An earlier rally for fixed income fuelled by weak growth and output data faded as equity investors proved a resilient bunch on Tuesday. There were blatant signs of worry sounding from central bankers in Britain and Australia as they warned about the potential for dislocation stemming from fragile financial markets. Although such worries might be warranted, investors seem to be of the belief that having stood the strain of last week, perhaps we're already beyond the point of maximum stress.

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Eurodollar futures - July housing starts dipped from a downwardly revised June number to a 604,000 annualized pace. Meanwhile the forward-looking picture did little to spur hopes for a sustained recovery as building permits also eased to 597,000. The housing market along with its bloated inventory overhang continues to feel the currents buffeting it around the ocean floor. September treasury futures remain afloat after yields rose Monday when equities advanced. Currently, equity prices are erasing earlier losses but bond buyers can't help advance prices to shave three pips off the 10-year yield to 2.27%. Industrial output snapped back during July as factories increased production as the supply-chains came back online in the aftermath of the Japanese earthquake. Remarkably hot weather also boosted energy production across the nation leading to a monthly gain in industrial production of 0.9% and so almost twice the predicted pace. Capacity utilization also strengthened to 77.5% from 76.9% of overall capacity.

European bond markets - German bunds remain higher but are off the day's best levels with the yield declining by just one basis point to 2.31%. Both German and Eurozone second-quarter gross domestic product sadly lacked the vim and vigor of the previous quarter and was greeted by jaw-dropping disappointment by investors who were quick to sell out of short-term gains in equities and clutch at the safety of government bonds. Later in the day the ECB appeared to be at work lifting Italian and Spanish government debt in the secondary market and providing a silver lining to the day's trading. The GDP data poses questions at Tuesday's Merkel-Sarkozy meeting in Paris. Most would like the pair to announce a joint initiative to pave a revolution for European government financing along the lines of mutual guarantees for joint issues of Eurobonds. Both nations have previously rejected such moves and it's unlikely that last week's now-subsided volatility will force them to undergo a change of mind. According to French Finance Minister Baroin the two will discuss how to expand the coordination of national policies and tightening of budget rules within the euro-area.

British gilts - An unchanged reading for consumer prices between months forced the annual pace of increase higher to 4.2% and more than twice the government's target rate. The Bank of England Governor continues to write explanatory notes to the Chancellor of the Exchequer outlining why government policy is behind the increase in the cost of living and admitting that short of raising monetary policy and creating a recession, there's nothing left for its to do at this point except mull the potential for further asset purchases. Some onlookers fear that embarking on a second wave in Britain could only fuel a further increase in inflationary pressures. Short sterling prices gave up some more of its recent gains, but the strip has a positive slope of less than 25 basis points between September 2011 and March 2013. Gilt futures expiring September fell and the only major market facing a loss today as the benchmark 10-year yield rose by one pip to 2.545%.

Japanese bonds - Former Finance Minister Sakakibara's prediction that the Japanese yen will continue to rally is hard to contend and is perhaps even insulated against policy initiatives that would deal with Japan's own stagnant economy. He suggests that the yen's appreciation is simply a matter of time and although he supports further currency intervention he says it must be sustained and of a massive scale to be at all successful. Sakakibara does offer other remedial policy initiatives and suggests further "massive" fiscal stimulus coupled with a "considerable amount of quantitative easing." He also suggests underwriting of the huge amount of government bonds in circulation to aid confidence in financial markets, which should help the economy. Yields on government bonds were unmoved by the day's events and closed at an unchanged 1.032%.

Australian bills - Having tried to come back to earth each time equity investors attempt to rouse confidence, Aussie bill prices took off once again sending implied yields in search of probably monetary easing later in the year. Bill yields dipped by as much as 14 basis points along the curve after the Reserve Bank released minutes from its early August meeting. Policymakers decided that the financial market turmoil meant that they certainly shouldn't serve up a rate increase given that the potential for dislocation was more likely than not to cause domestic demand to undershoot its general forecast. Interest rate markets predict with full certainty that the Reserve Bank will slash 50 basis points off its short-term rate of interest by its October meeting. Aussie government bond prices advanced sending the 10-year yield lower by seven pips to 4.47%.

Canadian bills - September government bond prices advanced by 32 ticks lowering the yield to 2.46%. The premium over Washington has recently expanded to 19 basis points as demand for U.S. debt remains elevated. Manufacturing sales data was sorely disappointing on Tuesday with the volume of July sales of C$45.3 billion the lowest reading since November 2010. Implied yields on 90-day money nevertheless inched higher as bill prices moved marginally lower.

Andrew Wilkinson

Senior Market Analyst       

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