Market Economics | Interest Rate Strategy - BNP PARIBAS ...

Market Outlook
Further flattening for
Treasuries
The strategy call for the Treasury market remains a neutral one in the short
run, with a bias towards recommending long positioning later in the month.
The market remains stuck in a very narrow range and instead of directional
trades, the preference is to play the curve via the 5/10s flattener instead.
With regard to macro news flow, the FOMC meeting next week looms large.
It will be a two-day meeting, with the Fed to set out its quarterly forecasts
ahead of the Chairman’s semi-annual testimony to Congress in February.
Data have continued to confirm that Q4 is shaping up to be a strong quarter
for final demand growth but the labour market indicators have shown little
benefit to date. Headline inflation has picked up but the core rate, and wage
pressure, remains unusually low.
Fed status quo likely…
…despite musical chairs at
the FOMC
Supply problem for
EGBs…
At December’s meeting, the FOMC opted for a cautious interpretation of the
improvement in the economy and this is likely to continue. Indeed, Bernanke
reiterated that cautious stance at his Congressional testimony following the
release of December’s employment report, saying: “though recent indicators
of spending and production have generally been encouraging, conditions in
the labour market have improved only modestly at best…overall, the pace of
economic recovery seems likely to be moderately stronger in 2011 than it
was in 2010”. Most Fed speakers have publicly supported the completion of
QE2 and we expect little change to the tone of the policy statement to be
released on Wednesday.
There may be some speculation over the implications of the annual rotation
of FOMC voters. All Governors at the Federal Reserve Board are permanent
voting members, as is the President of the New York Fed. However, four of
the twelve regional bank presidents serve rotating one-year terms as voters.
The regional Fed Presidents which are rotating in as voters this year have a
more hawkish bent than those rotating out. This is not expected to make a
material difference to the policy stance but it does open up the possibility of
some dissent. President Plosser is the most probable dissenter as he has
opposed nearly all of the Fed’s unconventional policies.
The evolution of core EGBs over the last few sessions points to the absence
of positive factors for sovereign debt during a period of huge supply. The
market is struggling to absorb the paper at present, with supply apparently
far outstripping demand. There is tentative evidence to suggest that what is
bad news for the peripheral markets will also weigh on the core as the bigger
the fiscal difficulties in the former, the bigger the burden on the latter.
In this context, and with the macro news flow in Germany still going strong,
positives for core markets are in short supply. The strategy call remains a
neutral one, therefore. Curve wise, flattening remains the call. The front end
has, according to our assessment of the economic and fiscal outlook, moved
too far, too fast in discounting more than one rate hike this year. However, it
makes sense for the market to discount a less favourable ECB scenario than
previously given the signals of increased anxiety over inflation risks.
…as we await progress on
EFSF changes
Regarding EGB spreads, peripheral and core markets have also been in a
trading range, albeit with a wide corridor. This situation is likely to persist as
long as there is no agreement forthcoming on the proposed amendments to
the EFSF – this could yet take a while.
Ken Wattret 20 January 2011
Market Mover
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