German bonds consolidate, but US Treasuries cannot find their composure

On Wednesday, German bonds had a somewhat calmer session, but US Treasuries still could not find their composure and tumbled lower in the latter part of the session.  It was mostly a sentiment  and technical driven session. The US eco data were on balance somewhat stronger, good rebound from NY Fed and industrial production and subdued inflation, while the EMU Q3 employment data were still weak. However, the data didn’t play a role.

Intra-day,  the Bund tested the downside in early trading, but the reaction low held and the contract reverted towards Tuesday’s closing levels, which was followed by sideways range trading throughout the remainder of the session. The rating action of Moody’s regarding Spain (negative outlook) ahead of the session was unable to trigger some safe haven flows towards the Bund. The shorter end slightly outperformed the longer end in a daily perspective. 2-and 5-yield closed down 2 basis points, while yields at the longer end closed nearly unchanged. US Treasuries traded moderately positive throughout the session, little affected by the data or the Fed Treasury purchases. However, later in the session, without any particular news, we are aware off,
Treasuries slid lower and the move accelerated when a key technical level (119-00/02+) was broken. A new low at 128.20+ was put on the tables.

In the periphery, yield spreads versus German bonds narrowed with the exception of German/Greek (+12 bps) and German/Portuguese (+4 bps) spreads. Ahead of the Head of States meeting, the Portuguese government proposed a series of measures to increase the country’s competitiveness and to convince Europe
that it can avoid a bailout. FM Teixeira dos Santos said: “We are taking initiatives that are crucial so as to avoid resorting to foreign (aid) mechanisms.”  At the start of the day German/Spanish yield spread went out, after Moody’s announced that it changed the outlook for Spain’s sovereign debt rating from stable to negative, but eventually the yield spread came in 7 bps. Spanish FM Salgado  said that Spain’s current rating (Aa1; only 1 notch lower than Aaa) showed how solvent Spain is and was positive about the future: “I expect that within three months we shall be able to offer sufficient arguments to turn that negative outlook into positive.” The Irish parliament voted for acceptance of the €85B EU/IMF bailout loan.

Today the IMF will decide on approving its €22.5B aid tranche to the former Celtic Tiger. The finance spokesman of the main opposition  party Fine Gael, who will probably be FM in the next Irish government, said that losses should be imposed on investors who hold bank senior debt that is not covered by a government guarantee, which amounts around €15B. This way the amount of the bailout loan could have
been lowered. The proposal might just be a political move to make the current government even more unpopular, ahead of next year’s elections, given that the pride Irish people opposed international aid very strongly. Current FM Lenihan reacted sharply that  “Those who think we can unilaterally renege on senior bondholders against the wishes of the ECB  are living in fantasy land.”  If the next government would decide on such a measure it would be on collision course with the EU/IMF/ECB as it would be against the bail-out package.

Also today, the eco calendar remains well-filled with the first estimate of the euro zone PMI’s, the final figure of euro zone CPI inflation, the US housing starts and permits, weekly claims and Philadelphia Fed index. Spain will tap the market, but markets might probably look mostly forward for the EU Summit which starts at 5pm. Last month, both euro zone manufacturing and services PMI surprised on the upside of expectations due to strength in Germany, while sentiment across the peripheral countries remained sluggish. For December, the consensus is looking for a slight decline in both manufacturing (55.2 from 55.3) and services (55.2 from 55.4) PMI. While German activity will probably remain strong,  there is some uncertainty regarding the peripheral countries. After the significant increase last month, we believe therefore that the risks might be on the downside of expectations. In the euro zone, the final figure of November CPI is forecasted to confirm that inflation rose from 1.8% Y/Y to 1.9% Y/Y. Interesting will however be the core reading, which is expected to stay unchanged at 1.1% Y/Y confirming that inflationary pressures remain muted, but also that deflation fears are overdone.

In the US, housing starts are forecasted to show a 6.0% M/M rebound in November after falling sharply in the month before. Building permits are expected to show a slight increase in November (by 1.5% M/M).  Both starts and permits remain however close to the lows, which might cause some swings in the percentage data. Nevertheless, as inventories of unsold houses are high, credit tight and unemployment remains elevated, it will take time for the housing starts and permits to recover. In the week ended December the 11th , US initial claims are forecasted to show a slight increase (by 4 000 to 425 000) after a significant decline in the week before. Also continuing claims are forecasted to show a slight increase after dropping to a two-year low. The week under review was the first week since the expiration of emergency and extended unemployment insurance benefits (1st  of December), which was however renewed last week and therefore we have no idea what  impact it will have on the continuing claims. The Philly Fed manufacturing index is forecasted to drop from 22.5 to 15 in December, after a sharp improvement in November. We believe however that the decline might be smaller.

Today, the Spanish treasury taps the market with the on the run 10-year Bono (4.85% Oct2020) and the on the run 15-year Bono (4.65% Jul2025) for an amount of €2-3B. This is less than the normal auction size of the Spanish treasury. This weekend, Spanish FM Salgado warned that Spain will have to pay a considerable price for its debt.  “It’s true that we might have to pay  a little more for bond issues than we have in the past. For that  reason we have said we will  reduce the volume until the markets stabilise.” On Tuesday, the treasury had to pay 100 bps more for 12- and 18-month bills than they did in November.

