Global bonds couldn’t confirm Thursday’s consolidation

In the US, the belly of the curve suffered the most with yields up about 11 bps. German bonds opened higher but gave back their gains and traded sideways in a narrow range. The shorter end underperformed again, flattening the curve. 2-, 5-, 10- and 30-year yields went up respectively by 5.9, 2.5, 0.7 and -0.4 bps. Moves were sentiment (positioning?) driven.
  • US Equities  rose on Friday as investors ignored additional restrictions on bank lending in China and focused on strong economic data from the US. This morning, Asian shares trade in positive territory led by China. 
  • European officials are considering measures to overhaul the euro zone’s €440 billion rescue fund, including using it to buy bonds of distressed governments, the FT reports on its website. 
  • European Union leaders are expected to agree to insert two sentences into the EU treaty to pave the way for the creation on the European Stability Mechanism from 2013, draft conclusions of the summit showed. 
  • On Friday, China’s central bank decided to raise lenders’ required reserves by 50 basis points, its sixth official increase this year. Chinese leaders gave yesterday greater prominence to the fight against inflation at the end of the Central Economic Work Conference. 
  • Bank’s total exposure to Ireland and the southern rim of the euro zone in the second quarter was greater than previously thought, according to data from the Bank for International Settlements. 
  • Crude oil prices ($ 88.28)  are steady to slightly higher this morning after the OPEC met over the weekend and agreed to keep crude output levels flat. 
  • Asking prices for homes in England and Wales have fallen 3.0% over the past month to stand just 0.4% higher than a year ago, due to economic uncertainty and low mortgage approvals, property website Rightmove said. 
On Friday, global bonds, at least US ones, couldn’t confirm the consolidation that seemed to have started on Thursday after a huge sell-off in the previous sessions.  Indeed, in the US, the Treasuries selling resumed when US traders got involved. Especially the belly of the curve was hard hit with yields up by about 11
bps. The wings did better though with the 2-year yield up 1.5 and 30-year yield up 3 bps, the latter profiting from a strong bond auction on Thursday eve. The US data, surprisingly strong trade figures and improving consumer confidence, suggest that Q4 GDP might be a lot stronger than most observers had counted on. 

However, it is far from sure that the data were the big driver, as the selling occurred mostly in late session.  The absence of a pre-weekend profit taking on short positions and higher equities were enough to convince some traders to throw in the towel, pushing prices substantially lower in very thin trading through. The rout continues this morning in Asia with the March Note future setting new (recent) lows and the 10-year yield testing the key 3.37% level.  

In EMU, the German bonds held up better. The market opened stronger in a delayed reaction to strong US bond auction on Thursday eve and the concomitant strong run of Treasuries. However, the Bund rapidly gave back the gains and traded sideways in a very narrow range until the official close. The markets barely reacted 
to the Chinese increase of the bank’s reserve requirement by 50 bps. There was some spread widening in the peripheral markets, but it hadn’t much impact on German bonds and there were no important data released either to drive the moves. In European after-trade, the Bund did lose some, albeit modest, ground after Treasuries tanked.  There was again a noticeable underperformance of the short end of the curve, but it occurred at the very end of trading, making us think that it was due to repositioning, more than to any particular event. In the end, German yield curve was nicely flatter with 2-, 5-, 10- and 30-year yields up by 5.9, 2.5, 0.7 and -0.4 bps. Also here, the trading occurred in low volumes. The weakness in the US Treasuries suggests German bonds will open considerable lower this morning.  

In the periphery, yield spreads versus the German bonds increased. German/Portuguese yield spread by 16 bps, German/Irish by 10 bps and German/Spanish by 11 bps. The rumours are that the spreads are drifting further away because the ECB has lowered the amounts of peripheral bonds it is buying (in very thin markets) via its bond buying programme. On Friday, the IMF announced that it has postponed its decision on approving a €22.5B aid tranche to Ireland to Thursday. 

