The real challenge with quantitative easing is knowing when the policy is working. By forcing the yield curve lower the central bank provides incentive to lend. If the policy is successful, economic indicators flash green igniting asset prices and causing upwards pressure on the yield curve as investors conclude that monetary conditions must be reversed. When the policy is not working, investors do the Fed’s job for it: Bankers buy bonds for fear of a slowdown and precisely because they see few signs of demand for loans from customers. By walking away from its concluding second wave of quantitative easing the Fed has left the bond market to its own devices, letting bond buyers find a new equilibrium in the face of a weaker growth trajectory and stiffer unemployment.
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Eurodollar futures – The Fed didn’t say it wouldn’t do any more in terms of easing policy: Indeed it said it still has some tricks up its sleeves, such as cutting bankers’ deposit rates or announcing additional time to its already “extended period” language. But a solemn description of the economy and a liberal downgrade that shaves 0.4% from its 2011 growth projection has left credit markets worried about the future. Bond buyers are increasingly comfortable with the return of a period of benign inflation and today’s headline from the IEA that it will release 60 million barrels of crude oil to safeguard against rising energy prices that have threatened the recovery reinforces that view on inflation and strengthens the dollar. The latter will help undermine the case for rising commodity prices and shift yields on to a lower path and aid a natural recovery beyond the reach of quantitative easing. September Treasuries surged to 124-14 toward a fresh contract high while Eurodollar futures rose at deferred maturities. The short end of the curve was deprived of gains on account of rising liquidity fears in Europe. The benchmark 10-year yield eased by six basis points to 2.92%.
European bond markets – ECB Chief Trichet’s warning that risk signals in the area were flashing red had the same type of impact on bond and short interest rate futures as when he warns over inflation. Euribor contracts rose as though to extend the period of low interest rates, despite the fact that the central bank has only once hoisted its benchmark rate. The ECB appears to be increasingly boxed in to its prevailing policy as inflation pressures subside and as economic growth slips, while risks to the global economy mount on account of the dangerously high potential for default in Greece. The June 2012 future saw its implied yield slide by 10 basis points to reach the lowest since mid-January as investors shunned the thought of further monetary tightening from the ECB. At this rate the confidence of the market’s view that a July rate increase is a done-deal has to be up in the air. The yield on the 10-year German bund slid by seven basis points to 2.87% widening further against peripheral government debt whose prices slid for fear of financial contagion within the banking sector. Confidence was undermined once again by events in Greece. The political opposition leader told the Financial Times newspaper that he’d vote against Papandreou’s austerity package, while domestic paper Kathermerini said that officials from the EU and IMF had viability concerns over 2011 measures totaling €3.8 billion aimed at reducing the Greek deficit. Those measures represent about 60% of the total for this year.