Thursday, February 25, 2010

Rising risk aversion caused by a threatened downgrade to the sovereign status of Greek debt sent the yield on 10-year German bunds to a cycle low of 3.10% today. Meanwhile the spread between German and Greek maturities widened out 14 basis points to 352 basis points while yields at the two-year Greek maturity shot up like a rocket to 6.28%. The daily change was a surge of 61 basis points. Growing global risk aversion contrasts with a firmer tone from Fed Chairman Ben Bernanke who spoke of the nascent U.S. recovery. His continued use of the extended period phrase in reference to easy monetary policy provoked a gentler sloping yield curve as buyers locked into declining yields across all maturities.


Eurodollar futures - In addition to the soothing nature of Mr. Bernanke's words, a slump in new home sales and a decline in mortgage lending attracted Eurodollar buyers in the belief that there are unlikely to be any near or even medium term changes to short term interest rates. The spread mapping the gradient of the one-year curve starting next month eased to 90 basis points today with a four basis point rally for the March 2011 contract comparing to a two basis point rally in the contract expiring next month. The flattening nature of the spread compares to a far steeper 160 basis point curve evident at the turn of the year.

March treasury notes added a further half point to 118-16 this morning as demand for the relative safety of U.S. government debt continues to rebound from lows seen last Friday when the 10-year yield spiked to 3.90%. The rally today has sent the yield down to 3.63% as global risk aversion manifests itself in triple digit losses for the Dow industrials index.

Initial jobless claims data reported on Thursday indicated deterioration in the labor market with claims through last Saturday uncomfortably close to 500,000. The market has become accustomed to a gradual improvement in this data series, which has foreshadowed an underlying improvement in job creation. Unless this week's data is well and truly accounted for by an administrative backlog on account of adverse weather-related conditions, the economy just took a step backwards and one that's uncomfortably consistent with the reported downturn in consumer confidence by the Conference Board.

European short futures - Euroland market action continues to react to the ticking time bombs of peripheral European governments. When Standard & Poors rating agency announced overnight that it might further downgrade the long term credit rating of Greece before the end of March, investors plundered the domestic bond market and sent investors scurrying for the relative safety of core German bunds. The March bund contract is currently higher by 22 ticks to 124.23 driving prices are following through on.

Euribor futures continue to push to new highs as the cash curve slips and investors consider the double-whammy being served up. Ongoing fiscal austerity will slow Eurozone demand, while making the ECB's retreat from ultra low interest rates ever harder. As bond yields push lower investors may yet consider how the monetary-fiscal mix is now creating tighter conditions that could conceivably provoke calls for further monetary relaxation from the ECB. The official policy rate is still at twice the interest rate in the U.K. and four times that of the U.S.

British interest rate futures - The British yield curve continues to flatten following official color on the hapless state of the domestic economy with its downside risks. And while the pound is also falling investors continue to assume low interest rates will remain in place for the months ahead.

Next week represents the one-year anniversary of the Bank of England's final half point cut to leave its bank rate at 0.5%. At that time the March 2011 future reached a peak implying that rates would rise sharply over the next two years through expiration. The implied yield that day reached 2.67% indicating a strong degree of optimism that monetary policy would heal the economy looking forward. Indeed it was not until October 2009 that the March contract traded at a lower implied yield as slowing growth rekindled doubts that interest rates would be lifted. Since then and with the exception of a hiccup at the start of 2010 the March contract has moved higher at a 45 degree angle as implied yields slip.

Today March 2011 contract is priced at 98.58 and still implies a yield of 1.42% but it does illustrate the ongoing reining in of expectations over the future course of monetary policy. The March 2010/ March 2011 calendar spread has halved from 150 basis points on January 21 to 75 basis points today. That's a major flattening of interest rate expectations especially against the backdrop of ongoing chatter about the neck brace the government finds itself in over Britain's comparable debt burden.

Australian rate futures -A jump in the value of the Japanese yen knocked confidence in exporters share prices and added to already broadly weaker stock market prices as risk aversion mounted. Australian government bond prices continued to rise as regional stocks fell. The 10-year note slipped to 5.48% while shorter term bill futures ticked marginally higher ahead of next week's RBA meeting. The December contract has a huge range of 95.26 seen after the RBA unexpectedly left rates unchanged and a low of 94.87 when the subsequently released minutes revealed more rate increases on the cards. Today the contract is trading at 95.04 implying a yield of 4.96% by the end of this year.

Canada's 90-day BA's - The 10-year Canadian yield continues to shadow comparable 10-year U.S> treasuries with the yield on the decline by five basis points today to 3.39%. Bill prices gained by five basis points with the June10/ Jun11 calendar spread at 142 basis points today, which compares to a 120 bp spread for the equivalent Eurodollar spread.

Japan - Weakness in regional stocks saw government bond yields sink to a seven week low at 1.28%. Next week brings news on consumer prices, expected to show ongoing deflation.

Andrew Wilkinson

Senior Market Analyst