The decision came after PM Cowen announced that he will seek approval for the EU/IMF bailout package in parliament on Wednesday, something he previously said was not obliged. This vote is probably just a formality driven by political reasons; this way PM Cowen puts the main opposition  parties under pressure ahead of the national elections early next year. The  Irish banks dependency on ECB funding increased to €136B in  November from €130B in October. Portuguese PM Socrates reassured that the country would not need a bailout and that the current crisis is not country specific: “We don’t have any problem that requires that we turn to the IMF.” “Our problem is just a budget problem that has to be corrected, as in other countries. 

Whoever doesn’t understand that what we are seeing is a systemic question, regarding the euro, hasn’t understood anything about the crisis.” The economic calendar remains thin today, but will heat up during the remainder of the week with the industrial production,  inflation data and (regional) business confidence indicators in both the US and euro zone, together with retail sales and housing starts/ permits in the US. But much attention will also go out to the EU Summit (Thursday/Friday) and last Fed meeting of the year (Tuesday). Regarding auctions, issuances are limited to Spain (and UK) and Central Bank appearances only include to ECB Ordonez (today) and Fed Lockhart on Atlanta regional economy (Wednesday).  

In September, the euro zone  industrial production data brought a major disappointment, falling by  0.8% M/M, while the consensus  was looking for a slight increase. For October, the consensus is looking for a major rebound (1.5% M/M) on the back of strong data from Germany (2.9% M/M). We believe however that the risks might be on the downside of expectations as French and Italian data surprised on the downside of expectations last Friday. Also in the US, industrial production is expected to have picked up in November, although more slowly, after weakness in the previous two months. The timelier, and very relevant, euro zone PMI’s are forecasted to show a marginal decline in December after an upward surprise in November (led by Germany). In the US, the NY and Philly Fed indices are forecasted to move in opposite directions. After a crash  in November, the NY Fed index is forecasted to improve, while the Philly Fed index will probably fall back after its impressive surge last month. 

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 increase from 1.1% Y/Y to 1.2% Y/Y, confirming that inflationary pressures remain muted, but also that deflation fears are overdone. In the US however, consumer inflation is expected to fall back to 1.1% Y/Y in November, while the core reading is expected to stay unchanged at  the lowest level since core inflation data started to be published in 1958, keeping the fears for deflation alive. Finally US retail sales are forecasted to remain strong in November as Christmas shopping took off strong, according to the first data. 

This week, only the Spanish treasury taps the market, but it will get a lot attention, as Spain is considered a potential problem in the peripheral bond markets. On Thursday, it will auction the 10-year Bono (4.85% Oct2020) and the 15-year Bono (4.65% Jul2025). The auction will be supported by €7B Italian bond redemption. On Friday, 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.”

The FOMC meeting on Tuesday shouldn’t bring fireworks. Indeed, traditionally the Fed is reluctant to change its policy in December, as surprises may unsettle markets that are very thin ahead of New Year. So, the Fed took far-reaching measures during its November 3 meeting, when it decided to start a €600B Treasury Securities purchase programme. There was a lot of debate about the programme and a number of 
governors have openly criticized it. Even Washington-based governor Warsh, who voted in favour of the measures openly, doubted it would be beneficial. Afterwards, Fed governors said that the programme could be reviewed and if needed recalibrated or even stopped. Economic data had become better  following the decision, but the December payrolls report was again  a big disappointment. However, it is highly unlikely that after one month, the Fed would already re-adjust the programme, especially not as Bernanke one week ago said he didn’t exclude an increase of the amount of purchases. Doing otherwise  would be a mockery, as monetary policy works with a considerable time-lag. We also don’t expect major changes to the economic or inflation outlook either.  

The EU Summit of the Heads  of State at the end of the week 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?    

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 is however again put under test at the opening. For today, sentiment and technicals will be in the driver’s seat, as the calendar is nearly empty. 

Regarding the technicals, we should look to some important support levels of 119-02+ (62% retracement) for the March Note future (3.37% for US 10-year yield) and 124.21 (reaction low) for the Bund (3% for the 10-year). Later on this week, attention turns to some major eco releases and the EU Summit (more than to the FOMC meeting). 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.