Friday, March 26, 2010 - Friday, April 2, 2010
- US yields surge higher and the USD follows
- Treasury auctions ominous for rates but constructive for USD/JPY
- What happens next in EMU could depend on the next Greek bond sale
- UK fundamentals remain sour
- Key data and events to watch next week
(N. B.: This weekend, the UK will shift to British Summer Time (BST), which will move clocks in the UK one hour ahead of GMT. The difference between NY time and London will return to 5 hours.)
US yields surge higher and the USD follows
EU efforts to reach an accord on Greece captivated the market's attention for most of the week (more below), but the real mover was a sharp rise in US rates and a further steepening of the yield curve. Those moves sent the US 10-year credit swap spread into negative territory for the first time ever and triggered a position-driven sell-off in US Treasuries, sending yields higher. Treasury dumping increased after the pricey US Treasury auctions in subsequent days (see below), and 10-year US Treasury yields finished the week about +16 bps higher for the week, but lower from the +23 bp peak. The rise in US rates sent the USD sharply higher, aggravated by EUR weakness on Greek bailout concerns and breaks of key technical levels. USD/JPY experienced the largest move higher in line with its typical correlation with US rates. The directional move in US rates is not surprising, but the timing was, as the drop in credit swap spreads occurred before any of the US auctions, suggesting positioning played a key role.
To see whether the USD gains of the past week are sustainable, it helps to understand the reasons behind the run-up in US Treasury rates, as some are likely temporary while others are more durable. Among the temporary factors are potential Japanese asset managers' selling of US bonds for financial year-end accounting purposes. As they dispose of US bonds, they also buy back USD/JPY, which they originally sold to hedge their USD bond exposure. Those flows may be temporary and reverse after the March 31 financial year end. More interesting, Japanese financial media reported this past week that some Japanese insurance firms, massive bond investors, are considering moving to unhedged foreign bond portfolios. That would remove a significant source of JPY buying and lift the lid on all the JPY-crosses, but especially USD/JPY. Keep an eye out for more on this subject. Another likely temporary source of higher rates is concern that China may be stepping back from US Treasuries to express political dismay over US haranguing. This is likely temporary as China will ultimately need to return to US debt as a repository for its ever-accumulating trade surpluses. Of the potentially more durable sources of higher US rates are increasing expectations that the US recovery will continue to pick up steam. Consensus economist forecasts are for next week's US March jobs report to show a nearly +200 NFP increase, potentially rejuvenating consumer sentiment in the process. Lastly, the US Fed will be completing its purchases of MBS and agency debt at the end of this month and seems unlikely to extend the program looking ahead, removing a source of support for prices and allowing yields to move higher. On the whole, we would look for US rates to sustain the gains seen this past week, but we'll be watching closely for any relapse as we move into the month of April.
From the technical perspective, the USD breakout looks less compelling at the end of the week than it did in the middle of the week. EUR/USD is going out just a few pips below the key breakdown level of 1.3430, after having bounced from just above our expected target of 1.3200/50. The Greek bailout accord may give the EUR some breathing room (it bounced strongly on most of its crosses on Friday), but we would look to re-sell EUR/USD ahead of the bottom of the weekly cloud at 1.3587. Cable is closing at 1.4900 and failed to take out recent lows below 1.4800, potentially setting up a double bottom. There, too, we would prefer to be sellers on a further correction into the 1.5050/5100 area. USD/JPY has also run into a potential short-term top, with reported exporter offers surrounding 93.00, so we would favor buying a pullback to the 200-day mov. avg. at 91.51. Gold has similarly rebounded and is essentially finishing out the week unchanged from the prior week, when it tested the upside and failed. Here we'll be watching a break above the Kijun line at 1115.13 as a trigger to higher gold, and a drop below 1095 cloud base to signal lower. Even 10-year US Treasury yields have put in a less than convincing break, closing out the week right on the range highs of 3.85%. Next week will see month/quarter end with the attendant one-off flows, which may provide opportunities to see some of the levels outlined above.
Lastly, we would be remiss not to mention the sinking of a S. Korean naval vessel on Friday near the disputed maritime border between the North and South. Tensions in Korea typically work most against the JPY, given its proximity and history, but the USD may also come under pressure if the US is seen as likely to be dragged in to any conflict there. Gold looks to have found a bid on the potential for any escalation, and CHF could be expected to do better if events heat up, possibly suggesting a long CHF/JPY position. While we think this may end up without any further escalation, we can't rule out a further military response if N. Korea is found to have attacked. The problem here is that no one knows how N. Korea would respond to a S. Korean reprisal should one occur.
Treasury auctions ominous for rates but constructive for USD/JPY
The three Treasury auctions this week could only be described as sloppy. The trend in demand is worrisome especially as we approach mid-April, when the US Treasury could potentially label China a currency manipulator. We think this could mark a turning point for yields and this could open the door for considerable USD/JPY upside on the follow.
