US Treasuries sell off

Markets: Fixed Income
On Thursday, global bonds lost further ground, as equities extended their rebound on a further drop in the oil price and better than expected earnings from JPMorgan. In contrast to the previous day, the US yield curve didn’t steepen, but flattened, as the reversal of recent safe haven flows weighs mainly on the short end of the curve. The US data contributed to the downward correction on the bond markets, as both the housing starts and building permits and the jobless claims came out better than expected. The slightly weaker Philly Fed couldn’t change the course of events. In the euro zone, European bonds tracked the down-move in US Treasuries, as the calendar was devoid of data. The French and Spanish auctions nevertheless indicate that the demand from real money accounts remains lacklustre. In a daily perspective, yields rose between 7.8 and 2.2 bps in the US and between 5.6 and 2.5 bps in the euro zone. After closing, US Treasuries rebounded a bit following very disappointing earnings of Merill Lynch, which risks to spoil investor’s appetite for financial stocks again.

US Treasuries sell off for the second consecutive session
The eco calendar is completely empty today, a rare event, but the earnings of Citigroup will keep traders and analysts busy.

Overnight, the 75 Bn. $ TSLF auction went well. The bid/cover of 0.69 is in line with previous auctions. The stop occurred at the minimum of 25 basis points. The auction continues to show that the enhanced liquidity provision of the Fed is enough to keep the system well funded.

Regarding trading, yesterday, Treasuries sold off for the second consecutive on a similar set of conditions that were at work on Wednesday. Equities did well, at first due to encouraging results at JPMorgen, later on due to plunging oil prices. That drove Treasuries lower throughout the session. Eco data, claims & housing starts, were stronger than expected, (although this should be qualified cf. news section), having an additional, albeit small, negative impact on Treasuries. Interestingly, this time the curve bear flattened while on Wednesday it bear steepened. The flattening looks a little bit more usual to us, as the reversal of safe haven flows at the origin of the sell-off.

For today, the calendar doesn’t give us guidance, but it seems that equities might be in for some profit taking. Earnings results published after US closure disappointed and the up-coming Citigroup results might be a high hurdle too. So following two days of juicy equity gains, we suspect short term traders are eager to book some profits ahead of the week-end. The sell-off of oil may also need to be consolidated. That means that Treasuries could have a better session. However, the recent sell-off has made the technical pictures again neutral and ST there are the risks of bearish double bottom configurations in yields. All in all though, we count on some sideways trading in the days ahead.

European bonds fall, but technical picture undamaged
Today, the euro zone calendar remains thin and only contains the euro zone trade balance, which isn’t a market mover. In contrast to the US and the UK, the euro zone trade balance doesn’t have a large deficit, which should protect the euro zone economy from painful adjustments. That’s also one of the reasons why the ECB calls the economic fundamentals of the euro zone sound, despite the current weakening economic environment.

On the ECB front, yesterday ECB’s Wellink sounded rather downbeat on the economic outlook, but warned that this shouldn’t provide much relief on the inflation front, as ‘we shouldn’t take it for granted that ‘inflation will fall if the economy weakens’. He therefore referred to the 70s and warned that ‘if you don’t act against inflation, you get high inflation and low growth, stagflation’. This was also reflected in yesterday’s update of the IMF projections. Although the IMF still expects the euro zone economy to slow sharply from an upwardly revised 1.7% Y/Y this year to a very low 1.2% Y/Y next year, the inflation estimate for the advanced economies was sharply revised up from 1.5% to 2.3% Y/Y, albeit from a still higher and upwardly revised 3.4% Y/Y this year. As such, Wellink’s comments and the IMF forecasts contain a clear warning that a growth slowdown won’t be sufficient to bring rate cuts on the table, even though the current ECB staff growth projections of 1.8% for this year and 1.5% next year may prove too optimistic. More evidence that inflationary pressures are abating is needed.

Today, ECB’s Draghi will speak on ‘monetary policy expectations and financial markets’. He’s the first to speak following yesterday’s non-monetary policy meeting and therefore his comments may be monitored more closely to see whether there is any shift in tone. Last week, ECB’s Draghi was one of the first ECB governors to emphasize the slight fall in financial inflation expectations suggesting that the July rate hike was having its effect. In recent days, financial inflation expectations have fallen further in the slipstream of the drop in the oil price. Since the peak at around 280 bps at the beginning of July, inflation expectations have fallen to below 260 bps currently. So it will be interesting to see whether Draghi takes some further comfort out of this move.

Regarding trading, European bonds lost further ground yesterday, as the rebound on the equity markets continued. The technical picture of the Bund wasn’t however damaged, as the Bund remained above the neckline of the potential double top formation at 112.54 and above the previous daily downtrend channel. As such, we hold on to our more neutral view. Although oil and equity markets may continue to drive bond markets, the recent technical improvement may signal that the focus of the market has shifted a bit away from the inflation theme towards the increasingly gloomy outlook for the euro zone economy. Recent weak demand for the auctions nevertheless indicates that no strong rally should be expected.

Compared to German government bonds, the underperformance of Spanish and Belgian bonds continued. Yesterday, Belgian King Albert II rejected the resignation of Prime Minister Leterme and appointed three French-speaking negotiators to facilitate the institutional dialogue between the regions. This doesn’t however mean that the political crisis is over, but buys some time to ease the tensions. The OLO auction on July 28th will be an important test to check investor’s appetite for Belgian bonds in the current political turmoil. Until then, no change in sentiment towards Belgian bonds should be expected.

