Wednesday, May 12, 2010

Short sterling interest rate futures made substantial gains for a second day this week after soothing words from the Bank of England dragged down yields owing to implications for future monetary policy. The new Conservative and Liberal Democrat coalition has promised to detail up to £6 billion worth of spending cuts before 50 days of the new administration passes. Domestic government bond prices outperformed with yields falling sharply in contrast to mixed long-end performances elsewhere as global risks appeared to recede.

British gilt -Swirling British politics ended up with a change of occupancy in Downing Street on Tuesday as Gordon Brown threw in the towel on behalf of his Labour Party. He'd hoped that by offering to resign as party leader on Monday, the Liberal Democrats holding the balance of power, would be more open to doing a deal with his ousted party. But it was not to be and Britain now has a new Tory leader and liberal deputy. New Chancellor of the Exchequer George Osborne will now deliver an emergency budget outlining a slew of aggressive spending cuts with 50 days.

Bank of England Governor King welcomed the rapid formation of a coalition and its plans to put meat on the bones of manifesto plans to deal with Britain's dangerous budget deficit. In today's inflation report the bank pointed to better prospects for Britain's convalescence from recession but raised the threat to risks stemming from fiscal consolidation in a range of nations. The news that growth might rise to 3.5% by 2012 was tempered by low inflationary pressures mean monetary policy will remain nailed to the floor. Meanwhile the Bank raised the prospect of reinstating its bond-purchase program.

Through March the Bank bought £200 billion of government and corporate bonds today noting the success of the policy initiative. Owing to the prospect of intervention in the gilt market and the benign inflation profile as well as the presence of risks to growth, yields slumped across the yield curve. The December 2010 sterling future added eleven basis points sending the yield down to 1.07%. The contract high remains intact at 99.04 (yield 0.95%). Meanwhile deferred maturities continue to reflect a bull market for futures with the September expiration gaining 16 ticks as its implied yield declined to 1.75%. The contract high of 98.30 (yield 1.70%) was achieved on Friday. June gilt futures added 69 ticks to 117.26 here the yield fell five basis points to 3.83%.

Eurodollar futures -Treasury note futures are thinking seriously about giving up more of their recent fear-based gains. The June contract lost seven ticks to 118-25 adding four basis points to the 10-year yield at 3.57%. Meanwhile Eurodollar futures made slim gains forcing a steepening of the yield curve. A rebound for stock prices evident in yesterday's trading carried over to midweek is leaving the risk aversion bid for fixed income wanting and a break of 118-23 for June notes might open up a trap door to 118-13.

Canadian bills -Canadian bonds continue to trade lower in line with the more positive economic assessment. Given the nation's sensitivity to commodity demand, it's understandable that the perception of a recovering economy trumps a rally for gold prices today. Of course rising gold prices offer a knife-edge problem for investors here. On the one side Canada is abundant in minerals meaning gold drives demand for its dollar and mining companies. But on the flip side, rising gold signals investor nervousness over the prospects for paper currencies. The 10-year government bond future is a little lower and reflects a two pip gain in yields to 3.60%. Bill prices continued a decline that's lifted yields in the March contract from a trough at 1.80% as equity prices crashed on Thursday to 2.16% today.

European bond markets - The June German bund contract has been resting on its laurels today. The contract reached 125.95 before having to recover from an intraday low at 125.43. The presence of central bank bids for government bonds is helping choke off part of the fear gauge as reflected in widening spreads against core bonds. Meanwhile the sense of calm permits investors to buy equities with greater confidence. Lower perceived counterparty risk continues to be felt by easing pressures on cash markets, which in turn has provided minor gains for euribor contracts of around three ticks.

Australian bills -Positive news from the Australian government over its budget position helped shave a basis point off the 10-year yield today to 5.46%. The government now projects the budget deficit will peak at 6.1% of GDP in 2011/12 and will also return to surplus three years earlier than initially forecast. The economy skirted the depths of recession felt by other advanced nations and shielded the impact of slowdown.

The revised forecast is a positive for a reduced debt issuance calendar and may support the secondary market over time as supply is reduced. In today's market, investors focused on recovering regional stock markets and positioned for a strong employment reading due Thursday, which may reveal the creation of a further 22,500 new jobs. Bill prices therefore slipped three basis points.

Japanese bonds -Japanese 10-year bond prices continued to drift higher to 1.305% in midweek trading with little to influence movement either way other than recovering equity prices.

Andrew Wilkinson Senior Market Analyst