Bonds sour as investors see light at the end of tunnel

Bond traders faced another sloppy session as inflation jitters grew sending yields higher. The Federal Reserve’s policy of pump-priming the economy is working well enough to cause concern among its members that perhaps they should take their feet off the pedal if the finish line is now in sight. Lining the streets, however, are rising signs of inflation that are prompting bets that an end to the stimulus will come sooner rather than later. Those risks are showing up in inflation-adjusted securities where spreads over conventional government debt are widening in a sign that investor caution is growing.

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Eurodollar futures – The combination of low interest rates and rising inflation sent precious metals’ prices higher with gold making a second day of record highs midweek. Silver prices haven’t traded so high in 30 years. While the Fed might have rescued the economy, the side effect of upwards pressure on commodity prices is making investors wary that an end to policy stimulus might arrive faster than they had otherwise thought. Bond prices are slowly falling as a result lifting yields back above 3.5% as they go. The March FOMC minutes cemented the view that there is dissent among policy makers. What’s strange is that we’re all looking at the same data but there are two ways of reading it according to the Fed. On the dovish view at the Fed the economic recovery is just fragile and accompanied by a low core reading for inflation. By that token, policy stimulus must continue into 2012. On the other hand employers have driven down the rate of unemployment faster than was thought possible and confidence measures validate the recovery in output. It might therefore be time for the Fed to take its foot off the gas. Amid the anxiety of what might come next from the Fed, the yield curve continues its steepening bias with nearby Eurodollar futures making slim gains while deferred contracts are firmly lower midweek.

European bond markets – The ECB has already said it will lift its main short-term interest rate at the April meeting and investors continue to lock down borrowing before they do. Portugal auctioned six-month paper today and heading into the sale investors sent yields surging. Only afterwards did the cost of borrowing fall. The ramifications of allowing its budget deficit to grow to gargantuan proportions relative to its growth culminated in the government having to pay more to borrow for six months than Germany does for 30 year borrowing. Spreads were initially wider for Ireland, Italy and Spain against German paper, but having coughed up the fur-ball after the auction, investors’ appetite for debt improved.

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