Wednesday, March 3, 2010

Just when investors thought it was safe to jump back into the safety of fixed income, along comes another grain of truth to scotch the theory. Recent data proved perhaps a slowing appetite for mortgages as the sagging housing market barely budges, while consumer and investor sentiment has been sidetracked by inclement weather equally responsible for keeping workers at home and in some cases out of work. The crescendo in the Greek situation has also added to risk aversion sending yields lower and creating worries about the arrival of double-dip recession. The improvement in today's American ISM data was therefore a little bit of a shocker and adds weight to Friday's key employment report.


Eurodollar futures -Bond futures came under pressure sending the yield on the 10-year note to 3.65% after the composite reading of the non-manufacturing ISM survey came in at a more expansive reading of 53 compared to the marginal expansion witnessed in January at 50.5. A reading above 50 signals expansion and below indicates contraction. The predicted reading for today's report was 51. Nervousness about the state of the labor market grew following a jump to a three-month high for initial claims last week. Some reckon that this is a backlog owing to weather-related issues. Thursday delivers a fresh look at the same number. Today's ADP survey of private employers showed another 20,000 pace of losses and does not cover government hires. This precursor to the BLS data this Friday actually bodes well for an improving labor market and now has bond traders caught in the crossfire of what they felt was a deteriorating economy, which has more recently received contradictory data.

Not much change, however, for Eurodollar futures, which are higher at nearer maturities and ever so slightly lower at deferred maturities. As a result the recent curve flattening is turning somewhat with the June10/June11 strip widening back out from 114 to 117 basis points this morning.


Canada's 90-day BA's - Money markets are now entering a minor panic phase over the prospects for possible interest rate increases later in the year in Canada. The response to unchanged monetary policy delivered with Tuesday's monthly statement was unusually bearish for interest rates. However, a far more upbeat view on what the Bank referred to as a vigorous pace of domestic spending and a further recovery in export markets has taken its toll on expectations. In addition the Bank no longer made reference to any slight downside risks to inflation nor output. That fact was made all the more believable by a Q4 GDP report revealing a 5% pace of expansion while the rate inflation is already back to the 2% target.

And while the central bank extended its pledge to maintain cheap money through June, investors are wasting no time discounting the time when the BoC will address an exit strategy for an ultra-low policy setting. Since Friday, the December 2010 three-month BA contract has lost 21 basis point sending up the implied yield to 1.40%. At the start of the month as global recovery looked threatened the yield slumped to 1.16%. The same June10/June11 calendar spread referred to above for Eurodollars has surged from 142 basis points wide earlier in the week to 160 points as traders sell deferred contracts harder. The easy money trade in this environment suddenly becomes the classic curve steepener.

European short futures - Euribor futures have a slightly softer tone in light of the Greek budget that delivers a package of spending and revenue reductions equivalent to 2% of GDP. The ramifications of the entire Greek drama have been felt Eurozone wide not least in terms of exchange rate pressure, but it's also raised the demand for core government bonds. Today the market welcomed the Greek package by reducing the yield on its government bonds. The 10-year yield fell 18 basis points to 5.96% while the premium that buyers demand over and above German bunds slipped by 20 basis points during the session as investors sniff resolution in the air. If Athens can appease both Berlin and Paris by demonstrating actionable and feasible deficit reduction plans that allows pressure on the Eurozone to subside, there is a far greater possibility that the EU will stand ready to buy new Greek issuance as slugs of maturing bonds turn up over the next several months. March bunds slipped 15 ticks to 124.05 where yields rose to 3.13%.

British interest rate futures - British yields remained unchanged at the long end of the curve as investors wrestled between the potential for a weak incumbent government after a likely May election and recent well received auctions. Short sterling futures are lower in line with euribor but also weakness at maturities into 2011 and beyond. The June10/June11 calendar spread recently traded at 105 basis points but has today reached 120 basis points. While investors were recently burned in trying to nail 2010 as being the year of central bank tightening, it appears that they are taking advantage of recent curve flattening as rationale for trying to predict that 2011 will most certainly see the removal of the punchbowl. If that's the case then curve steepening is the order of the day of such recent flatness.

Australian rate futures -Bills continued to fall midweek. Asian and Pacific markets remain robust and there is little fresh impetus to draw the crowd to fixed income right now. While the RBA gave the impression in its monetary tightening yesterday that it wouldn't seek fresh rate increases at each meeting going forward, it has stopped short of declaring balanced risks, which would signal it knows not whether the next move will be higher or lower. In that regards market expectations for more monetary tightening later remain appropriate. Bond yields rose four basis points while yields on bills rose by a similar amount.

Japan - Expectations for a weak capital spending report overnight and the fact that recent government bond auctions have been well received kept the yield on JGBsstatic at 1.32% today.

Andrew Wilkinson

Senior Market Analyst