Sunrise Market Commentary - From KBC Market Research Desk

• Global bonds plummeted and resumed their downward trend The tentative tax-cut deal Obama reached with the republicans made US bond yields end 11 to 21 bps higher. In the German market, yields rose between 6 and 9.5 bps. 
• Dollar profits from sharp rise in US bond yields. On Tuesday, there was quite a sharp intraday trend reversal in several markets and the currency market was no exception. At first, riskier assets enjoyed the approval of the US budget agreement. This supported EUR/USD, too. Later in the session, traders turned their attention to the sharp rise in US bond yields, triggering USD gains across the board. 
• News & Calendar: German factory orders rebound in October
• US Equities reversed gains in the final hour of trading as concerns grew about the impact of the extended tax cuts on public finances. The S&P ended the session marginally up. This morning, also Asian shares trade in negative territory.
• The  Irish government detailed yesterday the toughest budget on record, targeting €6 billion euros in spending cuts and tax hikes. The Budget 2011 contained  a few surprises, but there were no major shocks that might  threaten a political backlash. 
• Major rating agencies expressed concerns about the long-term impacts of the United States’ extended tax cuts on the country’s finances and credit-worthiness. Moody’s is worried the two-year extension could become permanent, while Fitch stressed the needs to reach broad political agreement on a plan for fiscal consolidation, in order to show commitment to its AAA-rating. 
• The head of the IMF criticized Europe’s disjointed response to the euro zone crisis after Germany and other states resisted the calls for bolder action. 
• Japanese core machinery orders fell at a slightly faster pace than expected in October, in a sign that companies are  holding back spending due to the yen’s strength and slowing demand at home and abroad. 
• The Bank of Canada held its key interest rate steady at 1% on Tuesday and set the stage for rates to stay unchanged into next year by emphasizing its concern over weaker exports and the risks passed by Europe’s debt woes. 
• Prices of gold and copper dropped sharply in a technical correction, after hitting record high levels. Also crude oil prices ($87.78) fell back after reaching a 7-month high above $90 a barrel. 
• Today, the eco calendar remains thin with only the German industrial production data. 

On Tuesday, global bonds tanked and resumed their downward trend. The  rout in US bonds left yields 11 to 21 bps higher, while the damage was only a bit less in the German market where yields backed up between 6 and 9.5 bps. 

The main reason was the tentative tax-cut deal Obama reached with the Republicans. While the deal, if agreed to, might be good news for the economy, it raises doubts on the US financial outlook, as the deficit and debt will raise more than the budgetary gains from the eventual higher economic growth. It sits also difficult as the Fed has  eased recently policy via another $600B Treasury Securities Purchasing Programme.  

Rating Agencies Moody’s and Fitch showed concern about the impact of the decision on the US finances and credit-worthiness. Moody’s is worried the 2-year tax extension could become permanent, hurting the  credit rating in the long run. Fitch did noted the positive economic impact, but stressed the US needs to reach broad 

political agreement on a plan for fiscal consolidation in order to show its commitment to its AAA status. Both agencies have no immediate plans to reassess the rating, but warn that in 2-years time (Moody’s) the situation may change.  

Other developments in the bond markets were the spread narrowing in the European peripherals, the strength in German factory orders and the weak 3-year Note auction, which were also bond negative, but dwarfed in impact to the developments and fears about US fiscal policy.   

Interestingly, the technical pictures of all important markets  showed signs of key reversals that of course need to be confirmed. The S&P set a new cycle high before plunging (see graph). The CRB commodity index tested the cycle high, plunged leaving a bearish engulfing pattern on the charts (similar for oil). The March T-Note future dropped sharply, leaving a near Marobodzu on the charts. The latter is more of the exhaustion-type signals that would point to at least some consolidation and the continuing crash in Asia overnight sniffs to a pinch of panic.  

