Deficit worries on either side of the Atlantic continued to spook investors midweek. There's apparently still not enough room for U.S. lawmakers to maneuver beneath an already dizzying $14.3 trillion U.S. deficit ceiling while investors looking over last week's clever rewriting by EU leaders of how to prevent the imminent collapse of a regional sovereignty have found some flaws in the works. Stocks are sliding once again while bond prices have used the opportunity to take another leg-higher, except in the U.S. where dealers have to be satisfied with a standstill for bond yields.

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Eurodollar futures - It remains hard to say whose the least unappealing battle is. The Obama versus Boehner epic continues to play out with each party leader trying repeatedly to bash his head hardest against the stone wall. Meanwhile, just when European leaders had collectively tied the knot at an EU summit last week agreeing to stand by each other for better or for worse, the newlyweds have already started bickering over the vows. Failure to agree ahead of an August 2 deadline on extending the debt ceiling will result in a potentially costly downgrade for the AAA-debt rating of the U.S. Trading in Eurodollar futures was nevertheless nonchalant and futures prices only eased by two ticks, while the yield on the 10-year treasury note stood at an unchanged 2.95% by lunchtime in New York. At the start of the week the yield rose to 3.05% as fears of default loomed.

European bond markets - German bunds surged on Wednesday after its Finance Minister Schaeuble spelled out to lawmakers the German interpretation of precisely what enhancements were agreed to in terms of the bailout fund. Investors were treated last week to news that the €440 billion fund could be used to buy bonds of debt-laden governments across the region. German Chancellor Merkel indicated following the summit that this meant under strict circumstances. It seems that the Schaeuble letter today has opened up a deep division across Europe at least in terms of revealing to investors that the marriage over which they were always skeptical over is predictably again on the rocks. The September bund future surged by more than a full point to 129.48 at the daily peak lowering the cash yield by a whopping 10-basis points to 2.64%, while yields on the region's peripheral nations' debt jumped by as much as spreads started to widen again. Euribor futures made gains as tensions rose around the Eurozone with implied yields slumping by seven basis points as dealers ponder how long the ECB will be able to stand by its policy of tightening monetary policy as the potential for a growth-damaging sovereign default rises.

 

British gilts - The yield curve edged lower supported by the fallout in the Eurozone, while further evidence of economic pessimism was served up in a retail trade survey indicating a bleak outlook by store operators. September gilt futures surged by around one full point to 123.94 lowering the 10-year cash yield by nine basis points to 2.97% following a slump in retailers' optimism during July. Respondents turned bearish on the outlook for sales with the balance of sellers turning the index in to negative territory to read negative 16 following a positive June return of 16. Short sterling futures moved higher sending implied yields lower as the yield curve continued to narrow by around seven basis points.

 

Australian bills -Aussie bill prices slumped in response to a report that some dealers fear will force the central bank to pick up the monetary reins and further tighten policy as the year progresses. The quarterly consumer prices index rose by 0.9% during the three months ending June to a yearly pace of 3.6% and faster than the 3.3% pace in the first quarter of the year. Clothing costs rose at the time by the most in three years, while transport costs rose to a three-year high. Food costs have risen for three consecutive quarters prompted largely by crop shortages following earlier devastating cyclones and flooding. The government dumbed down the report saying that agricultural output would eventually rebound and would alleviate tightening import prices. Interest rate traders were not in compromising mood especially as confidence in a global growth rebound appeared to be on the rise. Bill futures slumped by close to 20 basis points along the strip as borrowers locked in to a yield structure forecasting lower rates ahead. Likewise the yields on two-year government debt rose by 12 basis points to 4.49% for the biggest increase in five months, while 10-year bonds fell sending the yield up by one basis point to 4.93%.

 

Canadian bills - Bill futures moved in the opposite direction to Eurodollar futures following a report showing weakness in durable goods orders in the United States and Canada's largest export haven. Rising concerns for the health of the global economy in the face of political gridlock in Washington and fallout from European sovereign debt concerns pushed thoughts of a Bank of Canada interest rate increase off in to the sunset.       

Japanese bonds - Japanese fixed income buyers refused to unload bonds again overnight despite a rebound in optimism among small businesses. An index of confidence rose but failed to dent demand for government paper in light of further upwards pressure on the Japanese yen. The potential for economic weakness among manufacturers and exporters from a strengthening yen weighed heavily especially at the Bank of Japan, where an official hinted at a proactive response to currency appreciation. The 10-year government yield fell by a single basis point to remain close to the lowest point of the year at 1.078%.

Andrew Wilkinson

Senior Market Analyst ibanalyst@interactivebrokers.com       

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