Thursday November 19, 2009

Interest rate futures are higher across the globe as investors continue to tread further and further down the seemingly endless red carpet rolled out by global central banks. Recent accentuation by various political and monetary chiefs confirming the period of low rates is practically a permanent fixture in the global house of cards is again a key factor today. With jobless claims in the U.S. coming in at an in-line 505,000 reading bond and short term yields continue to heed the words of central banks as interest rate yield curves flatten out.

An OECD report overnight predicts firmer growth than at the time of its previous June survey but still expects no change in Fed or ECB policy until one year from now. The OECD forecasts growth across its leading 30-member nations will be 1.9% next year and 2.5% in 2011. Underscoring the impact of the healing banking crisis is the fact that they don't predict the pace of growth last seen during the first quarter of 2008 until the third quarter of 2011.

The OECD predicts U.S. growth of 2.5% in 2010 revised from 0.9% growth while Eurozone growth is no longer expected to contract; rather it will rise by 0.9%. The Asian region, which was last-in-and-first-out of recession is expected to become a global growth driver with Japan expected to grow by 1.8% next year and China returning to a pre-crisis double-digit advance of 10.2%.

Its forecast compounds the recent softening of yields across the world, but comes with a warning to central bankers to go easy with monetary policy on account of sluggish growth. The report echoes the words heard from British and American central bank governors who have referred to heavy spare capacity and rising unemployment as reasons not to remove stimulus measures.

What we thought might be an interesting exercise in today's report is to look at the yield spread between the European and U.S. rate futures give the OECD's projected path of monetary policy. It says that the both Fed and ECB will start to lift monetary policy a year from now - the Fed from almost zero, and the ECB from 1%. The ECB will double its short rate to 2% while the Federal Reserve will move its policy stance to 2.5%.

In other words U.S. rates are expected to cut above European rates. In futures terms the price of Eurodollars should be priced lower than euribor. The current expectation, however, reflected in the December 2010 contract is that euro rates will be at 1.71% and U.S. rates will be at 1.16%. That means the current spread is 55 basis points. But the December 2011 contract shows a similar structure, admittedly with the spread having narrowed sharply to just 16 basis points. If you believe the OECD's predictions and formula for the extent of relative monetary tightening, the spread is mispriced with the 2011 Eurodollar future priced higher (lower yield) than the comparable euribor contract.


Eurodollar futures are higher once again today following the initial jobless claims reading, which remained above 500,000. The amelioration in the jobs market continues to prove glacial and in an environment of declining global equity prices yields have further softened today. The March future today yields 0.34% and is down from 0.5% as of November 4. Meanwhile the curve continues to flatten as far-dated contracts rise faster. The December 2009/December 2010 futures spread is once again below 90 basis points for the first time in six months. The 2/10s curve continues to widen out as the 10-year treasury note treads water, trapped by conflicting forces of an extended pause in monetary policy and massive supply demands as the government borrows ever more cash to deal with the problem. The 10-year currently yields 3.35%.

British rate futures rose in price as yields continued to decline on account of the resurfacing of possible bad news for the banking sector. An executive at credit-checking company, Experian Plc doubts that we have seen the last of credit losses across the banking sector and has a dismal view of the health of British banks, calling them the worst in the world. Short sterling futures faced the headwinds of a strong retail sales report for October where a 0.4% rise was accompanied by a revision to September's report resulting in a 3.4% annualized pace of growth among retailers. This data may impact the third quarter growth reading for the economy as a whole. However, this report in isolation doesn't stand up well in the face of sickly equity markets in Asia and Europe today. Finally, gilt yields were higher after the worst October reading for public sector debt since records began in 1993.

European interest rate futures are higher in concert with global yield declines. The market-friendly comments from Juncker suggest that exit strategies are a non-starter for 2010 as they would pose a recovery threat according to the finance minister. The December 2010 euribor future carries a yield of 1.69% down from 2% at the end of October.

Australian rate futures added to gains made since the RBA sounded less hawkish on monetary policy in minutes from the November meeting. The December 2010 90-day contract is at its session high of 94.60 implying a lower yield today of 5.40%. That compares to a yield of 5.75% at the end of October - so you can see the magnitude of the recent shift.

The Canadian yield curve continues to flatten with deferred contracts making all the running. 90-day bills of acceptance (BA's) are trading up one basis point at the front end but five or six out at the September strip and beyond.

Andrew Wilkinson

Senior Market Analyst