The EU-27 Finance Ministers meeting didn’t bring that much news. The outcome of the meeting can be reduced to  three broad conclusions. First of all, the ministers agreed on a second bank stress test in February. In July, only 7 out of 91 European banks failed the test. EU commissioner Rehn said that the 

new test would be based on a new financial architecture. “We need to opt for the fullest transparency when conducting the bank stress test.” Secondly, the ideas of enlarging the EFSF bail-out  fund and issuing E-bonds were respectively swiped off the table and not even discussed. IMF director Strauss-Kahn reacted disappointed that Germany and other states rejected his calls for bolder action. “The euro zone had to provide a comprehensive solution to this problem.” “The piecemeal approach, one country after another, is not a good one.” 

Finally, the ministers formally agreed on the €85B bail-out loan for Ireland. Klaus Regling, head of the EFSF said that the first sale of €5B of bonds to finance Ireland’s aid package will take place in the second half of January. In the periphery, yield spreads versus the German bonds narrowed 3 to 8 bps with the German/Irish yield spread outperforming and coming in 24 bps.

Around noon, there were rumours that  the ECB was buying Irish and Portuguese bonds. In Ireland, FM Lenihan presented the Irish budget. The 2011 Budget contained a few surprises but importantly, there were no major shocks that might threaten a political backlash.  As a result, it seems likely that all associated legislation will be passed thereby satisfying a major condition of EU/IMF assistance to Ireland.   If today’s announcements mean investors and policymakers across Europe rest a little easier, significant questions remain in relation to Irish economic and financial prospects.  

So, nervousness may be slow to fade.( For a detailed report, see flash).  In Italy, the Senate passed the 2011 austere budget which is considered vital to consolidate the public accounts and keep the country out of the hands of the euro zone crisis. The budget, containing about €25B austerity measures, aims at lowering the budget deficit form 5.3% last year to 2.7% in 2012.  

Also today, the eco calendar remains thin as only the German industrial production data are scheduled for release. Besides the eco data, Germany, the US, Switzerland and Sweden will tap the market today. In October, German industrial production is forecasted to show a 1.0% M/M increase after 0.8% M/M decline in September. Following yesterday’s rebound in orders, we  have no reasons to distance ourselves from the consensus. 

In the US,  the 3-year note auction did not go very well. The auction stopped above the 1:00pm bid side and the bid cover (2.91) was the lowest since February, significantly lower than this year’s average of 3.10. Indirect bidders took down 36.7% of the auction and Direct bidders took down 18.0% of the auction. Once again, the Indirect bid was light. The $16.8 billion Indirect bid was down from $18.7 billion last month 

and well below the $23.3 billion average of the prior year. The Direct bid has remained strong.

Today, the German treasury will reopen the 2-year Schatz (1% Dec2012) for a second issue of €5B. This year’s average bid cover is 1.76 and on average 16.68% is set aside for secondary market operations. Given the dreadful Bobl and Bund auctions over the past two weeks, who were both undersubscribed, it will be challenging for the Treasury to successfully complete the issuance. The US Treasury will hold a $21.0 billion reopening auction of the 2 5/8% 10-year note. The auction will raise all new cash. The 10-year WI is currently bid around 3.235%. This year, the 10-year auction stopped on average 0.3 bps below the 1:00pm bid side and bid cover averaged 2.81. This auction might also be a struggle given yesterday’s weak 3-year auction and this weekend’s proposal by president Obama to extend all Bush-era tax cuts for two years. However, yesterday’s rise (+20 bps) in 10-year yield might also be seen as an investment opportunity. So, the outcome of the auction will allow us to have a better take on the current sentiment.  

The ECB Reserve Maintenance Period ended yesterday with the traditional quick ECB liquidity absorbing tender and the also traditional spike higher in eonia (0.738%). The ECB held its weekly MRO and its one-month LTRO  liquidity tenders. 

For the week, the banks asked (and received) €197.3B liquidity, which was about €17.6B more than last week, while they asked and got 68.1B in liquidity for the maintenance period (till Jan19 2011), more than the €63.6B of one-month liquidity maturing. The upped demand for liquidity might have been due to end of year liquidity needs by the banks. There might have also been some higher demand for precautionary motives from peripherals, but we would think these concerns should be satisfied more by the 3-month liquidity tenders, the next one taking place on December 22.

