More fears gripped investors on Wednesday as a second-look at the tone of the message from the FOMC the day before raised doubts over the economic recovery. Some suggest that the next stop will be a recession that central bankers appear powerless to prevent. A slide in French banking stocks amid wild rumors over the possible insolvency of a big name also boosted the appeal of government debt around the world, dragging financial shares lower on the way. Investors can't be blamed in this environment for thinking that they were given some kind of wonder-drug when the authorities embarked on asset purchase plans. Only now, as the effects wear thin, the worrisome financial pain appears to have never gone away.

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Eurodollar futures - Traders fell over themselves in a rush to flatten the yield curve after the Fed warned on the "considerably slower" pace of recovery saying it was "prepared to employ" additional tools to bolster the recovery. At the heart of the flattening was the change in its statement wording in which it dropped its "extended period" language adopting instead a defined period of "at least two-years." Implied yields on Eurodollar futures contracts dropped like a stone with maturities through March 2013 (19 months forward) are now beneath 0.5% compared to a current reading of three-month Libor of 0.25%. The two-10-year spread also flattened hugely with the gradient of the curve falling below 200 basis points (2%) for the first time since October and ahead of the expected second round of quantitative easing. At the end of trading in July, less than two weeks ago, the curve was trading with a gradient of 250 basis points. Immediately after the Fed's statement on Tuesday buyers locking into surging 10-year note prices drove the yield down to 2.04% matching its low point in December 2008 and shortly after the failure of Lehman Brothers just months before. That event was widely blamed as the straw that broke the camel's back tipping a shocked global economy into outright recession.

European bond markets - Weakness in a French summertime reading of industrial output helped light the fire beneath a rally for government bonds before rumors of a major financial insolvency among the top-ranking French names created mayhem. Banking shares across Europe tumbled and the German bund emerged as the savior of the day. The September contract advanced by almost two full points easily clearing Friday's panic-high. The surge in prices drove down the yield on the 10-year benchmark by 15 basis points and through resistance to stand at 2.21%. Such is the ongoing state of nervousness in the Eurozone that interest rate traders have started to think that at least some of the ECB's two recent monetary adjustments to its short rate will come undone. At the start of August swaps rates implied a 25 basis point rise in short rates. Just over a week later, that view has changed markedly with the market currently implying a 31 basis point reduction in short-rates over the coming 12 months. Euribor futures are surging in London again with implied yields shedding a full quarter point as any and all of the fears associated with the financial crisis from yesteryear re-emerge.

British gilts - A downside revision to British growth for 2012 at 2% still looks mightily optimistic, which possibly explains a strong performance for the September gilt contract. The Bank of England in its quarterly report shaved 0.5% off next year's growth rate and warned that inflation in the near-term might yet reach 5% further squeezing household finances. It also predicted that in the medium-term inflation would fall below target, justifying its maintenance of its 0.5% short-rate. Monetary policy can't deliver all the goods necessary to restore growth claimed Governor King. Short sterling prices jumped by 20 basis points at deferred maturities, while nearby contracts saw implied yields dip by half as much.

Japanese bonds - Upside pressure on the yen maintained downside pressure on Japanese yields as traders wondered whether the Bank of Japan might follow the Fed's lead in announcing a point in time through at least which it would maintain a zero interest rate. There are growing expectations that the Bank might also intervene for the second time in a week as the yen squeezes the recovery. September JGB futures added 11 ticks to trade at 142.24 sending the yield back down to 1%. An index of activity within the services industry rose 1.9% in June and twice as fast as the prior month.

Australian bills -Bond buyers showed signs of fatigue at an auction of 10-year government bonds midweek with the bid-to-cover ratio drying up to just 1.7-times. The June 21 auction drew bids worth 3.25-times the bonds on issue that day, admittedly at far higher yields. Cash bonds rose by the end of the day with the yield slipping by four basis points to 4.48%. An index of consumer confidence reinforced a worrying domestic situation falling to a two-year low. The Westpac confidence reading slid to 89.6 as global panic warms up. Bill prices added a further 10 basis points with the March 2012 maturity depicting the trough for rates at 3.61% depicting monetary relaxation of more than 1% before then.

Canadian bills - Canadian fixed-income traders trying to keep a finger on the pulse of the American economy had a hard time locating the pulse after the FOMC statement. As the nation's largest export market, what happens in the world's largest economy is critical to Canadian manufacturers. The slide in treasury yields was mimicked by the move in Canadian government bonds, but managed a yield decline of just 11 basis points Wednesday. The two-day outperformance of treasuries has cracked open the gap between the 10-year yields forcing those south of the border 15 basis points lower than on those of Canada. The September government bond future added 62 ticks by lunchtime sending the yield down to 2.34% compared to a 2.15% reading on the U.S. issue.

Andrew Wilkinson

Senior Market Analyst       

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