Strong EMU business sentiment push core bonds lower

Rates

On Thursday, better than expected EMU PMI’s and the ongoing equity rally on an improvement of risk sentiment weighed on core bonds. The downleg once again lacked panache though, maybe as weaker details took the shine of a promising rebound in headline business confidence in the manufacturing sector. In a daily perspective , the German yield curve bear steepened. Yield changes ranged between flat and +3.9 bps. The US Treasuries had somewhat more difficulties to limit the losses and underperformed with yields 2.8 bps (30-yr) to 6.7 bps (5-yr) higher. A new Ebola case in NY was revealed in late trading, pushing equities off the highs and allowing Treasuries to bottom. It set the scene for a rebound of US Treasuries in Asian overnight trading.

After yesterday’s PMI’s, the euro zone eco calendar is less enticing today with only some national data and the EMU Q2 government deficit figures. In the US, the new home sales are on the agenda, while the UK will publish the first estimate of Q3 GDP. EU leaders will continue their Summit and markets will also look forward to the results of the asset quality review/stress tests of the banking sector, which will be published on Sunday. In the US, new home sales rose sharply in August, by 18% M/M to a new cyclical high of 504 000. After the exceptional jump in August, a drop by 6.8% M/M is expected, to 470 000. Due to strong volatility in the data, we believe that even a bigger drop is not excluded. Nevertheless, we expect the upward trend in home sales to remain in place. In the UK, growth is forecast to have remained exceptionally strong in Q3. The consensus is looking for an increase by 0.7% Q/Q (3% Y/Y), following a 0.9% Q/Q (3.2% Y/Y) in Q2. We see risks for a weaker outcome.

The EU leaders reached an important agreement on cutting greenhouse gas emissions by 40% (from 1990 levels) in 2030. The goal will be reviewed after the UN Paris conference next year. Eastern countries get compensations to help modernize their industry. To win over Portugal and Spain, Europe’s electrical grid shall be better connected, allowing countries to export 15% of their generational capacity by 2030. Member states also agreed that 27% of Europe’s energy should come from renewables by 2030. The agreement showed that the EU is still able to make progress on the political front.

As such, it is confidence-building. However, that should now also become visible in economic policy domain too. The economic and employment situation will figure on the agenda today during the euro Summit. Mario Draghi will introduce the subject. Officially, the government finances are not on the agenda.

Today, rating agency Fitch could review the Spanish and Italian ratings. Spain and Italy are both rated BBB+ (stable outlook). No changes are expected. Both countries are already rated higher by Fitch than by Moody’s or S&P. On top, we believe that chances are rather low that we still get an update from Fitch. Generally, S&P and Fitch releases updates on Friday morning, while Moody’s tends to wait until after the closure of US markets.

Overnight, most Asian equity markets trade positive. Gains are relatively small compared to Europe or WS. One possible explanation might be late WS weakness because of the NY Ebola case. Another one is the further decline in Chinese property prices (September data). South Korean Q3 GDP growth was in line with expectations (0.9% Q/Q; 3.2% Y/Y) but irrelevant to trading. Finally, EU leaders agreed to LT climate targets but we don’t think that it will influence the start of European dealings. A huge profit warning by BASF is a negative for German equities and positive for the Bund. Overnight, the US Note future trades modestly higher, suggesting a better opening for the Bund as well.

Today, the eco calendar is thin with second tier national data in EMU and US New home sales. Q3 GDP data in the UK might impact global markets in case of a significant deviation from consensus (0.7% Q/Q). Especially a downward surprise won’t go by unnoticed given recent fears of a global economic cool down. Sentiment on equity markets is the second factor to guide bond trading. Core bonds profit from weak equity markets whereas this relationship isn’t very strong in the opposite direction (eg yesterday German 10-yr yield +3 bps while DAX +1.2%). On intra-EMU bond markets, volatility increased as well of late. Risk-off sessions trigger large corrections higher. Cautiousness is warranted. Finally, this weekend’s release of the ECB stress test (AQR) could be slightly positive for core bonds if investors position for this event risk.

Technically, the German Bund closed below the uptrend line since June. If the break is confirmed, it is a first indication that the bull run slows. A sustained drop below 149.91 would change the ST technical picture to neutral. For the US Note future, attention could already start shifting to next week’s FOMC meeting (slower trading).