  

Regarding trading, we highlighted yesterday that the US tax-deal was a negative for bonds as was the US 3-year Note auction and German industrial orders. However, while we kept our negative MT bearish view, we totally underestimated the ST impact of the US tax deal. We thought that the oversold character and the ST technical signals (failed test key  support) would have started a  consolidation period. We were wrong, at least in our timing. The eco calendar is near empty today, while the German and US Note auctions are negatives, but it will be sentiment that will be most important. There were signs of selling climax and some panic yesterday. The selling started at the beginning of trading and only stopped in the close. In technical 

terms, it resulted in a near Marabodzu  (black candlestick with opening at the high, closing at the low, see graph T-Note, in the Bund graph it doesn’t look so because the official close is used, but if one looks to the whole day price action, it is similar). 

The panic selling wave continued in Asia this morning, but should be exhausted ultimately at the end of today’s session. So, short term traders may try to play the rebound. In a medium perspective, the  outlook remains bearish though and going against the flow may be dangerous, but we don’t side with the panic sellers. The only thing we are still missing in our analysis, are the news media coming up with sensational stories and unrealistic forecasts of where the selling will stoop. However, we emphasize, the outlook for bonds is still bearish.    

On Monday evening, the euro zone Finance Ministers didn’t take any new measures to address the sovereign debt crisis. In the run-up to this meeting, there was a lot of debate whether the EMU should raise the amount of the recue fund. Also the issue of an E-bonds was rumoured to be on the table. However, the EMU Finance Ministers dismissed these calls. One might have expected some euro nervousness on the back of this status-quo. In addition, the euro zone crisis remained in focus of the financial news agencies as the EU-27 Finance Ministers met on Tuesday. This meeting yielded again a lot of (sometimes divergent) comments from EU policy makers. 

However, this time the damage for the euro was limited. Maybe, markets in some way joined the ‘analysis’ of German Fin Min Schaeuble as he said that the EU didn’t need a new debate every week. To put it another way: the issues on the table were clear, but  there was no hard news on any possible further steps to guide the 

price action on the currency markets. So, currency traders had to look elsewhere for guidance. European equities performed quite a remarkable rebound as global investors reacted initially positive on  the US budget agreement. Risk was on and EUR/USD moved to the high 1.33 area already during the morning session in 

Europe. Demand for funds in the ECB  tenders (1 week and 1 month) was higher than at previous auctions. In theory this could have been euro negative. However, the result of these tenders was no big issue for currency trading. The same was true for the October German factory orders coming out slightly weaker than expected at a 1.6% M/M rise. In the US, there were only some second tier eco data on the agenda. 

US equities joined the optimism on the back of an agreement between the Obama administration and the Republicans on the extension of the Bush tax cuts and some other fiscal measures to support the economy. At first this continued to support overall risk appetite. EUR/USD reached a minor new high in the 1.3400 area early in US trading, but a clear break again didn’t occur.  

However, from there, sentiment on global markets gradually changed. The rally on the equity markets stumbled and EUR/USD changed course, too as the focus of investors turned to the rise in US bond yields in the wake of the US tax deal. One can raise the question whether  the combination of at the same time a loose monetary policy (cf Bernanke quotes this weekend) and a loose fiscal policy should in the end be supportive for the currency (in this case the dollar). However, markets apparently focused on short term swings in yields/interests rate differentials and this development was seen USD supportive.  

Some headlines of IMF chief Strauss Kahn, mentioning the option of a spilt of the euro zone, might have weighed on the euro, too. So, EUR/USD completely reversed the earlier gains and closed the session in negative territory (1.3261 compared to 1.3308 on Monday evening). Rating Agency Moody’s expressed concerns about the long-term impact of the extended tax cuts on the country’s finances and creditworthiness. However, at least for now, this is not yet seen as a concern for the US dollar.  

As was already the case over the previous two days, the calendar of eco data is again thin. The German industrial production data of October will be published. However, this report is usually only of intra-day significance for currency trading, at best. In the US, only the mortgage applications are on the agenda. Yesterday and on Monday, the  financial news wires had a good excuse to continue to dig into all kinds 

of European issues as the E(M)U finance Ministers met in Brussels. This factor might gradually disappear today. However, yesterday, rising US bond yields apparently has become a factor of growing importance for currency trading. It will be interesting to see whether this theme will continue to gain in importance.  

