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Markets: Fixed Income

On Monday, global bonds extended their recent rebound, as investors booked profit on the three-month rally in the equity and commodity markets. The larger than expected deterioration in the NY Empire State Manufacturing Survey and a gloomy ECB Financial Stability Report contributed to rising fears that markets may have run too far ahead of themselves and caused an increase in risk aversion. This drove investors again towards the safety of government bonds. As such, US and German 10-year yields fell further from their recent highs, which resulted in a bull flattening of the yield curves.

In the US, 2-year yields fell by 4 basis points compared to 8.3 basis points in 30-year yields. In the euro zone, German 2-year yields fell by 6.4 basis points and 10-year yields by 11.2 basis points, but 30-year yields declined by only 5.9 basis points. The deterioration in market sentiment was also reflected in a slight widening of the intra- EMU sovereign spreads.

ECB Financial Stability Review highlights banking risks

Today, the calendar heats up both in the euro zone and in the US. In the euro zone, the final figure of May CPI and German ZEW index (June) are scheduled for release. According to the first estimate, euro zone CPI came out flat on a yearly basis, well below the consensus estimate of 0.2% Y/Y. The final figure is forecasted to confirm this outcome, but the risks might be on the upside of expectations after the upward revision in German CPI. Core CPI is expected to drop to 1.6% Y/Y after rising from 1.4% Y/Y to 1.8% Y/Y in April. The German ZEW index is forecasted to extend its impressive rally in June. The consensus expects an outcome of 35.0 (from 31.1), but more interesting might be the development in the current situation index, which is forecasted to show a slight uptick after dropping to a new cyclical low last month (from -92.8 to -92.6). In the US, the housing starts and permits (May), industrial production (May) and PPI data (May) are on the agenda. In April, both housing starts and permits disappointed, dropping to a new record low. For May however, the consensus is looking for an improvement in both indicators with housing starts rising from 458 000 to 485 000 and building permits increasing from 498 000 to 509 000. We have no reasons to distance ourselves from the consensus. US industrial production is expected to show its seventh consecutive contraction in May. The consensus is looking for a decline by 1.0% M/M with a large negative contribution coming from the auto industry due to automotive production cutbacks by Chrysler and GM. Producer prices are forecasted to have risen by 0.6% M/M in May, mainly driven by higher energy prices. On a yearly basis, PPI is forecasted to come out at -4.4% Y/Y (from -3.7% Y/Y).

On the supply front, Ireland will tap the market today via the sale of two different bonds in the 3- and 7-year segment for a total amount of between €0.75-1B. Yesterday, Austria announced its plans to issue a new 15-year benchmark via syndication this week (€2-3B). Price guidance has been set at 70 basis points above mid-swap. This premium should ensure a successful sale of the new benchmark, even though the peripheral bonds may underperform German debt again now that general market sentiment is turning more negative. This may drive intra-EMU sovereign spreads wider again.

There are also some central bankers scheduled to speak both in the US and the euro zone. Yesterday, the Cypriot governing council member Orphanides summarized the current situation as follows: ‘Some vaguely positive signs, which come from developments in financial markets and some sentiment indicators, have appeared, indicating that the rate of the worsening of the global and European economies is slowing. For the moment, however, these signs don’t translate into a measurable improvement. Uncertainty continues to be very great’. This uncertainty was also reflected in the latest Financial Stability Review, which highlighted the risks to the financial sector and estimated the additional losses at more than $283B for this and next year. Although the amount was much less than what the IMF has forecasted, it still raises questions about the shock-absorbing capacity of the European banking system. As such, ECB vice-president Papademos urged the banking sector to take advantage of the government support schemes. Overall, the Financial Stability Review indicates that the woes in the European banking sector are far from over, which is still a necessary condition to come to a sustainable economic recovery.

Regarding trading, yesterday the correction on the bond, equity, commodity and currency markets gained further momentum, as investors concluded that markets may have run too far ahead of themselves on the economic recovery story. As such, investors decided to book profit on the equity and commodity rally and switched again to the safety of government bonds and to the dollar. From a technical point of view, the break in the Bund above a short-term double bottom formation with neckline at 119.31 suggests that the rebound may have further way to go. The obvious target of the current rebound is the 3.40% level in German 10-year yields (neckline longer-term double bottom formation).

Also in the UK, the CPI inflation data are on the calendar. In May, CPI inflation is expected to have risen by 0.3% M/M, while the annual figure is forecasted to extend its downtrend (2.0% Y/Y from 2.3% Y/Y). In the coming months however, CPI inflation is unlikely to drop as quickly as previously anticipated, due to the increase in oil prices. Core CPI is expected to stay unchanged at 1.5% Y/Y in May.

On the supply front, the DMO is expected to issue its new 25-benchmark via syndication. It will be the first Gilt, since the 50-year benchmark issued in 2005, that will use syndication reflecting the difficulties the DMO is facing to sell the record amount of Gilts this year. The issue is expected to be £5B in size, carry a 4.5% coupon and mature in September 2034.