Debt-impasse aside, you could say that the U.S. economy took a unilateral step towards a credit downgrade on Friday after first-half growth simply evaporated in the government's GDP report. The huge downgrade in growth in the first quarter could be taken to imply lower tax and revenue implications and at the very least sets the world's number one economy on a lower trajectory at a time when global growth least needs it. Government bond yields slumped as a result conveniently overlooking the rather difficult weekend ahead likely to be plagued by political negotiations. One can only hope that Friday's data might convince the political factions to pull together.

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Eurodollar futures -The cost of borrowing slumped across the Eurodollar futures extending to the treasury market sending yields below the lowest closing level of the year. Consumer spending, which accounts for 70% of the economy, barely budged ahead in the three months ending June and rose by just 0.1% according to today's GDP report. The economy expanded by 1.3% at the time but up from a first quarter pace revised sharply lower to 0.4%. That growth rate was originally reported at 1.9%. Eurodollar futures surged ahead at maturities beyond 2011 sending implied yields down by more than 10 basis points at maturities one-year forward and beyond. Nearby futures failed to budge as resurfacing worries over the Eurozone sparked fresh liquidity fears across the interbank cash market. The 10-year government yield slid to 2.85% as the September note future rose by a full-point.

European bond markets -European bond markets are once again falling apart at the seams after Moody's warned over the progress of the Spanish budget deficit as it placed the nation's Aa2-rating on review for a possible downgrade. Yields across peripheral nations rose while those in Germany slumped forcing a widening in spreads as perceived risks rose. Implied cash rates on euribor futures softened by around six basis points while the 10-year bund yield declined by eight pips to 2.55%. Irish bonds plummeted lifting the benchmark yield by 33 basis points while yields on Greek, Belgian and Portuguese government debt rose by as much as German yields fell. Spain and Italy suffered by more with an increase in the cost of borrowing adding a further 12 basis points.

British gilts - Short sterling futures advanced as the yield curve softened in response to growing turmoil in Europe, pressure from the U.S. debt impasse and on account of softer domestic data. A measure of GfK consumer confidence underscored the weaker economic outlook, while the Bank of England reported a nasty contraction in the broadest measure of the money supply. In June the M4 measure of money fell by 0.5% leaving the annualized pace of contraction at 0.7% and symbolizing the struggle facing the economy as the government tightens fiscal policy in a weak growth environment. The 10-year gilt future expiring in September advanced further following the U.S. GDP debacle to reach a session peak at 125.23 driving its yield lower by 10 basis points to 2.86%.

Australian bills - Aussie bills advanced by around 12 basis points driving implied borrowing costs lower according to Sydney futures contracts. The central bank reported a 0.1% contraction in private sector lending during the overnight session for the month of June. A separate report revealed a second monthly drop in seasonally adjusted home prices. Bond prices surged shaving 12 basis points off the cost of government borrowing.

Canadian bills - Canadian bill futures rebounded on news of the awkward growth report from its biggest export venue, while at the same moment domestic growth during May also soured. Growth of 0.3% was expected after an April standstill but in the event output unexpectedly declined by 0.3%. Together the two reports helped undermine fears of a resumption in monetary tightening out of the central bank. Implied cash yields fell by seven basis points while the 10-year government bond futures contract added a half-point to 127.28.       

Japanese bonds - An overnight rebound in the dollar helped temporarily alleviate some of the week's upwards pressure on Japanese government bonds and encouraged a degree of profit-taking ahead of ongoing political negotiations aimed at lifting the debt-ceiling. The September JGB futures contract edged lower to 141.81 with the 10-year yield rising marginally to 1.072%. A July PMI report from Markit/JMMA showed expansion in the nation's manufacturing sector boosting confidence in a post-earthquake rebound in activity. Consumer prices rose nationwide by 0.2% in July and increased for a second straight month.

Andrew Wilkinson

Senior Market Analyst       

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