Long ends continue to advance despite surge in retail sales

Monday November 16, 2009

While the treasury market bias was already tipped towards lower yields ahead of a key reading of U.S. retail sales, the unexpected monthly 1.4% jump was marred by an ugly revision to September data and highlighted the pocket of strength within auto sales. The price on the 10-year U.S. treasury note remains around six ticks higher with lower yields today coming in at 3.39%.

The trend towards lower long-end yields is already translated into other global bond markets today with German bund rising 50 basis points to leave its yield at a basis point discount to American yields.

Investors were swift to discount consumer strength. Despite a blip higher in the value of the dollar against the euro, the foundation of the stronger data is to be found in a further jump in auto-related business. Without auto-sales the data showed just a 0.4% rebound, which looks especially anemic in the aftermath of a revised September report, which now shows a decline of 2.3% rather than the original estimate of 1.5%. It would be difficult to expect treasury prices to respond negatively given today's data reading especially in light of continuing increases in the number of workers losing their jobs, albeit at a slower pace.

Analysts will pore over inherent weaknesses in Monday's retail sales data, which showed a 0.8% decline in furniture sales, a 2.4% drop in the value of building material and garden supplies and a 0.6% fall in sales at electronic and appliance store sales.

Eurodollar futures whose prices reflect market expectation for where cash rates are expected to trade across the time horizon were largely unchanged on the session but are higher by a half to one-and-a-half ticks. The December contract is unchanged at 99.72 implying a three-month cash rate of 0.28%. The December 2010 contract is up a tick at 98.66 implying three month cash rates will rise to 1.34% before the end of next year. The spread between the two contracts, which illustrates the magnitude of potential monetary tightening - at least in money traders' eyes - has narrowed from 140 basis points (1.4%) during the last three weeks.

British gilt prices rose after data showed that Britons accepted lower buying offers on homes in October for the first time in three months. The report conflicts with last week's Royal Institute of Chartered Surveyors (RICS) scorecard, which gave a healthier report card on the number of surveyors reporting rising as opposed to declining residential prices across England and Wales. The 10-year U.K. government gilt yield stood at 3.75% this morning while the price of deferred short sterling contracts rose by four basis points - yields fell. The December 2009 contract is trading at an unchanged price of 99.36 and implied cash rates of 0.64% by year end. The same contract expiring in December 2010 yields 2.08% and implies a far-sharper rise in British rates compared to U.S. rates, despite the appearance of an economy mired in recession. Last week the Bank of England created a softening in expectations surrounding higher yields anytime soon, when its Quarterly Inflation Report showed that inflation is set to remain low if not static over a three-year time horizon.

European interest rate futures were higher in price and so slightly lower in yield terms. No one is expecting any move from the ECB in the near term although it has raised a red flag in terms of denying the market a rollover of a massive amount of one-year loans made in last December. The move marks a removal of the crowd barriers in terms of the end of quantitative easing. As the credit markets have eased the ECB feels that it no longer needs to act as a rationing mechanism and that banks can fund their own liabilities far easier in the current recovery.

December euribor trading on LIFFE is unchanged at 99.27 and so implies a three-month cash yield of 0.73%. There is a one percent (100 basis points) differential between the near and 2010 expiration contract, showing that while the ECB might lift lending rates next year it will do so at a calmer pace than the Bank of England is expected to.

Australian rate futures also joined in the easier money tone today, despite the fact that the Reserve bank of Australia is actively engaged in a monetary tightening process. The half percent increase enacted over October and November has so far lifted the Australian benchmark rate to 3.5% with dealers overwhelmingly predicting that the December 1 meeting will result in a further 25 basis point rise. However, whenever rate futures trade on the defensive during a rate rising cycle, they often overstate the likely movement from the central bank. And so today's respite is the result of dealers gently reining in some of their perhaps excessive expectations. In the following chart you can see how interest rate expectations continue to improve from a month ago when investors were braced for the November hike. When it was delivered, the RBA was a little softer in its tone.


The December 2009 Aussie bills traded up two ticks to 95.86 implying a year-end cash rate of 4.14%, which as you can see easily fattens the premium over the key benchmark. March and June contracts enjoyed stronger price rallies as investors pared back their fears over higher cash prices, with yields falling by six basis points to 4.61% for March and 5.09% for June. The Aussie dollar continued to rise after strong Japanese growth highlighted regional recovery, but clearly the impetus in the current environment does not serve to boost additional interest rate increase expectations from the RBA.

Canadian bills of acceptance (BA's) are flat to higher in price and so show marginally lower yields in line with Eurodollar futures. Being America's largest trading partner, its fortunes are partially determined by a return of demand abroad. However, the Canadian economy also thrives on its role as a commodity-rich nation whose fortunes are favored abroad at a time when demand for metals and minerals is on the increase. Currency strength is a hazardous by-product of being a commodity dollar and the economy does display signs of tiring on account of a rising currency. Canadian government bond yields stand at 3.45% today and are higher in tandem with other global bonds. Yields on bill futures at the short end imply a 0.44% year end rate with the one-year spread through December 2010 reading 125 basis points.

Andrew Wilkinson

Senior Market Analyst