Despite the evident whiff of risk-aversion in the markets on Tuesday, government bond yields are edging higher, while short interest rate futures are making price gains allowing implied yields to creep lower. The market remains spellbound by what the Federal Reserve has to say about the health of the world's largest economy this afternoon. In particular investors are clamoring to hear whether the central bank intends to further stimulate the economy now or later.


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Eurodollar futures - Two months ago the FOMC was debating its exit strategy having almost tripled the size of its balance sheet from a pre-recession value of $900 billion. Last month its members were short on ideas - as if no one had turned up prepared enough to propose what to do about the slowing pace of expansion. Subsequently interest rate futures have shifted the odds of an unchanged policy through August 2011 from one-in-five at the time to those of a coin toss. Admittedly those swirling expectations surrounding whether or not the FOMC will promise to buy more mortgage-backed and treasury bonds have come down in the past 48 hours. Investors have to an extent cooled their expectations as sense prevails over the extent of the slowdown. By the time the July jobs report showed up on Friday expectations for fresh measures had peaked. But bonds did their trick and yields have largely stayed near record lows. Ahead of today's meeting the September treasury note future is marginally lower at 124-13 carrying a yield of 2.83%. Far-dated Eurodollar futures have erased minor gains and are nursing losses of a couple of basis points. Heading into the meeting the two-to-ten yield curve spread is towards a recent low at 226 basis points.

Canadian bills - The premium commanded by investors to own Canadian government bonds rather than U.S. 10-year treasuries widened out to 25 basis points while the shorter end of the Canadian curve looks largely unchanged this morning.

Japanese bonds - The Bank of Japan left interest rates unchanged and failed to announce any further stimulus measures when it concluded its monthly meeting today. Even though a rise in the yen is likely keeping up pressure on the export market, a recovery in the general economy has remained in place for around a year. Faced with few choices on how to coerce lenders to fulfill their basic function, the Bank of Japan is clearly in wait-and-see mode. Yields continued to rise away from a recent seven-year low today although some dealers may have sold bonds ahead of an auction of a chunk of five-year bonds this week, clearing the decks in anticipation of feasting on a fresh tranche of debt. The 10-year yield closed up a couple of pips at 1.02%.

European bond markets - Spreads widened over those on German bunds today after the Irish government was granted EC permission to infuse another €10 billion into one of its ailing banks. The health of the Irish financial sector has been flashing red for some time and today's reminder may have sparked residual fears across peripheral nations. Italian and Spanish government debt prices fell causing the spread over bunds to widen by five basis points as German borrowing costs also rose. The Irish spread widened almost three times that pace.

British gilts -A couple of pieces of softer economic data provoked a minor softening for yields at the shorter end of the British yield curve while investors appear to be selling September gilts and banking gains on a recent healthy run higher for the contract. September gilt futures are lower by 21 ticks to stand at 122.25, while short sterling futures prices have gained two basis points. The BRC retail sales survey for July found it a tall order to repeat a healthy pace of growth for same-store sales over the earlier part of the summer. Today's pace was always bound to disappoint while a RICS survey indicated an unexpected dip in house prices for the first time in 14 months.

Australian bills - Investors continue to eye Australian yields, which offer a 225 basis point carry over and above U.S. treasuries. Yields at the 10-year slipped by another basis point to 5.08% as investors took Chinese data as a sign of further slowdown in Australia's biggest export market. A bank survey of business conditions and confidence indicated that recent monetary policy ambitions at the RBA have done their trick leading investors to raise the question of whether the RBA is now at the top of its game and fully in a neutral stance. Bill prices for three-month money made gains of a couple of basis points.

Andrew Wilkinson

Senior Market Analyst       

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