Markets: Fixed Income

On Wednesday, US equities declined on rising concerns about the future of GM and increasing fears that the sharp rise in longer-term US yields would choke the economic recovery hopes. GM shares fell sharply, as the carmaker moved ever closer towards bankruptcy filing following a failed debt exchange. Most attention however went out to the Treasury market, where, despite a strong 5-year Note auction, the sell-off continued. The sell-off was mainly due to mortgage related selling, as the recent sharp rise in Treasury yields forces ever more investors to sell Treasuries they had bought as hedges against the risk homeowners would refinance mortgages at lower rates. The refinancing of mortgages may however slow sharply due to the sharp rise in yields, which may in turn hurt any recovery of the housing market.

In response, there was a sharp bear steepening of the US yield, as technical selling accelerated the rise in US longer-term yields. US 5-, 10- and 30-year yields rose respectively by 13.3, 19.1 and 14.1 basis points compared to a rise of 6.2 basis points in 2-year yields. As a result, the 2/10 year yield spread hit a new all-time high at 276 basis points. The swap spread also widened dramatically.

In the euro zone, the sell-off on the US Treasury is reflected in the sharply lower opening of the European bond market this morning. Yesterday’s German, Italian and Portuguese auctions were however well received.

German 10-year yields test key longer-term resistance

Today, the calendar is well-filled both in the euro zone and in the US. In the euro zone, the calendar contains the European Commission confidence indicators (May), Belgian and Spanish CPI (May) and the German unemployment data (May). Last month, the European Commission confidence indicators showed their first improvement after falling to a record low in March. For this month, another (slight) increase (69.0 from 67.2) is expected. We believe the risks might be on the upside of expectations after the better than expected PMI’s and national business confidence indicators. In line with the German CPI yesterday, also Spanish and Belgian CPI are expected to extend their downward trend and the risks might be somewhat on the downside of expectations. The German unemployment rate is forecasted to rise further in May (to 8.4%).

In the US, the durables (April), new home sales (April) and weekly claims are on the agenda. In April, durable goods orders are expected to have risen by 0.5% M/M after falling by 0.8% M/M in March. Nevertheless, the improvement might be driven by civilian aircraft orders and therefore, durables ex transportations are expected to have dropped further in April. New home sales are forecasted to show a slight increase (1.1% M/M) in April, partially due to the California new-home buyers’ tax credit. Initial claims are expected to have stayed broadly unchanged in the week ended May 23.

On the supply front, Italy will tap two BTPs in the 3- and 10-year sector and two CCTs in 3- and 6-year sector for a total amount between €6.75-9.25B, while in the US, the Treasury will hold a 7-year Note auction for an amount of $26B. Yesterday, Germany successfully issued a new 2-year Schatz. The bid/cover ratio was good at 1.9, even though the Bundesbank had to retain the largest amount (1.68B) since November last year. Yesterday, Portugal also issued a new 5-year benchmark via syndication. The new benchmark maturing in October 2014 was priced at 67 basis points above mid-swap. In February of this year, Portugal still had to pay a spread of 135 basis points above Swap, when it issued its new 10-year benchmark. The decline in the intra-EMU spreads mainly reflects the improvement in risk appetite, as the outlook for public finances still looks rather awful.

On the ECB front, several ECB council members will speak today, including Constancio, Liikanen, Weber and Tumpel-Gugerell. We don’t expect them to break new ground, as ECB President Trichet has signalled that rates will remain unchanged for now and no new unconventional measures are anticipated.

Regarding trading, the sell-off on the government bond market continued yesterday in the US, where longer-term yields moved again higher forcing ever more investors to reposition and sell Treasuries. The move came that far, that it now starts to threaten the economic recovery hopes. Yesterday, US equities for the first time fell on the continuous rise in US Treasury yields. In the euro zone, longer-term yields are moving higher too and German 10-year yields have already broken above the January highs at 3.4%. Next key resistance stands at 3.67%, which is the neckline of a major double top formation (see graph below). And a sustained break above this level would suggest that we are heading for a crash on the bond markets and in this case, we would close any long position on bonds. We are however not that far yet, and if the rise in yields would indeed threaten the recovery, the rise in yields may naturally run out of steam.

In the UK, Gilts underperformed the European bond market following the Bank of England’s reverse auction.

Today, the calendar contains the CBI distributive trades report. Last month, the CBI report showed an impressive rebound in sales (3 from -44), which was at least partially related to the timing of Easter. For this reason, sales are forecasted to have fallen back somewhat in May.