The EU Summit of the Heads of State starts this evening. It is a very important moment for the EU in crisis time. At the end of October, the European Council agreed on the need to set up a permanent crisis mechanism, the European Stability Mechanism (ESM) to safeguard the financial stability of the euro area. The ESM is based on the EFSF that provides financial assistance under strict conditionality. So the ESM will complement the new framework of economic governance that will focus on prevention and will substantially reduce the probability of a crisis in the future.

Rules will be adapted to provide for a case by case participation  of private sector creditors, consistent with IMF policies.  The ESM loan will enjoy preferred creditor status, junior only to the IMF loan. Assistance provided to a country will be based on a programme of economic and fiscal adjustment and on a  rigorous debt sustainability analysis (by EU, ECB and IMF). The Eurogroup ministers will take a unanimous decision on providing assistance. For countries considered solvent, the private creditors would be encouraged to maintain their exposure to the country. In case of insolvent countries, the country needs to negotiate a comprehensive restructuring plan with its private creditors with a view to restore debt sustainability. If debt sustainability can be reached through these measures, the ESM may provide liquidity assistance. To facilitate this process, collective action clauses will be included in the terms of all new euro area government bonds starting in June 2013. EU president Van Rompuy will put a proposal on the table of the Summit on a limited
Treaty change.  While the latter is important and might bring some surprises, according to the press (FT), the Summit may take other decisions to address the euro crisis, notably an overhaul of the $440B EFSF. The FT suggested that the EFSF may start buying bonds of distressed governments (to replace the ECB?). Another possibility is for the EFSF to provide ST lines of credit to countries struggling to borrow money but in no need of multi-year bail-out packages. However, still according to the FT, German officials said they want to wait until early next year to table new measures and on Friday to concentrate on the Treaty changes that are needed to put the ESM on the rails. We have become more suspicious on the FT reporting regarding the EMU crisis, after the journal misled us ahead of the ECB meeting, by suggesting that the ECB would announce a QE-1 sort of package to address the stress in the peripheral bond markets. While the measures the FT now suggests might be under consideration, they have a number  of downsides that make them unlikely to be adopted in  the form that they are presented. If the EFSF start buying bonds, there will be less money available for bail-outs and rating agencies might be critical and put the AAA rating into question. Short-term loans might become LT loans and who will decide and on what condition, which countries may get money without an adjustment package?          

In the past days, rumours have emerged that the ECB would request a capital increase, some saying it might want to double its capital (currently €4B). German government sources already said that it would answer positively towards an eventual demand, showing that it is more than a rumour. Taken into account provisions and the general reserve fund it would raise the total amount of its capital buffer to €16B.

The ECB has taken a lot of credit risk on its books (collateral, covered bonds and SMP bonds), but a large part might be recorded in the ESCB (European system of central banks) and not at the ECB. The SMP bonds have already been bought at lower prices, protecting the ECB (and ESCB) to some extent to eventual defaults. Of course the ECB has no mark-to-mark obligation and thus should not have to recognize losses, but provisioning might be an appropriate prudent practise. The whole issue is very technical and the move may be inspired by creating the possibility to up the SMP bond purchases, even if we think that the ECB is reluctant to do so, but the situation may oblige  the ECB to be more active at some point. So, we are eager
whether such an ECB request will be formulated. The ECB should be careful to explain why it deems it necessary, to avoid renewed fears in the bond markets after defaults. If a request is done, we suspect the Head of States will approve it.  

Regarding bond market trading,  the consolidation we counted on mid last week, didn’t concretize, at least not in the US Treasury market. In the Bund, there was some consolidation that remains however tentative. For today, the European PMI’s may be bond friendly, but the Philly Fed may be stronger than expected and thus Treasury unfriendly. However, we still think that sentiment and technicals will be in the driver’s seat. The Spanish bond auction is a challenge, but all in all it shouldn’t be too negative for the core bonds in case of a success, while it would be a positive in case of a failure. However, the Spanish government might have secured enough demand in advance of the auction. The EU Summit starts when European trading is
ending. A demand of extra capital by the ECB should intrinsically be mildly positive for the core bonds, we think, as it might stoke some fears about potential defaults.

Regarding the technicals, both the picture of the Bund and Treasuries are bearish, but hugely oversold conditions may be at play, even if it didn’t do much in recent sessions. Reiterating our weekly view, flows have thinned and will do so further out, making it very difficult to see which market moves are due to “fundamentals” and which to year-end positioning. The latter may easily be reversed early 2011. In this context, we feel uneasy to give short term guidance that might be nothing more than guessing. Our medium term stance is still that one shouldn’t fight the bear run that is ongoing, while short term we thought/think
that some consolidation was/is likely.
Full report : German bonds consolidate, but US Treasuries cannot find their composure