Investors are taking a three-pronged approach in responding to the fast flaring sovereign debt crisis in Europe. It would seem that mounting fiscal deficits at both United States state and federal level have been downgraded to side show status as the new daredevil high-wire act under the Eurozone big top draws a crowd almost hungry for blood.
Step one is to sell equities as investors discount a lower plateau for economic growth if governments need to raise revenue and restrain spending, thus hampering the recovery.
Step two is to either protect previously bought holdings of higher yielding sovereign debt through credit default swaps. Today the cost of protecting Portuguese and Spanish government debt is again on the increase as CDS rates widen out.
Step three is to buy “safer” government bonds, which is what’s driving yields on American and German 10-year notes and bunds lower again today.
Once all of these steps are in place the entire global slowdown and market meltdown scenario is intact leading to all manner of speculation that we’re all doomed. The selling pressure and heightened risk aversion has lead to a stronger dollar and of course that helps to weaken commodity prices. In turn we’ll “learn” that this is a withdrawal of speculative funds from the market spurred by fear of a slowdown. And so the cycle will continue to weigh on everything with the exception of the dollar.
Eurodollar futures – As the Eurozone debacle fuels notable weakness in European equity markets, U.S. notes become the preferred safe haven. An earlier 4% loss for Portugal’s main index and 2.6% declines for Spanish stocks are weighing on U.S. equity prices. The 1-0year note yield fell from a two-week high at 3.705 to 3.66%. Investors were further disappointed when Thursday morning initial claims data undermined hopes for January payroll growth due Friday morning. Eurodollar futures are approaching recent peaks and have rallied seven ticks in early trading.
While the S&P 500 index is discounting a 12-point decline at the open the index would still need to fall by the same magnitude to take out last Friday’s lows and accelerate to fresh weakness. In the meantime this has not had the impact of bringing note yields to test their recent lows at 3.55%. This move seems asymmetric. Either equity markets are suspicious about being dragged down on account of peripheral Eurozone woes, or bond investors remain skeptical about the ability to rally hard given that essentially the same market fundamentals are just beneath the surface of U.S. debt.
European short futures – Accelerating worries for German and French partners over addressing gaping fiscal shortfalls has lifted core debt markets. However a 29 tick rally for March bunds to 123.50 where the yield is 3.18% leaves them still short of last week’s peak at 123.70. One would think that the magnitude of this crisis and the fact it’s overhanging the recovery like the Sword of Damocles would inspire a swing lower for yields (and higher bond prices). But it’s not to be – at least not yet. Euribor futures are higher by four basis points following the ECB’s decision to leave interest rates unchanged as was widely predicted. ECB officials have stated that they need to see more growth and inflation data before figuring out what monetary changes are needed to address its withdrawal process from quantitative easing.
British interest rate futures – The Bank of England voted not to extend its £200 billion bond purchase policy at Thursday’s MPC announcement. While this was largely expected and the policy will now run its course until all bonds up to that amount are purchased, the statement today saved room for a reversion to later purchases if the economy relapsed. The Bank sounded resolute on the prospects for inflation. We’ll learn more about growth and inflation next week in its quarterly report. However, it blamed temporary tax and oil factors on the recent spike to a 2.9% rate of consumer price inflation. It further warned that pressures in both directions would cause that rate to both undershoot and overshoot the target. With this in mind and with the anemic nature of the recovery, there appears virtually no chance of a reversal for core monetary policy anywhere along the horizon.
Australian rate futures –Aussie government bonds were unchanged yielding 5.43% even after a retail sales report unexpectedly weakened in the December period. Bills didn’t rise to the bait, having staged a sharp rally earlier in the week when the RBA surprisingly paused its monetary tightening process. Later this week the Bank reveals its latest thought on growth and inflation in a quarterly review.
Canada’s 90-day BA’s – Canadian yields at the 10-year fell by three basis points, underperforming core U.S. notes. Bills were also more reluctant to rally compared to U.S. Eurodollars but are higher by around four basis points ahead of Friday’s Canada jobs report.
Japan – Earlier in the session JGB prices broke down sending yields above 1.35% at the 10-year horizon. Stops were triggered in the March future, which closed with a 20 tick loss to 138.87. Yields reached 1.38% before coming back to close at 1.365%. Buying was noted on behalf of insurance companies wanting ultra-long exposure at 10-year-plus maturities.
Andrew Wilkinson is a Senior Market Analyst at Interactive Brokers. ibanalyst@interactivebrokers.com
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