FOMC promise pushes 10-year bond toward 2% yield

More fears gripped investors on Wednesday as a second-look at the tone of the message from the FOMC the day before raised doubts over the economic recovery. Some suggest that the next stop will be a recession that central bankers appear powerless to prevent. A slide in French banking stocks amid wild rumors over the possible insolvency of a big name also boosted the appeal of government debt around the world, dragging financial shares lower on the way. Investors can’t be blamed in this environment for thinking that they were given some kind of wonder-drug when the authorities embarked on asset purchase plans. Only now, as the effects wear thin, the worrisome financial pain appears to have never gone away.

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Eurodollar futures – Traders fell over themselves in a rush to flatten the yield curve after the Fed warned on the “considerably slower” pace of recovery saying it was “prepared to employ” additional tools to bolster the recovery. At the heart of the flattening was the change in its statement wording in which it dropped its “extended period” language adopting instead a defined period of “at least two-years.” Implied yields on Eurodollar futures contracts dropped like a stone with maturities through March 2013 (19 months forward) are now beneath 0.5% compared to a current reading of three-month Libor of 0.25%. The two-10 year spread also flattened hugely with the gradient of the curve falling below 200 basis points (2%) for the first time since October and ahead of the expected second round of quantitative easing. At the end of trading in July, less than two weeks ago, the curve was trading with a gradient of 250 basis points. Immediately after the Fed’s statement on Tuesday buyers locking into surging 10-year note prices drove the yield down to 2.04% matching its low point in December 2008 and shortly after the failure of Lehman Brothers just months before. That event was widely blamed as the straw that broke the camel’s back tipping a shocked global economy into outright recession.

European bond markets – Weakness in a French summertime reading of industrial output helped light the fire beneath a rally for government bonds before rumors of a major financial insolvency among the top-ranking French names created mayhem. Banking shares across Europe tumbled and the German bund emerged as the savior of the day. The September contract advanced by almost two full points easily clearing Friday’s panic-high. The surge in prices drove down the yield on the 10-year benchmark by 15 basis points and through resistance to stand at 2.21%. Such is the ongoing state of nervousness in the Eurozone that interest rate traders have started to think that at least some of the ECB’s two recent monetary adjustments to its short rate will come undone. At the start of August swaps rates implied a 25 basis point rise in short rates. Just over a week later, that view has changed markedly with the market currently implying a 31 basis point reduction in short-rates over the coming 12 months. Euribor futures are surging in London again with implied yields shedding a full quarter point as any and all of the fears associated with the financial crisis from yesteryear re-emerge.

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