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

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Market Outlook EMU crisis: contagion risk still escalating Rising risk aversion supports flight-to-quality trades No surprise from the ECB The nature of the sovereign crisis in Europe has changed dramatically over the past few weeks, with the contagion effects escalating from EU peripherals to banks and equity markets. What is now at stake is the future of the eurozone. There are several reasons why the markets’ reaction to news of the Greek aid package has been poor and why the financial stress remains so extreme, including the authorities not appearing to be in control of the situation and fears that others will be dragged into the maul. What is needed is first for the cash to be disbursed, second for a favourable ruling on the package from the German constitutional court and third for the Greek government to deliver on its promises – which will be monitored over time. There are significant differences between the Greek situation and that of other peripherals and it would be simplistic to group them all together. However, while less acute, there are chronic problems in other economies such as Portugal and Spain and markets do not appear minded to discriminate at present. The authorities need to move quickly to get ahead of the game. Flight-to-quality trades are dominating with core EGB yields hitting new lows and Treasuries following the move, ignoring better-than-expected recent economic data. The latest developments can only reinforce the pressure on governments to put their public finances in order while also reinforcing deflationary pressures – one of the key reasons to maintain our mediumterm constructive call on core government bond markets. The markets are for the moment in complete disbelief and panic trading and contagion risks will continue to support core EGBs in the short run. Treasuries may also benefit from “flight to relative liquidity” trades, particularly if the safety of Bunds came into question at any stage. Curve wise, the risk is to see some bull steepening should the setback in equity markets develop much further. Peripheral ASW curves should disinvert over the coming weeks if, as expected, the cash is made available to Greece but other peripheral curves (Portugal, Spain) will likely remain under pressure until the authorities take new initiatives. There is overall little flow on peripherals and a tendency to reduce exposure on any rebound. With no new buyers on the horizon, this explains the latest widening move on spreads. We also need to keep a close eye on the widening of the cross-currency basis as it could raise fears of a repeat of the post-Lehman panic. Generally speaking, the cross-currency basis can be modelled as a function of global risk (S&P, VIX) and local market liquidity (OIS/BOR). The latest move, also linked to the increase in sovereign risk, is adding to liquidity pressures. The ECB meeting and press conference delivered no fireworks. On the subject of buying government bonds, Mr Trichet reiterated on a number of occasions in response to questioning that this was not an option discussed at the Governing Council meeting. It wasn't, however, definitively ruled out. As pointed out earlier, his comment last weekend that "at this stage, we have absolutely no decision on the purchase of government bonds" hinted at a greater degree of flexibility on the issue than before. We know that at least one Governing Council member is against it. The same may be true for less radical options such as re-introducing more longer-term refinancing operations. Differences of opinion were explicitly recognised on the decision to suspend the minimum credit rating for collateral relating to Greek government debt. The decision was made by "overwhelming majority", i.e. it was not unanimous. We suggested beforehand that the ECB would probably need to see conditions in markets worsen significantly further before considering radical action. Cyril Beuzit 7 May 2010 Market Mover 2 www.GlobalMarkets.bnpparibas.com
UK: all eyes on the election US: recent economic data continue to push higher… …but Treasuries are being driven by rising risk aversion EUR/USD: further decline ahead GBP at risk A new phrase was slipped into the Introductory Statement: "Monetary policy will do all that is necessary to maintain price stability in the euro area over the medium term”. This gives the ECB more wriggle room should it need it in future. One could imagine this phrase being trotted out should the ECB opt for the 'nuclear option' of buying government bonds – linked explicitly to downside risks to price stability. The UK election outcome is not known at the time of writing but markets seem to have become more optimistic in recent days about a late swing to the Conservatives. If this does not occur and, above all, if the result and coalition negotiations look to have fallen short of delivering a government that will tackle the deficit decisively, we could see sterling and sterling markets becoming very twitchy. We believe markets have priced in too small a probability of a UK downgrade. The US recovery continues to build, with the recent orders component of the manufacturing ISM, at 65.7, close to its January high. Non-manufacturing ISM held steady in the mid-50s but this is still five points above the levels at the turn of the year. Consistent with the picture of a slowly building and broadening recovery, but with bumps, is a gradual improvement in payrolls. The ADP data were consistent with private job creation approaching 100k. With the