Global context: since early November,  EUR/USD was captured in a negative trend. The trade-weighted dollar reached a new correction low (75.63) after the November Fed meeting with EUR/USD reaching a top in the 1.4280 area. However, the negative impact of QE-2 on the US dollar faded soon. The tensions in peripheral Europe came again to the forefront. EUR/USD was ripe for a more pronounced correction. Contagion fears kept  the euro under pressure. The pair reached a correction low at 1.2969 last week. Since mid last week, the tensions on the European markets eased as rumours on ECB bond buying gave investors some comfort. This caused a short-squeeze in EUR/USD too.  Recently, we also advocated that the 

combination of more QE-2 and reasonably good US eco data could yield some support for the US dollar.

However, after Friday’s payrolls and the comments from Bernanke, it looked that it was too early to play this card. At the start of this week, we changed our short-term bias for EUR/USD from negative to neutral. Euro sentiment is still fragile, but unless some high profile negative headlines on the EU crisis resurface, the 1.2969 reaction low should provide decent support. Yesterday’s price move was disappointing for euro bulls. We look out whether the dollar will continue to profit from a rise in US bond yields.  

From a technical point of view, the MT picture turned again EUR/USD negative. The pair lost several key support levels, including the uptrend line from this year’s low (at today 1.3433) and the  1.3334 neckline. At the end of last week/early this week, the pair tried to regain this area,  but at least for now the attempt has been aborted. Sustained trading north of this area would be an indication that the pressure is easing and that the rebound in EUR/USD might still go somewhat further. In this respect, the 1.3698/1.3786 area (Previous range bottom/reaction high) is the next high profile resistance area. We think that a sustained rebound beyond these levels will be difficult. Recently we looked to sell EUR/USD into strength for return action 

lower in the range. After yesterday’s price action it even looks that 1.3400 may have 

become a difficult hurdle. So, returned action to 1.2969 level (reaction low) might occur sooner than we expected until now.  

On Tuesday, USD/JPY reached a new correction low in the 82.35 area early in Asian trade. At that time, equity investors were not yet impressed by the US tax agreement. Rumours on a potential rate hike in China weighed on investor sentiment in Asia. Appetite to buy riskier assets returned gradually and USD/JPY reversed the earlier losses, supported by a strong start of the European equity markets. However, gradually US traders returned their focus to the sharp rise in US bond yields. USD/JPY tested again the 83.00 area, which capped the topside in this pair after last weeks US payrolls report. This time the attempt succeeded, triggering additional buying stops, even as (US) equity markets had to return there early gains. USD/JPY closed the session at 83.49, compared to a 82.66 close on Monday evening.  

This morning, there were plenty of  Japanese eco data. Trade balance and current account data were relatively close to expectations. Machine orders came out slightly weaker than expected at -1.4% M/M and 7.0% Y/Y, reinforcing fears on the pace of the Japanese recovery going forward. Most Asian equities are in negative territory this morning. Japan is the exception to the rule as the rebound in USD/JPY is seen 

positive for Japanese exports. USD/JPY is extending yesterday’s gains and already tested the 84.00 mark this morning. 

After the Mid-September interventions, USD/JPY trading for some time became a tactical game between the BOJ and the market. Investors felt comfortable with yen long positions (USD/JPY shorts) as Japan was considered to have little room of maneuver to execute a strategy of aggressive interventions to stop the rise of the yen, given the debate in G20 that excess countries shouldn’t take steps to artificially lower the value of their currency. However, finally the global decline of the dollar slowed and USD/JPY developed a bottoming out process. The rise in US bond yields became an important driver behind this move. This improved the ST technical picture in the pair. We didn’t/don’t expect a major U-turn in the USD/JPY cross rate.

 

Nevertheless, there was apparently room for a repositioning in a unidirectional positioned USD short/yen long market. Recently, we were  looking to sell USD into strength, but that we waited for a technical signal that the upward correction had run its course. This happed at the end of last week. The 84.40 area was tested 

several times last week and now looked like a strong resistance in this pair. So, we reinstall a cautious sell-on-upticks strategy for return  action to the 80 area. To be honest, yesterday’s sharp rebound in USD/JPY doesn’t go with our ST strategy. We don’t change tactics yet, but we put stop-loss protection in the 84.50 area to shield USD/JPY short positions against the potential fall-out of a further rise in US bond yields.  

