall, we think that the current flight to safety could eventually be an opportunity to sell-theupticks in core bonds as we expect Trump’s reflation trade to remain markets’ key theme.

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