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.
British gilts –September gilt futures are trading at a fresh contract high having rallied 61 ticks to 122.38 on fresh worries over the health of the British consumer. A CBI retail survey reported a likely ‘flat’ retail sales growth outlook according to survey respondents as the report underwhelmed. The MPC minutes sounded awfully cautious over the recent dip in economic activity while the prospect of a fresh wave of bond purchases by the central bank has investors digging their teeth into a bull market for bonds. Short sterling performed as did Eurodollars with nearby contracts falling while the rest of the curve rallied as short-term liquidity fears resurfaced as Europe knuckles down for a new wave of the crisis. The benchmark gilt yield fell by four pips to 3.14%.
Canadian bills – A decline in the price of commodities is welcome news for inflation hawks and the IEA’s decision to unleash global stockpiles to reduce the threat to the economic recovery certainly is positive news for world short-ends. Implied short-dated bill yields slid by a further six basis points in Montreal. The healthy fiscal situation in Canada ensures that government-issued debt keeps pace with U.S. bonds. The yield on benchmark government paper declined to 2.90% maintaining a discount to that issued in Washington.
Australian bills – The interest rate market sent a loud message to the Reserve Bank as it finally concluded that the central bank has finished its tightening process. Take a look at spreads between Aussie bill futures, which today surged a further nine basis points. The December contract even settled above the nearby September contract, while implied yields through June 2012 argue that three-month cash rates of 4.85% will not budge. The flattening of the yield curve in recent weeks is astounding especially in light of the hawkish comments from Governor Stevens who only recently resurrected the view that “rates must rise at some point.” With an overnight Chinese PMI report for the manufacturing sector from HSBC depicting a standstill in Beijing, all eyes will be on Aussie yields for signs of an inversion in the yield curve in response to an inflation-busting global crisis emanating from Europe.
Japanese bonds – The Japanese yield curve fell from two-to-10-years as government bonds rose in response to the glum Fed view that accompanied the conclusion to its June FOMC meeting. Two-year yields slumped to the lowest so far in 2010 while the September JGB contract advanced by 16 pips to 141.29 pushing the 10-year benchmark yield lower by one pip to 1.11%. Two-year yields eased to 0.15% in the world’s third-largest economy making for the lowest reading since November.
Andrew Wilkinson is a Senior Market Analyst at Interactive Brokers LLC
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