On Tuesday,. EUR/GBP was at first not able to developed a clear directional move. The overall improvement in risk appetite failed to give a clear sign for trading in this cross rate. EUR/GBP revisited Friday’s lows in the 0.8450/46 area early in the session. However, a clear break didn’t occur. On the other hand,  the pair also didn’t succeed to move away from this area. The UK production data failed to unlock this stalemate as the report came out mixed with the manufacturing figure coming out stronger than expected, but  industrial output showing a decline on a monthly basis. 

So, EUR/GBP continued to drift sideways. Later in the session the decline in EUR/USD dragged also EUR/GBP lower. This time the break of the 0.8450 area succeeded. The move was a bit ‘strange’ as we consider the late session decline in EUR/USD as USD driven in the first place. Nevertheless, the pair closed the session at 0.8415, compared to 0.8468 on Monday evening.  

This morning, the rise in the BRC November shop price index slowed from 2.2% to 2.0%. The impact on EUR/GBP trading was  limited. Later today, there are no eco data on the calendar in the UK. So, broader sentiment on the euro and the technical considerations will set the tone for trading in this cross rate.  

Global context:  from late August till end October, EUR/GBP rebounded from the 0.8200 area to reach a recovery high of 0.8942 on October 25. Investors started to discount higher chances that the BoE would join the Fed and enlarge its program of asset purchases. The harsh UK budgetary measures were seen as a potential drag on UK growth and this could be a good reason for the BoE to maintain an accommodative approach. This kept sterling under pressure. However, stronger eco data (especially the first estimate of the Q3 GDP) torpedoed the hopes for additional BoE policy accommodation short-term and helped  sterling to regain ground. Rising tensions in the euro zone were also a good excuse to scale back euro long exposure in 

general and EUR/GBP exposure in particular. The pair dropped below the key 0.8532 support area and reached a correction low in the 0.8335 area mid last week. 

From there, the pair joined the broader rebound of the euro.  

Longer-term, we don’t expect a major comeback of sterling (yet). The debate on more QE is delayed, but probably not closed. The impact of the budgetary measures on growth has still to materialize. We assume that the BoE will lag the ECB on the way to policy normalization. Last week’s ECB policy decision confirms this view. At the end of last week, we indicated that some bottoming out might be on the cards and that there was room for a rebound in this cross rate as long as there was no flaring up in the European sovereign crisis. So, we installed a cautious buy-on-dips approach. This week’s price action showed that global sentiment on the single currency remains fragile. Nevertheless, for now we hold on to our tactics. The pair regaining the 0.8598 area would further improve the ST picture in this cross rate. Stop-loss protection in the 0.8335 area (correction low) remains warranted limiting the damage in case of renewed intra-EMU tensions. 

EMU: German factory orders rebound in October 

In October, German factory orders rebounded from the sharp decline in September, although the bounce-back was slightly weaker than expected. On a monthly basis, German factory orders rose by 1.6% M/M, while the consensus was looking for an increase by 1.9% M/M. The details show that the increase was led by orders for consumer goods (2.4% M/M), but also intermediate goods orders (1.6% M/M) and capital goods orders (1.3% M/M) increased significantly in October. The rebound in orders is consistent with the recent improvements in PMI’s and Ifo and indicates that the German manufacturing sector remains on track, although production isn’t as strong as in the first half of the year.

Other: UK industrial production drops on utilities 

In the UK,  industrial production dropped for the first time in four months in October, while the consensus was looking for a slight increase. Weakness was however based in the mining & quarrying (-4.2% M/M), electricity, gas & water supply (-1.0% M/M) and oil & gas (-4.2% M/M), while manufacturing rose twice as much as expected (0.6% M/M). Although the headline index was significantly weaker than expected, this was entirely based in the volatile utilities, mining and extraction, while manufacturing activity remains surprisingly strong. In November however, utilities might post a strong rebound due to the cold weather.

Full chart report: Sunrise Market Commentary - From KBC Market Research Desk