Peripheral yield spreads versus German bonds came in significantly


On Monday, the surprise results of the EU-Summit and the ongoing deteriorating news about the devastation of Japan following the earthquake were the two overriding events that dominated trading. There were no economic data releases of importance. The results of the Summit brought a spread contraction throughout the peripheral bond market universe, which went at first at the expense of the German bonds. However, the latter could limit the losses further out as risk aversion linked to the Japanese earthquake and its consequences flared up, driving investors from equities and other riskier assets towards bonds. In a daily perspective, German yields rose by 1 to 2 bps throughout the curve, while US yields fell between 1.3 and 7.9 bps. However, the Japan theme was still more prominent present in overnight trading in Asia, as the Japanese government said that the risks on a nuclear meltdown at the power plant of Fukushima increased and radiation levels were considerable higher around the site. Also in Tokyo, some increased radiation was registered. Panic reigned and the Nikkei lost at some point 14%.

Peripheral yield spreads versus German bonds came in significantly as the unexpected EU-deal was welcomed (moderately) positively by investors. Intraday, some of the spread narrowing was reversed when risk aversion rose, due to the Japanese situation. However, despite that the decisions Europe made were a necessary, unexpected and important step forward, the relief on the peripheral debt markets eventually didn’t reach the proportions markets might have hoped for. Ahead of the Feb 4 EU-summit, investors priced in a positive outcome and European solution for the summit. Afterwards it seemed that they had been too optimistic and spreads widened again. This meeting, expectations were very low ahead of this weekend’s meeting and the positive outcome had more potential (see graph below). German/ Greek 10-year yield spread lowered 39 bps, but the difference on the shorter end of the curve was higher. German/Irish, German/Portuguese and German/ Spanish were down 17 bps. The German/Belgian spread lowered 11 bps. The Belgian treasury saw a window of opportunity and announced that it will sell a new long 5-year bond, maturing June2017, via syndication: “We think there is some momentum in the market, the market has been rallying and has been taking the news (on the euro zone deal) very positively, so we believe it’s a good moment to go in the market.” For the rest of the week, we expect some more moderate moves in the peripheral’s advantage, but risk aversion caused by the consequences of the Japanese earthquake might be a jammer.

The impact of the Japanese earthquake on markets is still very difficult to assess. The Northern part of Japan, Tohoku region, accounts for 8% of Japanese GDP, but the part of the region that is completely devastated is substantially smaller. Nevertheless, the damage will be substantial; also as power cuts might affect factories in other parts of Japan. The estimates of the damages have been upped in recent days. Later on, the reconstruction will raise output and growth and if the past experiences are repeated, the economic hit of the earthquake will have only temporary economic effects. Of course, financial markets will be influenced in many ways. The Japanese government coming up with an extra spending package and thus higher fiscal deficits won’t go unnoticed as the financial situation of the government is already precarious. Moody’s already warned that the financial cost may erode investors confidence in the ability of the country to repay its debts. This may weigh on JGBs. On the other hand, the BOJ announced once again an expansion of monetary stimulus. This is positive for bonds, as the flight to safety motive reigns. The first reaction on Friday and overnight was a decline in JGB’s yields (about 10bps in 10-year tenor, 5 bps in the 2-year tenor), but despite plunging equities, Japanese 10-year JGB yields are up slightly today. . Flight to safety has been the initial reaction of investors (Nikkei lost about 10% today). For global bonds, the situation is still less clear-cut. Japans oil demand may get a hit, driving the oil price lower (also overnight down $2/barrel), but as the effect on global growth looks small, once reconstruction starts, demand for commodities including oil may be higher, driving commodity prices up. The longer term impact of the serious problems at the Japanese nuclear installations on the energy supply in Japan, but also world wide, is difficult to assess. A slowing of investments in this technology might make the world more dependent of oil, which is scarce. The Japanese may also have to repatriate money from overseas investments, including US Treasuries, to pay for the reconstruction, hitting US Treasuries. Overnight, the panic in the Japanese equity market drove Treasuries, but not JGBs, sharply up, but volume might have been small. Concluding, a lot of uncertainties for global bond markets makes it difficult to have a good view of the impact on global bonds

Today, the eco calendar contains the NY Empire State Manufacturing index, the US NAHB housing market index and German ZEW survey. The FOMC meets on rates and EU Finance Ministers meet in Brussels, while Belgium will tap the market.

