Debt crisis fears wrangle euro bond market

IB Interest Rate Brief: Peripheral selling fizzles after suspected ECB purchases

U.S. and German yields erased declines to seven-month lows in trading symptomatic of any market mania worth its salt. The reversal came after European government debt traders grew suspicious that a tight-lipped ECB was busy buying Spanish and Italian paper days before an Italian auction that under currently tumultuous conditions could easily deter regular buyers from being the first to commit their capital.

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European bond markets – Tuesday trading got off to an ugly start with peripheral bond yields rising awkwardly in response to elevated fears that EU officials remain clueless on how to resolve the sovereign debt crisis. A meeting between EU officials closed with a short statement offering a new strategy “soon” without specifying a timeframe. That was hardly the reassurance that an increasingly fractious government bond market needed and forced fresh sales. Yields rose on peripheral debt with that on the Spanish benchmark rising to a euro area era high while Italian yields breached 6% for the first time since 1997. The market faces the additional hurdle later in the week of Eurozone bank stress tests. In the European afternoon government bond prices suddenly turned around with ECB support suspected. The gravity of the situation is exemplified by the crunch on liquidity in the short-dated cash market. The implied three-month yield on March 2012 expiration euribor fell to 1.59%. Only last week the ECB raised its short-term cash rate to 1.50%. At that time the implied three-month yield stood at 2.05% and represents a retrospective step to January when the futures contract last traded at that price.

British gilts – The pressure on the front end of the European yield curve remains intact and spilled over into the British yield curve aided by weaker than expected consumer price data. The June CPI came in to show a 4.2% annual pace of increase down from a 4.5% pace in May, which is welcome news to the Bank of England despite still running faster than its 2% ceiling. Short sterling futures are currently ahead by two basis points although were higher by as much as six pips earlier. The government bond yield remains unchanged at 3.08% but earlier recorded its first decline below 3% for the first time in eight months.

Eurodollar futures – The European liquidity crunch remains a factor in Eurodollar futures trading. Banks needing cash as the debt crisis roils the region’s bankers are paying higher interbank rates and exerting downwards pressure on nearby futures contracts. December expiration Eurodollar contracts traded at a three-month low in the Globex session with the implied yield rising to 0.56% compared to the recent low point of 0.38% just about one month ago. The situation is a tricky one for traders. While nearby contracts appear to represent a screaming buy in the medium-term, an acceleration of tight liquidity conditions could persist for several days forcing further liquidation compounding an already bad situation. Treasury futures surged in early trading sending the yield sliding to 2.81% before the European situation appeared to calm down. The 10-year yield recently traded at 2.91%.

Canadian bills – Canada implied yields softened taking a lead from Eurodollar contracts. Bills of acceptance futures earlier edged ahead with contracts reversing a four basis point gain as speculators are tripped up by possible ECB intervention in the regions ailing debt markets. Government bond yields added two basis points and trade pretty close to par with U.S. treasuries having surrendered a five basis point discount as recently as last week.

Japanese bonds – An effervescent European debt crisis played its role in driving yields on Japanese benchmark bonds to a two-week low of 1.10%. Bonds gained for a second day as the domestic stocks were marked 1.4% lower and as the Bank of Japan maintained its short-rate of 0.1% and left unchanged a ¥10 trillion asset purchase fund. The September JGB futures contract added 62 pips to 141.61.

Australian bills – The chances of an Australian rate reduction in the next 12 months increased further overnight as commodity prices and equity benchmarks around the region swooned. Investors, rightly or wrongly, now expect the central bank to hack 32 basis points off its 4.75% benchmark short-rate of interest. A slide to a six-month low for an NAB business confidence index didn’t help restore any enthusiasm as dealers responded to a weak European Monday. Implied rates on short-dated bill futures slid by a further 18 basis points at deferred maturities with the curve flattening markedly. Indeed the curve completely flattened to zero at the September 2011/September 2012 calendar spread. Only a week ago that spread traded at 25 basis points proving how far the curve has flattened in such a short space of time.

Andrew Wilkinson

Senior Market Analyst

ibanalyst@interactivebrokers.com

Note: The material presented in this commentary is provided for informational purposes only and is based upon information that is considered to be reliable. However, neither Interactive Brokers LLC nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. Neither IB nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.

About the Author
Andrew Wilkinson

Andrew is a seasoned trader and commentator of global financial markets. He worked for several London-based banks trading cash and derivatives before moving to the U.S. to attend graduate school. Andrew re-joins Interactive Brokers following a two-year stretch at a major Wall Street broker-dealer as their Chief Economic Strategist. His coverage of stocks, options, futures, forex and bonds regularly surfaces in global media, and over the last several years Andrew has made many TV appearances on Bloomberg, BBC, CNBC and BNN and Yahoo Finance.

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