Monday, November 15, 2010

Fixed Income: Contagion : Irish turmoil hits European bond markets

Fixed Income: Contagion

Irish turmoil hits European bond markets
The problems in Ireland has been spreading to the debt markets in Greece, Portugal, Spain and to some extent Italy. Sentiment has been deteriorating rapidly and in the past few days the markets have moved into a vicious circle where higher yields and lower prices are forcing even more selling instead of spurring demand.

With the ECB very reluctant to step in to buy so far, sovereign spreads to Germany have been widening at a pace not seen since the spring. The risk of global contagion remains high although the situation has calmed down a bit this morning. Until a few days ago there had been only limited signs of impact. But signs are showing now. Asset swap spreads have widened, signalling declining liquidity and increasing risk premiums.

If the turmoil continues it might lead to increased uncertainty in the interbank market. There are already signs of this in basis swaps, which have been widening. This could increase the demand for liquidity at ECB’s upcoming allotments. If this turns out to be the case the yields in the shorter end of the curve could also drift lower.

There is no doubt that the main theme next week will be the evolving debt crisis. European leaders might be able to calm the market over the weekend by the recent statement issued at the G20 meeting, but the situation remains very fragile. If the jitters continue next week we think Germany yields will move lower, while asset
swap spreads and basis spreads will widen further. In any case volatility is likely to remain high in the next few days.

Are US bond yields bottoming out?
Over the past few weeks the US economy provided some encouraging news. The earnings season has been surprisingly solid and there are signs of improvement in US macro data. For instance, the ISM index and the payrolls surprised positively in September and recent claims data have also been moving lower. In the coming week we expect to see more of this with solid retail sales and a rebound in the Philadelphia Fed index.

If the recent signs of a turnaround in economic data continue, we doubt that the Fed will be able to keep yields in check for several months and we do not expect to see new lows. That said, we continue to see mixed data in both the US and Europe in the coming months and from that perspective it is too early to expect a big sell-off in bond markets, in particular when the European debt crisis is currently re-intensifying. The most likely scenario for the coming three months is in our view that 10-year US bond yields will trade in the 2.40-2.80% range.

With signs of improvement in the US economy and the European debt crisis back, we expect German bonds to outperform the US in the near term.

FX: Dollar rebounds on Ireland fears
Over the past month, the European debt crisis has resurfaced and is now increasingly affecting the currency market. The situation in Ireland has taken a turn for the worse, with Irish bond yields soaring on mounting speculation that the country will soon need a bailout. This may explain why EUR/USD has shed seven big figures from levels just shy of 1.43 over the past week, though the fall could also be attributable to a string of strong US data releases. The move lower might also have been triggered by the unwinding of the significant speculative short USD positions in the market.

Nevertheless, investors are concerned that Ireland will fail to reduce its deficit without external help, as it could be facing the most expensive banking sector bail-out in history. In that respect, Chancellor Merkel’s push for investors to bear some of the costs of a post- 2013 bailout seems to be causing worries. However, the impact on the FX market might not be confined to a EUR sell-off, as a deterioration in global risk appetite would also leave, for example, the Scandies exposed.

We expect that the PIIGS crisis will have a significant impact on the FX market over the coming week, with several comments from eurozone officials likely to draw attention. Hence, in the short term, the euro might continue to suffer. There are only a few other events on the data calendar to divert the market’s attention, although we might get further clues on whether the eurozone continues to underperform versus the US on the data front (e.g. through ZEW, US retail sales). The BoE minutes will also attract attention, though downside risks to GBP appear to have decreased significantly lately.

G20 – not much new here
The final communiqué from the G20 meeting contained little new on exchange rates, and it was close to a repeat of the previous statements. The statement says, “we will move toward a market-determined exchange rate system and enhance exchange rate flexibility to reflect underlying economic fundamentals and refrain from competitive devaluation of currencies.” Hence, the statement did not specifically mention that this process should be gradual, as has been mentioned in some press reports. Hence, the US basically keeps the pressure on China to revaluate here and now.

However, the statement also added that “advanced economies, including those with reserve currencies, will be vigilant against excess volatility and disorderly movements in the exchange rate.” Indirectly this is a clear nod to the US that the impact from its monetary policy (QE2) on exchange rates and global capital flows should be taken into consideration. However, we also argue that it gives Japan room to intervene if the
appreciation of JPY continues.

Finally, the statement gives the green light for some capital controls for emerging markets, if their currencies are overvalued and they have adequate reserves. This is a clear concession to emerging markets likes Brazil, South Africa and Turkey that have complained about strong appreciation pressure. Brazil has already adopted measures to curb foreign bond buying and Turkey cut specific rates by 400bp to discourage investors from holding short-term deposits.
Full report: Fixed Income: Contagion : Irish turmoil hits European bond markets

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