Chairman Bernanke's position that the U.S. recovery isn't quite there yet is another stitch of evidence weaving together a bigger view that the Fed may further stimulate the economy through purchasing mortgage securities. A second wave of quantitative easing would further couch the world's largest economy while expanding an already ballooning balance sheet at the Fed. A lead article in today's WSJ argues that the FOMC might elect to use reinvest proceeds from maturing bonds to buy more at the forthcoming meeting. The market response is a weaker dollar weighed down by lower short-term borrowing costs and a slide to a near-two-week low for treasury yields.


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Eurodollar futures - It's not yet clear whether investors perceive the first installment of the Fed's bond buying spree a success or not. While there is possibly a taxpayer profit yet to be realized from earlier purchases, the opportunity cost of not catching a collapsing financial system is undoubtedly sharply higher. The economy has subsequently shown signs of moderating, while employment gains have been worrisomely slim. Indeed the economy is likely to have shed a net 65,000 jobs in July in data scheduled for release on Friday. The danger facing the Fed is whether action might be costlier than inaction as the economy is unlikely heading for the rocks as opposed to a moderation.

Eurodollar Libors continued a smooth trajectory lower as dealers lent out cash along the yield curve for fear that the Fed will address the cooling economy with action at next week's meeting. Eurodollars made minor gains of less than two basis points at shorter maturities while deferred contracts added up to six basis points. The December 2011 contract moved to fresh contract highs late last week sending implied yields beneath 1% for the first time by the time the contract expires at the end of next year. September treasury notes gained after data for both personal income and spending showed no signs of life at an unchanged pace. Expectations were for marginal increases in both readings. The 10-year yield eased three basis points to 2.93% as the futures contract rose a healthy 19-ticks to 124-00.

Japanese bonds - A highly successful 10-year government bond auction attracted more than four-times the number of available samurais today s investors flocked to the safety of fixed income as they continued to soul-search over the ongoing health of the recovery. Demand for the ¥2.2 trillion ($25.5 billion) worth of bonds was the highest in five years and sent yields down to the lowest since 2003. September JGB futures rose six ticks to 142.04 with a mercurially lower yield closing at 1.024%.

Australian bills - The Reserve Bank shelved any notion to further raise the 4.5% cost of borrowing today allowing bond prices to gain, sending yields on 10-year government debt down by one basis point to 5.15%. 90-day bill prices rose as investors downplay the likelihood of further interest rate increases this year. The implied yield on the year-end futures contract eased to 4.81%. Also pacifying investors was a retail sales report indicating that while consumers did spend throughout June, they didn't accelerate buying plans to the degree forecasters had assumed. Sales rose 0.2% for the month. Meanwhile building approvals for June dipped unexpectedly by 3.3%.

British gilts - A larger than anticipated decline in the British construction sector PMI reading set a fire beneath gilt prices today. The September contract shot up by 80 ticks to 122.10 allowing for a seven basis point dip in the 10-year yield to 3.28%. Short sterling futures were also trading sharply higher with the December 2011 contract gaining seven pips to imply a drop in expected cash rates to 1.45% at expiration in 16 months time. Still this contract is struggling to breach the fear-induced resistance of just a couple of weeks ago before it can trade at a fresh contract high.

European bond markets -German yields also dipped towards the lower end of a two-week range with gains at the 10-year maturity shedding six basis points to stand at 2.63%. The two year bond dropped by five basis points to stand at 0.734%. European stocks were unable to gain after a strong rally on Monday. Producer prices for the Eurozone also rose by 0.3% in the month to June for a yearly increase of 3%, which was on the favorable side of market expectations.

Canadian bills - Canadian government bond traders continued to chase down yields although the one pip decline to 3.09% failed to match the three basis point dip in comparable treasury prices south of the border. Dealers also took the opportunity to buy short term 90-day bills of acceptance where the pattern of accentuated contract gains was apparent at deferred maturities. The implied three-month yield at the December 2011 maturity fell none basis points to 1.81%.

Andrew Wilkinson

Senior Market Analyst       

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