Inflation shakedown dampens European yields

Proving that “it ain’t what you say, it’s the way that you say it,” the highly anticipated wording at Thursday’s ECB press conference indeed signaled a July rate increase, but a markdown for inflation expectations wrong-footed interest rate traders. The September German bund future screeched higher after the press conference shaving five pips off the benchmark 10-year to 3% and halving the premium above Treasuries to five basis points.

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European bond markets –Jean-Claude Trichet stuck to his scripted comments and once again talked about the need to display strong vigilance over inflation virtually guaranteeing a shift to 1.50% for the ECB’s main refinancing rate at the July meeting. However, interest rate traders dampened expectations for future rate increases when Trichet lowered the forecast range for 2012 inflation albeit by a smidgeon. The ECB now says that inflation will rise above 2.3% next year and predicts CPI will range between there and as low as 1.1% throughout the forthcoming calendar year. And while the move shaves just one-tenth of a percent off its projection, traders began to doubt the extent of future tightening sending implied yields tumbling across the euribor curve. The December contract added 4.5 basis points while the implied yield on the June 2012 contract shed 10 basis points in the fervor slipping to 2.04% at the session high. Investors also bought government bonds after an earlier selloff drove the yield on German two-year paper up five pips to 1.71% ahead of the meeting while later slumping to yield 1.61%.

Eurodollar futures – Three month Libor slipped to its lowest level since February 5, 2010 edging below the 0.25% fed funds ceiling rate set by the central bank. Abundant liquidity at the front end of the cash market and an implicit cast-iron guarantee that policy is on hold for the remainder of the year has forced the short-end of the curve lower. Eurodollar contracts surged midweek as dealers responded to the moribund state of the world’s largest economy lopping around 17 basis points off implied forward yields. The trade deficit unexpectedly narrowed in April as imports hit the rocks. Trade with jump fell by $3 billion causing some optimism that trade will benefit during the current quarter as demand rebounds. Eurodollars have subsequently pared an earlier positive start with implied yields turning a little higher after a six basis point dip ahead of today’s data. Ten-year note yields are static at 2.95% having earlier reached a year-to-date low at 2.935%.

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