Thursday February 18, 2010

Bonds are lower late in the week as investors continue a reaction to FOMC minutes that included a broader discussion of leaving emergency stimulus measures behind. The spluttering addition of marginally firmer economic data in some cases is also convincing investors that, although global central banks are not in a race to the exits, it will be the Fed that is able to move faster than the ECB as Eurozone funding continues to rely heavily on emergency liquidity measures. The return of rising equity prices, simmering commodity prices and widening budget deficits have conspired to steepen the U.S. yield curve to its greatest point of this cycle. However, the picture seems less clear. Sovereign debt problems are still lingering and as yet are more in the foreground than in the background.   


Eurodollar futures -The extent of the yield curve steepening is evident with the spread between two and 10-year maturities in the U.S. matching the 291 basis points reached in early January when fixed income markets were convinced that a Fed tightening was imminent. Since then it gave back perhaps 20 basis points. Today the two-year note yield slipped to 0.83% while that on the 10-year note rose to 3.74%. The signal this sends off is once again that the Fed is either on the cusp of raising rates or that an imminent meltdown is fast-approaching.

At the depths of the still-fluid Greek fiscal crisis the yield on longer dated notes only fell to 3.55% and as the situation looks marginally less serious investors are turning to the discussion aired in Wednesday's FOMC minutes suggesting that members are eager to reduce the Fed's swollen balance sheet. In other words, despite its role as lender of last resort, it doesn't want to be left holding a bag of mortgage debt for ever.

Despite the broad discussions within the minutes about preparing for an early exit, the yield curve is facing the strain at the long end where March notes are off by 13 ticks at 117-08. Eurodollar futures are lower by no more than two basis points at far-dated maturities. Near maturities are not taking the talk of changes to policy with any seriousness. The June expiration contract is unchanged at 99.60 to imply a 0.4% yield, while the December contract at 99.04 still yields sub-1%.

A disappointing reading of weekly initial jobless claims earlier today reminds policy-watchers that the current pace of recovery remains slow and in itself argues against official policy changes from the FOMC.

European short futures - Bund futures are off by about 50 ticks at 123.02 and threatening a three-week old support line. Yields meanwhile picked up two basis points to 3.21%. The sensation is that additional demands from Eurozone area banks indicates the fragile nature of local recovery and is likely to hinder ECB ambitions to exit its own extraordinary policy initiatives.

British interest rate futures - Gilt prices fell sharply after the news that the January tax collection period fell short to leave the public sector in deficit at the largest pace in at least 16 years. The dire British public finances put additional strains on the government from twin directions. The shortfall implies weaker growth meaning that future revenues will stymie plans to reduce the deficit, while it also raises the amount the government will need to sell to fund the widening deficit.

The prospect of more issuance led investors to ditch government bonds with eth March contract down 59 ticks to 114.16 and at its weakest price in five weeks. Yields at the 10-year rose by three basis points to 4.06%. Conversely the shoddy state of the economy reinforced the view that short-term interest rates are heading nowhere fast leading to gains for short sterling with nearby maturities adding two basis points as yields fell commensurately.

Australian rate futures -Bond yields continued to rise in Australia where the benchmark 10-year rose in yield to 5.53%. Bill prices also eased further despite the abundant tightening already predicted. The Deputy Governor's comments that Chinese infrastructure plans are likely to benefit Australia through an increase in exports of minerals and metals served to underscore the fact that the Australian economy is distinctly in a recovery track.

Canada's 90-day BA's -Canadian futures moved in lockstep with U.S. monetary markets after the government reported a rise in inflation to a core 2% pace during January. This was higher than the 1.5% pace for December and reminds investors that the Bank of Canada has promised not to change its near-zero policy stance until the end of the second quarter -unless inflation changes.

Japan - JGB futures were unchanged after the BoJ announced no change to monetary or quantitative policy at its February meeting earlier today. 10-year yields stand at 1.305%.       

Andrew Wilkinson                                                                    

Senior Market Analyst