Thursday December 3, 2009

Respite for the U.S. economy courtesy of the Fed's Beige book summary yesterday and the evening comments from Richmond Fed President, Jeffrey Lacker don't necessarily sit well with the current shape of the U.S. yield curve. For his part Mr. Lacker states that the U.S. economy having reached rock bottom will see reasonable growth next year. The fact that twice as many of the Fed's 12 regions pointed to rising consumer spending as the reason for 'modest' expansion last month hardly sits well with two-year yields knocking on the door of an all-time low. Declining market yields are a legacy of last week's Dubai crisis and the scale of that lending wobble, although large, is humbled by Bank of America's offer to mail a rebate check to Washington.

Government bonds around the world are sliding as a result today. Investors instead continue to prefer anything other than fixed income and are again drawn towards all manner of riskier assets pumping global stock indices ever-higher. The dawning realization that the global economy is at an altogether stage of recovery, while prefaced by the Beige book report, is playing out in a marked upward shift in short-duration interest rate curves. Comments from the ECB are heavily impacting the European rate complex as they unveil plans for a forthcoming loan maturity.

Eurodollar futures are weaker in an all round bear mood for interest rates today. The initial claims data at 457,000 fell short of expectations marking three straight sub-500,000 readings and creating a bullish sensation ahead of the big BLS report on Friday. Futures from December 2010 maturities outwards are lower in price (higher in yield) by six basis points as investors lock-into low borrowing costs. The recent push towards a two-year yield of 0.61% - the all-time low - suddenly looks incredible as investors are reminded of the recovery in the labor market. The two-year note now carries a yield of 0.77% and has added five basis points today. March t-notes have lost more than half a point and at a yield of 3.37%, bulls must be wondering where the shroud of Dubai suddenly faded to.

European short futures - have been trashed following the ECB's press conference. While short-dated futures are left unchanged, the June 2010 expiration has added six basis points to yield 1.2% while contracts maturing from September outwards are at least 10 basis points higher. The December contract yields 1.81% in the aftermath of the ECB's tone.

British interest rate futures can't stand the tone of the less-friendly rate environment today. The selling of short dated sterling rate contracts only picked up after the ECB's comments, but the impact remains. Futures dropped by six basis points along the curve and the December 2010 expiration now carries a yield of 1.83%. An earlier positive reading  on service sector expansion brightened the economic mood earlier and the follow-through from an overall improvement in global risk appetite is playing out through a negative environment for yields. The yield at the 10-year March gilt future rose by seven basis points to 3.65% today as the gilt shed 50 ticks.

Australian rate futures continued Wednesday's slippage and will likely see more follow-through session Friday when the dust has settled from the European and North American sessions. 90-day bolls were automatically on the backfoot from the start of the session as regional stock markets rebounded sharply. The Hang Seng in Hong Kong added 1.3% and Tokyo's Nikkei 225 index surged 3.8%. The domestic market added just 0.2% but rising metals prices, including a rally to $1,225 for gold spurred demand for the Australian dollar. A strong rise in the October reading for retail sales (+0.3%) will do nothing to alleviate RBA concerns that the economy may require further tightening. Don't forget that the Australian yield curve already has plenty of tightening priced in. Rates are currently seen peaking by next September where the yield today rose to 5%, which indicates a further 1-1.25% on top of the prevailing short-term benchmark at 3.75%. 10-year government bonds rose earlier by two basis points to stand at 5.33%.

The Canadian yield curve is suffering the least today with the March 10-year Canadian bond future down in price by just eight ticks to yield 3.27% - up two basis points on the day. This is creating a widening of the spread between Canada and the U.S. opening the premium to 10 basis points in favor of treasuries. The 90-day bills of acceptance (BA's) are suffering only a small amount with prices falling or gaining a tick. The market appears content to hold the Bank of Canada to its word of stable policy through mid-2010 and eagerly awaits Friday's dual employment reports North and South of the border.

Andrew Wilkinson                                                                    

Senior Market Analyst