Friday July 16, 2010

Bond responded to a weak U.S. consumer price inflation report today with some caution. Yields have already dropped on account of perceived economic weakness and a rise in the core rate of inflation defined by the ex-food and energy component did little to deter buyers who still expect the Federal Reserve to leave interest rates well alone. Meanwhile the weakness in the U.S. dollar perfectly reflected in a stronger euro is weighing on the performance of core German government bonds which face a second week of losses as investors begin to recognize that imminent European collapse is an over rated fear factor.

European bond markets - When bond yields rise they tend to do so rapidly as investors traditionally dumping bonds can't find fear-gripped buyers. When yields fall they tend to do so gradually as confidence returns. Yet such theory has been tested this week after the Spanish government closed the books on the bulk of its funding requirements with more buyers lured by rampant yields turning up to snap up fresh issues. Spanish bond yields have collapsed sending yields down by a huge 40 basis points in just two days following the successful auctions. Two-year yields slumped to a six-week low while the 10-year yield hit a one month low while the premium over German bunds slumped to 177 basis points - a near one-month low.

A mid-morning slide in equities is ruining the script here with the September bund contract surging in recent minutes. Having traded as low as 128.42 earlier the contract is now up on the day at 129.10 as growth fears consume investors on the other side of the Atlantic. Until this point of the day the closing theme was that successful Iberian government auctions were lifting fearful shrouds from the Eurozone sovereign debt problems leaving investors to worry more about U.S. slowdown. Bunds were heading for a second straight weekly gain in yields with the two-year yield heading to its highest in as many months and a third weekly loss.

Eurodollar futures -A weaker than forecast University of Michigan confidence reading spurred additional gains for September treasury-note futures, which last traded up 11-ticks to yield 2.95% and lower by five basis points on the day. Eurodollar futures have gone off to the races after the report with nearby maturities facing a decline of implied yields of five basis points while deferred contracts are up by 11 basis points. The dollar curve continues its aggressive flattening process, and one that's uncomfortably difficult to argue against at this point in time. The one year calendar spread implied using the front September Eurodollar contract has slumped to 35 basis points compared to about 85 basis points since the start of June. In fact it last traded at a 100 bp differential at the start of May.

British gilts - Despite the hoo-hah in the bond markets gilt futures seem unable to maintain a rally that took the contract to a session high at 121.32. The September contract has eased to 121.09 and remains barely higher on the day with a yield of 3.35%.

Japanese bonds - A dry view on the prospects for the U.S. economy, sliding equity prices in the region and a strengthening yen dampening exporters' earnings have all conspired to drive government bonds to their biggest weekly gain in eight months. The four basis point slide overnight saw the 10-year JGB yield decline to 1.075%. September JGB prices actually eased 11 ticks on the session to close at 141.62.

Canadian bills - A leading indicator for the Canadian economy released today rose for the a straight 13th month in a row inspiring earlier losses for the 10-year government bond future, which slipped to 122.48. However, the decline in the Michigan data for the U.S. saw investors drive futures up and yields down with the September contract at its best reaching 123.18 where the yield is 3.19%. The 10-year spread above the comparable U.S. treasury note has widened to its greatest since February 2009 at 24 basis points as investors prepare for the Bank of Canada to repeat its earlier monetary policy bias towards tighter money next week. Meanwhile, as bonds gain today, 90-day bills of acceptance are tailgating the Eurodollar complex and have so far advanced by six basis points sending yields a little softer.

Australian bills - Aussie government bond yields rose two pips overnight with the yield adding to 5.10%. The Asian equity markets continued to fret about the outlook for the U.S. economy but there is less to suggest an Australian slowdown is in store at this point. Bill futures were mixed as the week wound to a close.

Andrew Wilkinson

Senior Market Analyst       

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