Tuesday June 1, 2010

The Bank of Canada pulled the interest rate trigger on Tuesday after a tear away GDP report the previous day. The central bank had found itself cornered by economic strength at every turn during the first half of the year and had all but announced a rate increase several weeks ago when it abandoned its conditional commitment to easy policy on account of rising inflationary pressures. While the conviction was clearly evident in its delivery today, the policy statement did little to fuel expectations of a further policy adjustment anytime soon. The central bank stated that, The required rebalancing of global growth has not yet materialized.

Canadian bills - In its statement the Bank clearly noted the disparate pace of growth around the world. Emerging economies remained a hub of momentum while the industrialized economies of the U.S., Japan and others were at a point of consolidation. There remains a clear possibility of renewed weakness stemming from Europe. The Bank stated that the impact so far on the recovering Canadian economy has been felt through falling commodity prices and some tightening of overall financial conditions.

The Bank's statement leaves the reader with the impression that it didn't want to fail to deliver a previously promised interest rate adjustment but is clear in its projection that it is no hurry to repeat the trick given the uneven recovery. In fact the Bank states that it will be global events that factor most heavily upon further reductions in monetary stimulus ahead. Considerable monetary stimulus, however, remains in place but at its current stance remains consistent with its 2% inflation target given the significant excess supply in Canada.

The soothing nature of today's policy measure gives the appearance that what it took the Australian central bank six months to achieve the Canadians have done in a single month. Money market traders bought bills hand-over-fist in response and were caught out in response to the Bank's soothing tone. The contract expiring in December rallied 10 basis points while farther maturities rallied as much as 16 basis points. The 10-year yield slipped by six basis points to 3.28%.

Australian bills - News form China that its manufacturing base expanded at a slower pace during May caused dealers to fret that economic expansion is now past the peak. More worrying is the growing view that a second wave of recession maybe emanating from China whose export growth will be slowed on account of weaker European demand. The overlooked reality is that China needed to cool its overly hot economy to stop inflationary pressures from mounting as well as stem speculative property buying, which presents obstacles to government policies of maintaining affordable housing. March expiration bill futures rallied by five basis points as yields continued to decline. The 10-year government bond yield slipped three pips to stand at 5.33%.

Eurodollar futures - Credit markets abruptly reversed course following U.S. ISM and construction data during Tuesday morning. Both revealed that the recovery continues to build even if at a slower pace. The broad investor mindset changed from one of becoming worried into an early grave to one of optimism. Treasury note futures gave up a half point gain on the session, which had pushed yields down to 3.22% earlier. Eurodollar futures at deferred maturities also faced mild losses. Front-end Eurodollar futures made out marginally better as Libors in London stood still. Recently, pressure on cash rates became evident as investors worried that a second cash-crunch was coming on account of rising pressure on European banks translated via their dollar-funding needs.

European bond markets - The earlier flight to the September bund has melted away with the contract falling to 128.00 after reaching 128.88 in earlier trading. A further notch higher in Eurozone confidence iced the bearish cake after the news of slowing activity in China weighed on sentiment. An earlier ECB report indicated that it still expects sizeable bank loan write downs during 2010. Such a view was extrapolated by investors to mean that banks might end up being crowded out of capital raising efforts by governments aiming to plug their deficits. Front end euribor prices have subsequently slipped.

British gilt -Despite a standstill in the British PMI manufacturing survey at a 15-year high, money continued to flood into gilts for fear that a European-inspired slowdown will weigh on aggregate British exports and output. The September-expiration gilt contract earlier rallied to 119.03 before sliding to 118.34 following a more optimistic take on U.S. data.

Japanese bonds - The cooler China PMI survey harmed regional equity prices and raised dealer appetite for fixed income. June JGB futures also rose in response to a well-received auction of 10-year bonds where yields fell to 1.234%.

Andrew Wilkinson Senior Market Analyst