Wednesday August 4, 2010

An unscheduled expansion in the non-manufacturing services sector, which accounts for 90% of U.S. economic output, caused bond traders to scratch their heads as they questioned the recent slide in yields. The interest rate curve shifted northwards by a couple of basis points as dealers swung away from the arguments posed by James Bullard, who in his recent Fed paper noted the U.S. was slipping towards Japanese -style deflation. Fed Chairman Bernanke speaking earlier noted the likely modest recovery in consumption given the slow pace of employment growth, yet that's without further stimulus. The rise rather than fall in the expansion of the service sector during July leaves the index above its monthly average during the past 13-years and provokes a key question for the FOMC when it meets next week: Does the economy really require a further jolt?


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Eurodollar futures - The June reading of the ISM services sector at 53.8 was on the wane yet was just about the average monthly reading since 1997. Following weeks worth of slackening activity, economists were braced for a dip in the activity reading, but instead it rose to 54.3. And while the trend doesn't fit in with other anecdotal indicators, what it does tell us is that the notion of a double-dip recession is not as likely as many observers have predicted. Look to corporate earnings for more evidence if necessary.

Eurodollar futures had a little rethink after many deferred contracts reached contract peaks earlier in the week gung-ho on further stimulus after next week's FOMC meeting. Further mortgage buying now might ultimately accelerate monetary tightening further down the road if the issue right now is merely a crisis of confidence. There is a world of difference between stimulating a shrinking economy and a dormant one. Deferred futures contracts shed up to 10 basis points while September note futures are extending gains late in the morning with the contract now down 10-ticks with yields gaining three basis points to stand at 2.94%.

Japanese bonds - The fear that the world economy is on the cusp of a slowdown and a 2.1% meltdown for Japanese stock prices sent yields on 10-year government bonds to beneath 1% for the first time since 2003. Helping spur the decline in yields these days is a resurgent yen in response to global growth woes. In addition the decline in yields is across the globe rather than just in Japan, which was the case seven years ago when Japanese yields were this low. September JGB futures ramped up to 142.25 sending yields on government debt to 0.985%.

European bond markets - Bund prices got off to an enthusiastic start by reaching a two-week high as Eurozone retail sales failed to impress. July data was static despite an upwardly revised jolt to June data. German, French and Eurozone services PMI were all marginally weaker indicating the peak of the revival may be past. Euribor prices declined as three-month cash prices rose in response to a money-market drain from the ECB. The central bank is likely to maintain an unchanged policy at Thursday's meeting. The 10-year German bund yields an unchanged 2.60% after the futures contract expiring next month erased an earlier gain. Having reached an intraday high at 129.47 the contract recoiled to 129.11 later.

British gilts -The British service sector PMI seemed to pull back more than most and provided limited insulation from firming yields midweek. However, gains for the September gilt future quickly turned to losses following the better U.S. report. Gilts are down 10 ticks at 121.89 to yield 3.29%. Losses for short sterling prices also accelerated following the data with contracts slipping by around five basis points along the curves.

Australian bills - The jump to a record for the June trade surplus amply illustrates the healthy Asian recovery with Chinese demand for aggregates helping Australian exporters. The impact, however, was limited to a decline in bill prices along the Aussie money market curve where losses of around four basis points were evident. Aussie government bond yields fell as investors joined the global bond market rally and sent that on the 10-year down three pips to 5.12%.

Canadian bills - Canadian government bond yields jumped in-line with those on treasuries today following the healthy ADP report indicating private U.S. employment growth last month of a higher than forecast 42,000 positions. Bond futures tumbled 43 ticks to 123.65 while three-month bill futures shed eight pips and losing nearly as much as Eurodollars.

Andrew Wilkinson

Senior Market Analyst       

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