In the UK, BoE’s Gieve will speak at the London Stock Exchange. We don’t expect him to break new ground.

Currencies: dollar picture not unequivocal
On Thursday, EUR/USD showed some sharp intraday swings and the pair was influenced by many different factors, making the global picture far from cleared out. Early in the session the FT headlines on sovereign wealth funds looking to reduce their dollar exposure might have played a (minor) role and could be used as an excuse to block the rebound of the US currency. EUR/USD gradually rose to test of offers in the 1.5890 area around noon in Europe. Better than expected results of JP Morgan and US data (mostly due to special factors) temporary helped the dollar. EUR/USD returned to the 1.5820 area early in US trading, but again the US currency could not hold on to its gains, until another sharp decline in the oil price triggered a new wave of USD buying. EUR/USD even temporary dropped below the 1.58 area. However, again the move could not be sustained as after the close of the official trading on the US stock markets some US bellwethers reported weaker than expected results. In particular the disappointing Merrill Lynch results brought the theme of the credit crisis back to the forefront. EUR/USD closed the session at 1.5863; compared to 1.5826 on Wednesday. So, while influenced by conflicting factors, even the sharp drop in oil prices was not enough to give the dollar strong support, at least not against the single currency. This is slightly disappointing from a dollar point of view.

Today, the US calendar is empty and in Europe only some second tier releases are on the agenda. So, the focus for EUR/USD trading will go the US earnings and in particular to the earnings of the big financials (Citigroup) and to oil.

Earlier this week, EUR/USD seriously tested the top of the MT term sideways trading range. The EUR/USD 1.6020 level was temporary broken as the flaring up of credit concerns (GSE’s) put the dollar again under pressure. However, the dollar was saved by the bell as credit headlines turned somewhat less negative and as the dollar finally received some help from a rather sharp correction in the oil price. For now, it is not yet clear whether the credit storm is over its top and whether lower oil prices will be enough a reason to help the dollar building a solid bottom. Longer-term, we continue to think that both the Fed and the ECB face a similar problem of too high inflation and low/slowing growth and have little room of maneuver to fix this difficult situation. In this hypothesis there is no need for EUR/USD to start another up-leg beyond the key 1.6020/40 area. However, resurfacing credit headlines remain a shortterm risk for the US currency.

Earlier this week, we argued that EUR/USD had to move away from the EUR/USD 1.60 area soon and in a convincing way to avoid an additional USD stop-loss selling move. The risk is not completely out of the way yet with EUR/USD still less than 200 ticks from the highs, but the dollar has again some breathing space. Regarding the day-to-day tactics, we hold on to approach that courageous dollar optimists may to try to sell EUR/USD on up-ticks hoping that the range holds. Stop-loss protection (e.g. in the 1.6050 area) is still warranted.

Contrary to USD/EUR, USD/JPY delivered a much better performance. Constructive stock market sentiment, the (temporary?) easing of credit concerns and, at the end of the session, another down-leg in the oil price helped the dollar the stage quite a powerful rebound. An aggressive short-covering move in EUR/JPY, through the crosses probably also supported the rebound in USD/JPY. The pair closed the session 106.27, compared to 105.14 on Wednesday.

This morning, USD/JPY trades slightly lower as Asian stock markets fail to build on the strong close in the US yesterday evening. The minutes of the previous policy meeting show that the BOJ continues to hold a balanced approach as the risks to growth are seen to the downside and while at the same time the risk is that inflation will accelerate.

Looking at the charts, the turmoil on global markets caused USD/JPY (and EUR/JPY) to temporary drop below first important support levels. (USD/JPY 104.99; EUR/JPY 166.09), but yesterday’s rebound completely reversed the attempt to move lower. USD/JPY is now again in the previous sideways trading range (cf graph). Oil, (the easing of?) credit concerns and the global stock market performance remain the key drivers for this pair. A less bright stock market sentiment might make further gains in this pair difficult today. We are neutral for USD/JPY. Recently, the 200-day moving average (today at 107.14 proved to be a strong resistance).

On Thursday, there was absolutely nothing to say on EUR/GBP trading. There ware no important UK or European data on the agenda. The pair kept a tight sideways trading range between 0.7910 and 0.7935 with the pair looking to big brother EUR/USD for intraday guidance, closing the session at 0.7915, compared to 0.7917 on Wednesday.

Overnight, there were news headlines that Chancellor of the Exchequer Darling is preparing the next set of rules on government spending. Market speculation that this could lead to higher borrowing and spending weighed on the sterling overnight with EUR/GBP trading at around 0.7940 at the moment of writing.

Today, the UK calendar contains the Public Finance data and the Money supply and sterling lending figures, while BOE’s Gieve speaks. We don’t expect him bring new insights to the market.

Since mid April, EUR/GBP developed a very uninspiring consolidation pattern (0.7766/0.8098). We turned neutral as the pair shows no trading momentum at all. An attempt to move higher early this month again ran into resistance and also at the end of last week and early this week a test of the key 0.8033/34 area was rejected. EUR/GBP is now again in the middle of the long-standing trading pattern. So, the short-term alert on sterling is again called off. In a longer term perspective we hold on to our sterling skeptic attitude.