The big splash for yields came with the US 5-year and 7-year auction results. Demand looked relatively steady and the bid/cover metrics (the amount demanded compared to the amount on offer) were not significantly below recent trends. The ominous piece of news was in what happened with the yields. In both cases, the auction participants demanded a yield that was 4-5 basis points above where the market was trading at the time. This is the so-called market tail and in this case suggests investors are increasingly demanding a higher rate of return for each unit of risk in US government paper. The second week of April brings another three major auctions (with the 10-year as the highlight) that will be closely watched.
That month could be extremely significant for the US rates environment as the Treasury department is expected to release a report (sometime mid-month) in which they are likely to label China a currency manipulator. The move is widely viewed as symbolic in nature and part of the populist posturing ahead of the November Congressional elections. However, the attempt to earn some cheap political points could have serious ramifications. One must not forget that China is the major holder of US Treasury securities - clocking in at nearly $900 billion currently. The country does not necessarily have to sell massive amounts of that paper to elicit a run-up in US yields. They merely have to limit their participation in the auction process. This is something that is already suspected to be afoot following the poor auctions this week.
In terms of the implications for the currency market, we look to the extremely robust correlation between US 10-year yields and USD/JPY for guidance. Since the beginning of 2010, these two securities have moved in tandem about 87% of the time. Weak auctions coupled with a ramp-up in the Chinese currency rhetoric should see the 10-year head towards the 4.0% area in the short-term. Using the 2010 relationship as a guide suggests this level of rates would coincide with a USD/JPY trading closer to the 95/96 realm.
What happens next in EMU could depend on the next Greek bond sale
The EU has finally agreed that an EMU member country in serious fiscal difficulties will be able to receive bi-lateral assistance from its Eurozone partners as well as draw support from the IMF. Following weeks of discord, it had become politically important that there be a show of unity on how to deal with fiscally errant members. In this sense the announcement of an agreement was an important step in the right direction. The proof of the pudding is in the eating, however. Greece still has to sell a significant amount of debt in the open market this spring and the EU will be hoping that Greece, never mind Portugal or Spain, will not have to tap its EMU partners for a loan.
Greek bond spreads tightened in response to news of the support mechanism, though the initial move in the longer end of the curve was half-hearted with the 10 yr still yielding over 300 bps over bunds. Similarly while the EUR performed well after the announcement, EUR/USD has only retraced a small part of its recent falls. The Greek debt office will almost certainly have to announce another bond sale in the coming weeks. Not only will this sale be a crucial test for Greece but it will set the scene as to what happens next in the EMU. A poor response to the sale will raise the likelihood that Greece will be forced to ask for financial assistance and Germany, despite recent protests, is likely to be the biggest contributor under the new support plan. Poor results in the next Greek bond sale would also increase the risk of contagion to Portugal and this could intensify the pressures on the new support mechanism, on EMU and on the EUR.
UK fundamentals remain sour
There may have been no strong sell off in the pound after the UK budget but cable continued to churn lower during the week. In part this is a function of the generally strong USD. That said there is little hope that the dark economic clouds that are hanging over the UK economy are likely to disperse soon. The Chancellor was quick to point out during the budget presentation that recent data releases had brought confirmation of declines in unemployment and better than expected public sector borrowing figures. This may be true, but it is also true that employment is at its lowest levels since November 1996 and the borrowing requirement is more or less twice as high as at the same time last year. The Q4 UK GDP revision is expected to confirm that the economy grew an apparently relatively healthy 0.3% q/q. Once again the headlines are likely to disguise the grim truth that if it wasn't for a surge in government spending last year, the economy would almost certainly have registered further contraction right up to the end of last year. Given that opinion polls continue to point to the likelihood of a hung parliament after the general election, the market is likely to continue to worry about the combination of slow grow and a massive budget deficit suggesting that cable could continue to press lower.
Key data and events to watch next week
The economic calendar is busy in the United States in the week ahead. Personal income/spending and the core PCE price index (the Fed's favorite inflation gauge) kick things off on Monday while Tuesday brings the Case-Shiller home price index and consumer confidence. Wednesday has the ADP employment report, Chicago PMI and factory orders lined up. Thursday brings initial jobless claims, ISM manufacturing, construction spending and vehicle sales while Friday rounds out the week with the all-important nonfarm payrolls report.
It is an important week in the Eurozone as well. Monday has the business climate indicator, consumer confidence and German consumer prices. French gross domestic product highlights Tuesday. Wednesday sees employment and consumer prices while Thursday closes things out with PMI manufacturing and German retail sales.
The UK calendar is on the light side. Consumer credit and mortgage approvals are up on Monday while Tuesday brings the final cut of 4Q GDP. Thursday closes out the week with PMI manufacturing.
Japan kicks off the week with employment and industrial production on Monday followed by small business confidence, housing starts and the Tankan business indices on Tuesday. Motor vehicle sales round things out on Thursday.
Canada sees an ultra-light week ahead with industrial product prices on Tuesday and monthly GDP on Wednesday as the only noteworthy releases.
It is not very busy down under either. Australia has retail sales on Tuesday and the trade balance on Wednesday. New Zealand sees building permits on Monday and business confidence on Tuesday.