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Today, all attention will go to the June US payrolls report
Markets: Fixed Income
On Thursday, global core bonds started the session on a weaker footing, but later on weakness in various US economic reports supported bonds, the safe haven in times of risk aversion. However, bonds have risen outstandingly in recent weeks and are at very expensive levels and the rally is showing signs of fatigue. Therefore, selling re-appeared when US equities struggled back higher during the US session. Technical factors and the upcoming payrolls reports certainly impacted trading. The S&P tested extensively the downside (see graph), pushing bonds to new intra-day highs, but equity investors were cautious ahead of the payrolls release and thus took a more neutral position, allowing the equities to limit the daily losses. Similarly, bond investors didn’t want to push long positioning to the extreme and sold the market when equities turned. So, at the end of the day, despite weak eco data, US yields were, albeit it marginally, higher. The 2- and 5-year yields were up 2.5- to-3 bps, while further out increases were minimal.
In the intra-EMU market, there was initially some selling of peripherals on the back of Moody’s decision to put Spain’s AAA on review for downgrade, but the decision was fast digested and damage limited. The surprisingly low demand at the ECB 3-month LTRO auction on Tuesday have eased fears about the funding stress and the 6-day fine tuning liquidity operation did nothing to turn the sentiment again in a more negative way, on the contrary. Rumours that all German banks would have passed the stress tests got a lot of attentions, while Spanish able to sell €3.5B of 5- year bonds was in such a context embraced as a positive too. So, looking through the intra-day wiggles, spreads to German bonds were narrower, a little bit at the 10-year sector, but not surprisingly more at the 2-year sector (where easing liquidity concerns are a more important factor). Interestingly, the flattening continued in the German market, due to successful liquidity operations and easing fears on the financial sector, as the 2-year yield was up 7.7 bps, the 5-year 1.7 bps higher, but 10 and 30-year yields were actually down 1.1 and 3.3 bps.
Today, all attention will go to the June US payrolls report. The EMU eco data, unemployment and PPI, are uneventful for markets and so is the other US eco release, the factory orders. The market reaction might be very dense, as the bond market will be closed on Monday in observance of the July 4 market holiday. Many trading desks will be sparsely staffed.
In May, the payrolls report was a big disappointment for markets as private payrolls (41K) fell back sharply after a decent April-rise (218K). Last month, also the claims continued to trend somewhat higher, which have raised concerns by the government and also the Federal Reserve, but which might also have been due to workers falling off the census payrolls. If the (private) payrolls would again be weaker than expected, markets will take it as a serious sign that the labour market is cooling again after some improvement since the start of the year. It would also question the outlook for the overall economy, as strong payrolls are needed to support household income and thus consumption spending, at a time the impact of the government support starts to weaken. Yesterday’s ISM, claims, pending home sales and car sales showed signs of weakening activity in all main sectors of the economy. The consensus is looking for a decline in the overall payrolls by 125 000, but weakness is mostly due to the Census 2010 workers being discharged (+/- 230K). Therefore, more important is the private payrolls reading, which is forecasted to show an increase by 110 000 in June (from 41K in May). This figure is slightly below the three-month average (139 000). The ADP report published on Wednesday was quite weak (+13K private jobs) and also claims and ISM employment, all suggest the risks might be on the downside of expectations. However, on the other hand, there are suspicions that the May weakness in private payrolls was due to the census workers hired (partially from private sector), an effect that might have been partially reversed in June. So, concluding, the payrolls may surprise on either side of consensus. As a rule of thumb, to have a decent reaction, the actual figure should be about 50 000 off consensus, with the secondary details of the report giving colour to the reaction on the headline.
Given the pessimism in the past two weeks, we think that the US equity market may have the inclination to react asymmetrically to the payrolls report, rebounding stronger in case payrolls exceed consensus than dropping in case the outcome is weaker than expected. In case of an outcome in line with expectations, that may already be enough to keep equity indices above major support levels. or even about as expected.
However, given the proximity of the key support area (1029/1040) for the S&P (under test), a further decline of the S&P should not be ignored, as technical selling might kick in. It would also technically (head and shoulder) suggest the start of a downtrend. Next support levels are situated at 1007 (38% retracement), 957/938 (1 and 2 target H&S) and the very major 943 (neckline previous inverted H&S that signalled the end of the sharp crash of 2008/09).
Regarding US Treasuries, a stronger payrolls outcome would definitely be negative. Indeed, US Treasury had a terrible strong run of late and 10-year yields (now 2.94%) dropped a stunning 105 bps since its peak in early April, and was only lower once in the last 50 years, notably in the November 2008/April 2009 period. The 2-year yield even set an all-time low this week at 0.58%. Very recent price action showed that Treasuries had difficulties to sustain the rally, even in case of Tfriendly developments. There are signs of fatigue and many investors are ready to book profits. So, Treasuries looks vulnerable in all scenarios, but a very dark one (risk on deflation/depression). Also, we are a bit surprised that the sharp decline of the dollar yesterday, hadn’t a negative impact on Treasuries. Is this sustainable? Therefore, we would consider a tactical short position in Treasuries.
Also the German bonds look vulnerable to profit taking, but less than the US Treasuries that outperformed German bonds sharply. The 10-year yield spread halved in less than 1 month to 36 bps. The Bund has probably entered a sideways trading range between 129.93 (contract high) and 127.58/12.
As we are close to the highs, investors might contemplate profit taking on longs. Outright shorts are not advised for investors with a medium term perspective, as the technical picture is after all bullish and fundamentals are also bond positive, even if the price is at very lofty levels.
The ECB allotted €111.2B at its 6-fay fine-turning operation (fixed rate of 1%). 78 banks participated. IF we take into account also yesterday’s LTRO (€132B) and Tuesday’s regular weekly MRO (€162B), a total of 405B in liquidity was allotted, while €593B matured (€442B in 1-year and €151B in weekly MRO) or an absorption of about €190B. As yesterday, €309B of liquidity was parked at the ECB deposit facility, the excess liquidity might still be around €120B. Taking all the operations into account, we deduct that there was less funding stress in the system than previously thought. The ECB might see this as a success and thus plan to pursue the exit strategy, without however putting into question the partial reversal of this exit policy. Indeed, the ECB will hold still FR/FA 3 month auctions at the end of July, August and September effectively giving banks guarantee on unlimited liquidity till the end of the year. However, markets may anticipate that the ECB could withdraw liquidity early 2011. This should already now affect the longer end of the money market.
There is another, less positive interpretation of the tender results. If the lower bidding is due to the change in duration of the funds (3 month instead of 12months), then one shouldn’t draw too many conclusions from the tender results for the health of the system. Indeed, the “healthy” banks may have bid massively last June because the 1-year liquidity gave them a nice investment opportunity (buying T-bills or shorter-dated bonds of peripherals for the nice yield pick-up) and that opportunity may not be available anymore today (3 month money and lack of appetite for peripherals). In that case. The lower bidding wouldn’t be a sign of reduced stress and the ability of the ECB to exit its emergency liquidity policy might still be put into question. We might more clues from the bidding behaviour in the next weeks.
Published on Fri, Jul 2 2010, 07:43 GMT