In March, the NY Fed index is forecasted to show a slight increase (16.10 from 15.43), after a significant increase (from 11.92 to 15.43) in February. We believe however that the risks might be on the upside of expectations as the index remains at relatively low levels compared to other business confidence indicators. Last month, the German ZEW indicator rose only marginally, while both the Ifo and manufacturing PMI reached new record highs. For March, the consensus is looking for a another marginal improvement (from 15.7 to 15.9), but we believe that an upward surprise is not excluded as the ZEW index is at relatively low levels whereas the recovery remains exceptionally strong in Germany. Finally the US NAHB housing market index is forecasted to increase slightly in March after remaining unchanged in the previous four months.

ECB Bini Smaghi said the ECB aims to “re-normalize” interest rates gradually to head off any increase in inflation expectations. “The ECB needs to be ready to react immediately to prevent any increase in inflation expectations. “ He stressed that moving early and gradually would be better than running the risk to have to raise them more steeply. This is in line with our thinking that the ECB aims a normalization that should bring rates to about 2% around the turn of the year, if of course no new event risk materializes with far-reaching economic and inflation consequences. He welcomed the results of the EMU Summit as “satisfactory overall” and insisted that the euro zone should respond correctly to the results of the bank stress tests. It is a priority for the ECB that the banking sector is strengthened and Bini Smaghi’s comments should be seen in this context. His comment on the results of the EMU Summit was still not detailed enough to get a good take on how it may impact ECB policy. The results were mixed from the ECB point of view: No secondary market buying by the EFSF (and ESM) is a negative for the ECB, but the hint by the EMU leaders that banking plans should be prepared to react on eventual capital shortages unveiled by the stress tests is a positive.

We (and certainly also the overwhelming majority of investors and analysts) don’t expect the FOMC to change their policy stance, also not because of events in Japan. For a more in-depth analysis,( see our Weekly Pulse). More in particular, we do not expect changes to the pace or scale of the $600B asset purchases programme, nor to the re-investment of principal payments from its current securities holdings. We expect that, inside the FOMC, the discussion has started on the way to model policy once the $600B asset purchase programme has be executed at the end of QE-2. We don’t expect the statement to elaborate on this question, but the Minutes may be interesting lecture in this regard. In the same vein, we expect the FOMC to repeat that it will maintain the target range for the Fed funds rate at 0 to 0.25% and that it continues to anticipate that economic conditions are likely to warrant exceptionally low levels of Fed funds rate for an extended period of time. However, we do expect changes in the economic assessment that should be more upbeat than in the January FOMC statement. On inflation: in January, the FOMC still described inflation as trending lower, which at that point seemed already a bit stretched. We think that the FOMC will now upgrade its inflation assessment to “stabilizing” maybe accompanied by “at a low level”.

Regarding bond markets today, the US and EMU eco data are interesting, but events in Japan will dominate. Also the FOMC meeting, while interesting, might have lost its immediate importance for markets. The upped risk for a nuclear meltdown at the Fukushima nuclear power plant with consequences well beyond the Northern area of Japan has brought the event to a higher alert level. Panic reigned on Japanese bourses and spread to other Asian exchanges. Risk aversion is the name of the game where bonds fully profit from. US bonds rose sharply overnight and so did German Bunds when they opened a few minutes ago. Yields are down 9-to-15 bps, the 5-year outperforming. Our basic view was bearish on bonds. We won’t change track now. The world economy should digest the Japanese drama without too many hiccups, but the uncertainties mean that bonds might be in for a pause or even an upward correction. Therefore, we would stay sidelined and look for more clarity before contemplating whether the trend changed (still unlikely, but as the dramatic situation looks to worsen one cannot exclude it altogether) or whether it is a correction that gives a good opportunity to short the bond market again.

From a technical point of view, the surge higher in Bund and June US Note future paint massive double bottom configurations on the charts (Bund neckline 123.13 and Note future 120-09). It, of course, needs confirmation in the close. It would change the technical picture in a major way for the better. We have difficulties to believe, notwithstanding how dramatic the situation is for Japan and its citizens, that it has the power to fundamentally change the global economic outlook and at the same time cause a violent change in trend in most markets. Should the moves become more extreme on the bond markets because of panic, it is tempting to short it, notwithstanding what we wrote a few lines higher.


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