Friday December 4, 2009

Perhaps more important than today's extremely positive labor market reading are Thursday's words from St. Louis Federal Reserve Bank President James Bullard in an interview with Dow Jones newswires. He pulled the rug from beneath the conventional wisdom that the Fed has never raised interest rates when economy is losing jobs. His point: If this is truly a jobless recovery then conventional wisdom has to be thrown out of the window and we just better had get used to it. Labor market data is but one piece of the jigsaw puzzle in setting monetary policy and when it comes to raising rates it is lower on the data scorecard when jobs are being added. When lowering interest rates, job losses mean that its impact climbs the Fed's ladder of importance pretty quickly.

So the shockingly good reading of just 11,000 job losses for November provides Mr. Bullard's voice with a megaphone in calling on the Fed to start thinking about interest rate increases in 2010. And the report was no fluke either. Earlier, a rude report from north of the border saw a huge expansion in Canadian payrolls. The 79,100 reading was more than five times the anticipated reading of 15,000 jobs. Moreover, more than twice that number (38,000) were in full time positions.

Compounding today's U.S. report was a drop in the rate of unemployment to 10% from 10.2% along with backward revisions to September and October data, which means that 159,000 fewer jobs were lost than previously thought. The initial reading from October was the loss of 190,000 jobs and that decline was revised to 111,000. As far as American confidence is concerned, this data is extremely welcome. It does, however, not sit well with the ISM services sector report of the day before, which indicated a sudden reversal of gear from a two-month expansion to a contraction.

Eurodollar futures have the bears rolling in honey today! While the nearby December contract is just a couple of basis points richer since there is zero chance of a near-term hike in rates at the Fed, the deferred contracts are nursing price losses of between 10-20 basis points meaning we're watching a seismic shift in interest rate expectations. The yield curve continues to steepen as further-dated maturities face larger implied losses. The yield at the December 2010 Eurodollar contract has added 19 basis point in yield and stands at 1.37%. This is a 30 basis point shift in expectations since midweek. The Dec2009/Dec2010 spread has widened out from less than 90 basis points earlier in the week to 111 basis points as investors attempt to lock-down yields as the curve reverses its earlier fear-based flattening process on account of Dubai. 10-year note futures are lower by just under one point with the March contract trading at 117-27. The price touched 120-00 earlier in the week and yields have risen on the day to 3.48%, which again is a dramatic move when you consider that just a week ago yields slipped below 3.17% based on fallout from Dubai. The 2s/10s spread is stable at 263 basis points.

European short futures - The North American labor market reports are also impacting sentiment towards European rates, where futures had spent a quiet morning rebounding from Thursday's ECB commentary. They had been a little less under the gun with friendly comments from Trichet and Weber indicating that there was no need to signal rate strategy changes yet. In addition ECB forecasts predict low consumer price inflation over the next two years and substantially below the 2% goal. So it was time to make some light euribor price gains. However, the slide in Eurodollar futures spared no market as selling emerged and borrowers are keen to lock into rising borrowing costs. The spread between European and American rates narrowed today as the European rate futures sold off at about half the pace the Eurodollar complex did. The December 2010 contract rose by 10 basis points in yield terms to 1.86%. Bunds slipped 63 ticks to yield 3.24% - up seven basis points.

British interest rate futures suffered a similar fate as euribor as heavy selling pressures emerged. The British economy closely monitors events in the United States and its banking system is under a great deal of strain as a result of its exposure to writedowns. That makes the recovery process all the more arduous but you can bet your bottom dollar that a shift in global interest rate expectations won't bypass the United Kingdom. The yield on the June 2010 contract rose to its highest in three weeks to 1.02% as rate expectations rose. Gilts rose seven basis points in yield to 3.69%.

Australian rate futures were already falling as yields rose. The losses in price terms were between three and 10 basis points. The September contract, where investors expect interest rates to have peaked, rose in implied yield to 5.06%. 10-year bonds rose three basis points to yield 5.36%.

Canada's 90-day BA's took a double-shellacking today after domestic employment rose sharply followed an hour later by the U.S. jobs report. Rate expectations shifted significantly. While investors still hold the Bank of Canada to its word that policy will remain constant through the second quarter of next year, we feel compelled to pull a Bullard-style question here. How long will investors anchor this perception? Surely the BoC is at liberty to revise its timeline at some point and bring forth its timing. That means that the March contract could be at the mercy of tighter cash market prices at any point soon and that its stable 99.52 price (yield of 0.48%) is significantly at risk of downwards revision (up for yields). The June contract has already lost seven ticks today sending yields higher to 0.69%. 10-year Canadian bond futures are down in price by 67 ticks to yield 3.31% and again widening the spread between Canada and the U.S. to 18 basis points in favor of treasuries.

Andrew Wilkinson

Senior Market Analyst