census hiring, we expect an overall rise of 165k, a bit below the market consensus. The unemployment rate should stay at 9.7% and average hourly earnings should rise only 1%. Weak wage growth and good productivity delivered a 5.9% q/q aar fall in unit labour costs this week, emphasising the subdued inflation picture. Next week should see the March trade balance widen a bit while we suspect that retail sales at the end of next week will be softer than the market expects. We keep a neutral call on Treasury yields and the curve in the short run. The reason for our recommendation is that there is no clear catalyst for a move in either direction in the short term, yet the market could make a substantial move in either direction on a whim. While there could be some pressure if there is a positive surprise in economic data, the current rally is fuelled by external problems (i.e. the eurozone) and financial reform concerns, rather than the domestic macroeconomic situation. It would therefore probably take a very large upside surprise in Payrolls on Friday to have a meaningful impact on market direction. Finally, we also note that the larger-thanexpected Treasury supply cuts are contributing to the bullish momentum. We have adjusted our currency projection and now call for EUR/USD to fall to parity in Q1 2011. Europe has played its option of fiscal transfers but this policy has so far failed, as illustrated by the widening of bond and OIS spreads. The ECB must now rescue the EMU project and this will require a further easing of monetary conditions. Irrespective of how this easing is conducted, the result will be further EUR weakness. Since it came into existence, the ECB has been cautious when easing monetary conditions while often operating ahead of the curve when conducting tightening moves. This asymmetric policy approach is no longer feasible without putting the currency project at risk. EMU looks increasingly like Japan, which is a surplus-generating deflationary economy. In order to prevent outright European deflation, the ECB will have to pursue unorthodox monetary policies. EUR weakness will be part of the solution for keeping the currency union together. While we see the EUR being the weakest of the major currencies, risk contagion will keep the USD generally supported. Sterling will be sandwiched between USD strength and EUR weakness. Indeed, EUR/GBP is the only currency pair where we call for a change of direction compared to our previous forecast. EUR/GBP is likely to move lower provided the UK elects a government able to deal with fiscal and debt issues in a credible way. Should we be disappointed on this side, we will not hesitate to project the GBP following the EUR lower step by step. Cyril Beuzit 7 May 2010 Market Mover 3 www.GlobalMarkets.bnpparibas.com
Page 1: Market Economics | Interest Rate St
Page 5 and 6: Event response The ECB is being ove
Page 7 and 8: Eurozone Periphery: Compare and Con
Page 9 and 10: over 20% in Q1) and, last but not l
Page 11 and 12: Market Stress Charts • Signs of s
Page 13 and 14: Chart 7: Greek Bank CDS* 900 Greece
Page 15 and 16: • The plan also contains a number
Page 17 and 18: Germany: Downs and Ups • The impa
Page 19 and 20: Retail sales data from month to mon
Page 21 and 22: On inflation, the statement was als
Page 23 and 24: quarterly average of 2.7% in the fi
Page 25 and 26: US Credit: Still the Recovery’s B
Page 27 and 28: Japan: Rising Chance of Sales Tax H
Page 29 and 30: BNP Paribas Surprise Indicator •
Page 31 and 32: UK headline After surprising to the
Page 33 and 34: US: Supply Could Affect Swap Spread
Page 35 and 36: steep curve is typically associated
Page 37 and 38: decline. We continue to maintain ou
Page 39 and 40: Chart 12: 90-119 Day Dlq for FRE 90
Page 41 and 42: the gamma sector for some time now.
Page 43 and 44: EUR: Limited Nervousness at ECB Ten
Page 45 and 46: with the big redemption (EUR 17.7bn
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Page 49 and 50: Table 1: BNP Paribas' Inflation For
Page 51 and 52: Table 3: BNP Paribas' Inflation For
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Table 1: BNP Paribas Carry Analysis
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What’s the call? It is relatively
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Update on FIN SEN and FIN SUB 5/10y
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Germany 10y: Within MT falling wedg
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Judging Currencies by Liquidity •
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type of regulation would reduce mon
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Euro Dives • The euro is collapsi
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Currency Spot Trade Recommendations
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Economic Calendar: 7 - 14 May (cont
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Key Data Preview Chart 1: US Payrol
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Key Data Preview Chart 5: UK Manufa
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Key Data Preview Chart 9: French GD
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Key Data Preview Chart 13: US Indus
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Treasury and SAS Issuance Calendar
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Central Bank Watch Interest Rate EU
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FX Forecasts* USD Bloc Q2 '10 Q3 '1
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RESEARCH DISCLAIMERS: IMPORTANT DIS
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