o-forex: US T−Note breaks above first key resistance level

Markets: Fixed Income

On Wednesday, government bonds extended recent gains and moved (further) above first key resistance levels. Indeed, following the Bund, the US T-Note future trades now also above the neckline of a double bottom formation, which if sustained would improve the technical outlook. Overall, government bonds still benefited from the deterioration in risk appetite after Tuesday’s correction on the equity and commodity markets added to the feeling that the recent rally in more risky assets has gone far enough. However, looking cross markets, yesterday price action wasn’t as clear cut as Tuesday’s from the risk appetite/aversion spectre. Indeed, bonds gained as did gold and intra-EMU government spreads widened, but equities moved fairly sideways as did commodities and the euro gained (slightly) on the dollar. The Minutes of the August Fed meeting confirmed the market consensus that the current ultra- accommodative stance will be maintained for an extended period.

In a daily perspective, the US yield curve flattened, as 10- and 30-year yields fell by respectively 5.7 and 7.2 basis points compared to a decline by respectively 0.8 and 5 basis points in 2- and 5-year yields. Consequently, US 30-year yields fell slightly below the neckline of a double top formation at 4.15%, while 10-year yields are approaching a similar neckline at 3.25%. A sustained break below would materially improve the technical outlook for bonds. In the euro zone, the German yield curve steepened slightly ahead of today’s ECB meeting, where no change to the ECB’s monetary policy stance is expected. German 2-year yields declined by 2.1 basis points to their lowest levels since March last year, while 5- and 10-year yields fell by respectively 1.6 and 1.0 basis points and 30-year yields even rose by 2 basis points. The deterioration in risk appetite was also reflected in the intra-EMU sovereign spreads, which widened further to their highest level in a month.

US T-Note breaks above first key resistance level

Today, all eyes are focused on the ECB policy meeting. Despite the recent improvement of the economic outlook, we do expect the ECB governing council to maintain their ultra-accommodative monetary policy stance at today’s policy meeting. As such, no change in interest rates or non-standard monetary policy should be expected. Therefore, the economic recovery looks still too fragile, while the inflation outlook is not expected to threaten price stability. This is likely to be reflected in the new ECB staff projections for growth and inflation, which will show inflation to remain clearly below 2%, despite an upward revision of the growth outlook. Such a continuation of their ultra-accommodative policy stance will put the ECB in line with the other major central banks, which have recently also decided to maintain (Fed) or even to extend (Bank of England) their policy accommodation. During the Q&A, a lot of attention is likely to be focussed on the liquidity operations, as markets will be eager to know whether the next one-year tender at the end of September will also offer unlimited liquidity at a fixed rate of 1% or whether any surcharge will be imposed. Given the marked decline in money market rates in response to the first operation, we don’t expect any surcharge to be imposed. Another issue remains the hoarding of cash by banks, as banks are still parking huge amounts at the ECB deposit facility instead of lending it to customers. Therefore, it will be interesting to see whether Trichet is also considering any further steps to discourage banks from depositing money at the central bank. For example, in Sweden, the Riksbank has already taken an important step by cutting its deposit rate into negative territory at - 0.25%, while Bank of England’s governor King recently indicated the Bank will also consider a further cut in the interest rate they pay on bank reserves. Although we don’t expect a decision on the issue yet, comments with regard to the use of the deposit facility should be closely monitored.

Besides, the ECB meeting, the eco calendar is also attractive today with the euro zone retail sales (July), services PMI (final figure), US claims and non-manufacturing ISM (August). In June, euro zone retail sales dropped by 0.2% M/M, while a slight increase was expected. For this month, the consensus is looking for a slight increase (by 0.1% M/M). We believe that the risks might be on the upside of expectations due to the summer discounts. The final figure of euro zone services PMI is expected to confirm the first estimate which showed an increase from 45.7 to 49.5. After the upward revision in the manufacturing PMI, a higher outcome is not excluded. Last month, the US non-manufacturing ISM unexpectedly deteriorated. For August however, the consensus is looking for an increase from 46.4 to 48 and after the manufacturing ISM, we believe that the risks are still on the upside of expectations. In the week ended August 29, initial claims are expected to have dropped by 5 000 to 565 000. Continuing claims, which are reported with an extra week lag, are forecasted to have dropped by 8 000 to a total number of 6 125 000.

On the supply front, France and Spain will tap the market today. While Spain will tap two shorter-term Bono’s in the 3- and 5-year segment for an amount of €3.5-4.5B, France will tap three longer-term OAT’s in the 6-, 10- and 14-year segment for an amount of €6.5-7.5B. In the US, the Treasury will announce the amounts of next week’s longer-term auctions.

Regarding trading. Over the past two months, government bond markets have performed strongly despite the general improvement in the economic outlook. Indeed, despite the rally on the equity, commodity and credit markets, yields are still well below this year highs set at the beginning of June. The improvement in risk appetite has also led to a significant tightening in the sovereign credit spreads, which has even pushed yields of several EMU member countries to new cycle lows. This suggests that the outlook for central bank policy rates to remain low for extended period of time has succeeded in bringing also longer-term yields lower. This week’s trading however signals rising doubts about whether the recent rally on the equity, commodity and credit markets has gone far enough. A further substantial correction on these markets should continue to support the US and German government bond markets, but may at the same time also lead to a widening of the intra- EMU sovereign spreads.

Yesterday, the technical outlook for bonds further improved, after the US T-Note future moved above the neckline of a double bottom formation at 117-19. A sustained break above would materially improve the technical outlook for bonds, certainly if the break would also be confirmed in yields, where important support is seen at around 3.25% both in German and US 10-year yields.

In the UK, the calendar contains the services PMI. Services PMI is forecasted to extend its rebound in August. The consensus is looking for a figure of 54.0, but the risks might be on the downside of expectations after the deterioration in the manufacturing PMI. On the supply front, the DMO will tap its 30-year Gilt 4.25% 2039 for an amount of £2.25B.