Tuesday, July 14, 2009

Market Update: Temporary Counter-movement

Since I changed the tactical Bund market outlook to neutral last week and advised UST-Bund spread tighteners, i.e. long UST positions vs. Bunds (see: Rates Strategy - digging below the surface), the Bund bull market has started to stall and Bunds have underperformed significantly vs. USTs. Still, up to yesterday afternoon, the Bund future has moved in a tight trading range and speaking of a consolidation would have been exaggerated. However, since then a more pronounced setback seems to have started and this morning the Bund future dropped below its upward trendline which has directed trading over the past month (see chart).
Source: tradesignalonline.com

In combination with the current overbought stance this might indeed signal that the consolidation I am expecting to develop over the next 1-2 weeks has started. Furthermore, risky assets have been showing the opposite behaviour and I think especially the S&P500 is showing an interesting development. Over the past month, the S&P has lost almost 10% from its high (956 down to 869). On a closing basis, the support zone at 879 has held this week (even though on an intraday basis it was broken by approx. 1%). There has been a temporary recovery in late January which stalled at 878 and one in early February which stalled at 875. Furthermore, after the S&P broke through the 879 former resistance (after one failed attempt in April), this area served as a support and was tested several times in mid to late May. Therefore, from a technical perspective it is a strong signal that we could not move below 879 on a closing basis over the past days.

Source: tradesignalonline.com

In terms of newsflow, the start of US banks' earnings announcement is likely to provide some positive news (as was a key driver of yesterday's stock market gains). The former investment banks should have been able to profit from a recovery in risky assets during Q2 as well as high corporate bond issuance. As financial markets are ahead of the cycle, writedowns on risky assets tend to be ahead of the cycle as well. On the other side, loan losses tend to be more conincident but this affects more traditional banks than former investment banks.
Overall, the tactical outlook for government bonds has worsened whereas it has improved for risky assets. I maintain my defensive asset allocation stance from a more medium-term strategic perspective (see here: Asset allocation defensive stance) but would reduce risk temporarily on all fronts trying to get back in at cheaper levels. I expect the setback in government bonds to be relatively moderate and would look for the Bund future to trade down towards the 120 area. Tactically, I recommend a neutral stance for UST and Bunds. For investors wanting to get long duration in government bonds, the next 1-2 weeks are likely to offer the first opportunity to do so since the recent bull market started in early June.

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