The intention of S&P's downgrade on the U.S. government was to scold it for its failure to address profligate spending and deliver sufficient revenues through taxation. Just look at any of Europe's debt-stricken economies to realize that under normal circumstances a ratings event can have catastrophic circumstances. But for the United States the unintended consequence, however, was a quarter-point reduction in the cost of borrowing in a single blow. Under its two now retired asset purchase plans the Fed spent $2.3 trillion muscling down bond market yields to spur lending. Nobody mentioned the positives of a downgrade. In the case of the U.S. apparently the impact of a single-notch downgrade equates to 25 basis points off 10-year rates. Just think how much firepower the Fed might have saved if it knew that a four-notch slide to an A+ rating could slice 1% off the yield curve!

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Eurodollar futures - Ten-year yields have retraced some of the earlier slide to 2.27% for the lowest reading since January 2009. Just to put the current move in to perspective, yields climaxed in the prior month to reach 2.04% as the financial crisis reached its crescendo. Bond prices eased somewhat as equity prices spent the first hour of trading holding on to significant gains and before the Federal Reserve makes its regularly scheduled policy statement. Many investors are hoping for the central bank to cast out another lifeline and are looking for concrete signs of more quantitative easing. In reality the central bank will point to recent pockets of positive economic news, already low yields, which would arguably mitigate much of any lead they might take to encourage borrowing and might even spin the positive impact of the U.S. credit-rating downgrade. The loss of a risk-free credit-rating crown would materially affect the economy only if treasury yields rise to reflect growing risks. As they haven't yet done so, we may yet consign S&P's view to the garbage truck especially should the other two major agencies stand by their affirmed ranking of U.S. sovereign debt.

European bond markets - The ECB waded in to purchase Italian and Spanish debt in the secondary market for a second day leading to a third session of gains for those governments' bonds. Yields compressed relative to German bunds where prices fell and yields rose as anxiety increasingly calmed as U.S. stock prices rebounded. The September German bund contract yesterday failed to breach Friday's high put in place ahead of central bank buying and more importantly before the U.S. employment report showed reasonably strong data. Euribor futures are lower by just a couple of ticks while the 10-year German yield rose by nine basis points to 2.35%.

British gilts - Short sterling prices firmed while other short ends around the world softened in response to amelioration in the stock market climate. September gilt futures nevertheless softened by 50 ticks to 128.79 as global long ends pared Monday's panic-induced gains. The British economy was dealt another blow in the form of weakening manufacturing data for June where both industry and factory output fell short of analysts' predictions. Trade data also showed a wider deficit symptomatic of a weakening trade picture associated with external slowdown. Although a rise in 10-year gilt yields to 3.68% contradicts the data, it has to be put in the context of the earlier decline to a record low for British yields.


Japanese bonds - Such is the exhaustion with panic selling of stocks that yields have fallen so far that additional supply is finding less buyers forcing investors to push yields back up. Tuesday's 40-year auction was twice-covered but that still marked the lowest bid-to-cover ratio in almost four years with sellers later forcing a 14.5 basis point increase in yields. The 10-year yield edged higher by four basis points to 1.04% after an opening slump in the Nikkei 225 of 4% was reduced to a closing loss of 1.5%. Adding to marginally weaker enthusiasm for fixed income despite the ugly external climate was a continued rebound for consumer confidence according to a report on Tuesday delivering an index reading of 37.0 and up from 35.3.

Australian bills - A second wave of selling following on from where exhausted Wall Street traders left off on Monday washed over Sydney as Tuesday broke. Australian fixed income markets last week moved decisively into monetary easing mode with futures hinting strongly at guaranteed rate reductions out of the Reserve Bank. But the scale of reductions implied by futures contracts is perhaps even more violent than the stock market selloff. The current short-term policy setting at the RBA of 4.75% has been discounted by bill traders to 3.86% by year-end. However, at the most panic-stricken moment the contract reached an implied low at 3.51% implying five quarter-point reductions in short-term policy over just three more meetings. Do the math and you'll conclude that the market is looking for the central bank to either slash policy or engage in an emergency inter-meeting move. Government bond yields tumbled overnight to 4.41% before backing up in line with a general malaise ahead of the Fed's afternoon statement.

Canadian bills -Canadian bill futures also saw wild and furious trading ranges, although less so than seen in Sydney. Until last month's policy meeting many investors had been expecting the Bank of Canada to resume raising interest rates. But a weaker U.S. economy and a slide in global confidence has put the shoe on the other foot with dealers fully expecting the central bank to move towards easing. In the space of two weeks the December bill futures contract has shifted from implying a three-month yield of 1.50% to discounting a cut from the 1.00% policy-rate to 0.78%. Yield declines were arrested earlier in the session following a rebound for stock prices and a stronger-than-forecast reading for housing starts in July. The report showed work began on an annualized 205,100 dwellings last month and exceeding the June pace of 196,600 homes. Bill futures swooned by 11 basis points in response to the rapidly changing credit climate on Tuesday while benchmark government bond prices fell sending cash yields higher by three pips to 2.51%.

Andrew Wilkinson

Senior Market Analyst       

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