U.S. bond rally based on Eurozone weakness

IB Interest Rate Brief: Gains for treasuries tempered by earlier slide in yields

Investors sold into an early rally in U.S. government debt seemingly suspicious that lower yields were becoming increasingly reliant upon a worsening sovereign debt crisis on the far side of the Atlantic. A Eurozone stress test for its banking system failed to alleviate rising fears for the region's lenders helping put equity benchmarks under added pressure as investors cut riskier positions. Italian bond prices fell further sending the 10-year benchmark yield above 6% for the first time leading to a further widening of peripheral bond spreads above Germany.

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Eurodollar futures – Benchmark treasury yields rebounded from an early dip towards 2.87% on Monday as investors responded to fears in the aftermath of European banking stress tests that some 20 banks may need additional capital of €20 billion. Last week Standard & Poor’s warned that the U.S. is a coin-toss away from losing its AAA-credit-worthiness should politician fail to extend the nation’s $14.3 trillion debt ceiling by August. The front end of the Eurodollar curve continued to feel the heat from growing liquidity demands in Europe as pressures failed to recede. Long-end futures rose sending implied yields down in line with a fall in treasury yields as the entire yield curve continued its flattening bias. U.S. 10-year yields recently traded down to 2.90%.

European bond markets – A rise to a historic high for two-year paper issued by Greece went unnoticed while bigger problems surfaced. Spanish and Italian debt prices slumped sending yields to euro-era highs while investors jumped into the solace of German paper. Europe-wide risks appear to be bubbling under with the cost of insuring even core paper escalating. A Thursday EU summit of finance ministers promises to review the progress of financial aid to Greece and the financial stability of the Eurozone as a result. Dealers selling Italian paper forced the 10-year benchmark above 6% for the first time and its recent meteoric escalation leaves it within 1% of the cost of borrowing at which Greece, Ireland and Portugal all succumbed to a financial package from its regional partners. September delivery German bund prices advanced by 50 ticks to 129.48 lowering its yield to 2.65%.

British gilts – Is the cozy relationship between political, high-ranking police officers and the media taking its toll on the pound? The currency slumped in mid-morning trading in New York after another domino in the chain fell. With the known-relationship between Britain’s Prime Minister and News International Group’s Rebekah Brooks peaking the curiosity of the nation, the risks of an all-out collapse in the government are admittedly underpriced in terms of the value of the currency. Short sterling futures were higher earlier after a Rightmove home price survey indicated keen sellers recanted to lower prices in order to attract cash-strapped buyers. However, the pressure on the pound has the ability to lift implied short-end yields as the media crisis accelerates. September gilt futures nevertheless advanced by 45 ticks leaning on the 10-year yield sending it five pips lower to 3.05%.

Canadian bills – Apart from the nearby September contract Canadian bill futures advanced causing the yield curve to flatten further. Implied yields eased between three-and-five basis points along the curve as fixed income traders moved to price out anything more than one further tightening of the monetary screws from the Bank of Canada. A survey of executives by the Bank last week revealed an overwhelming majority of corporate leaders expect inflation to breach the central bank’s 2% ceiling within two years. The survey accounts for the reluctance among investors to eradicate the prospect of monetary tightening altogether, since measures of capacity continue to tighten. Government bond futures added just five ticks as the benchmark yield remained unchanged at 2.86% and at a four pip discount once more to yields on benchmark U.S. treasuries.

Australian bills – Investors continued to put pressure on the Aussie yield curve adding to recent gains for bill futures. Implied yields fell between two and 10-basis points at further maturities as dealers predicted the Reserve Bank would be more likely than not to loosen policy at some point. One week ago the market predicted that short-term interest rates would likely be 14 basis points lower in 12 months’ time. Today the market expects 55 basis points of easing as European contagion fears escalate and China maintains its death-grip on inflation through ever-firmer monetary policy. Aussie government bond prices eased by two basis points a day before the July RBA minutes are published with dealers wondering out loud what the central bank has to say about the role of the international economy on its policies.

Japanese bonds – Financial markets are closed in Japan for a national holiday.

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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