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The reported buying of dollars in exchange for yuan state-owned banks in China set off fears that the revaluation of the domestic currency is a whimper rather than a bang. That thought removed optimism over global recovery from center stage and invited all of the other little bug-bears to come back out on parade. Yields are on the fall once again as investors focus on escalating woes of the European banking system despite another favorable economic report from its largest economic member, Germany.

European bond markets – Fitch ratings agency said that France’s largest bank BNP Paribas was faced with deteriorating asset quality as it cut its rating to AA-, four points from the top of the league table. Meanwhile ECB member Christian Noyer blamed the consequences of the sovereign debt crisis for leaving some members of the European banking system facing a hard time raising funds in the wholesale money market.

Both long and short ends have rallied as yields declined while stock markets reversed Monday’s positive tone. September bund contract has risen by 46 ticks this morning to 127.86 where the yield stands at 2.70%. The safety of German government debt was back under the spotlight again today after a story carried by Germany’s Bild suggested that the borrowing requirement might be as much as 25% lower than currently projected for this year. Spain had another successful series of short-term auctions raking in more than the €4 billion it initially planned. Pressure nevertheless remained on bond spreads above Germany.

An IFO report suggesting that business sentiment was riding high across Germany was largely overlooked with naysayers pointing out that the expectations element of the report fell short of dealers’ hopes.

Eurodollar futures – The FOMC today begins its two-day policy-setting meeting and is widely anticipated to state that no change is required while policy should remain accommodative for some time to come. Treasuries are higher in response to delicate sentiment and a reversal in yesterday’s hearty stock market gains. Yields slipped by three basis points to 3.20% as notes gained for the first time in three sessions with the September contract rising six ticks to 120-16.

British gilt – Short sterling interest rate futures and long-dated gilt futures appear to be responding well to Tuesday’s emergency budget and the first under the new Liberal-Conservative coalition. The budget aims to restore the nation’s finances to balance within five years but is loaded with spending cuts naturally having the potential to derail growth. The September gilt contract is trading at 119-70 for a 32 tick session gain, although it has fallen from an earlier high as the U.S. stock market fails to follow through with losses indicated ahead of the session. The 10-year government yield fell by five basis points to 3.45%.

Japanese bonds –Prime Minister Kan today unveiled an ambitious government plan aimed at reducing the staggering budget deficit to zero within a decade. The political atmosphere has recently changed in light of the European sovereign crisis. The Japanese debt burden is far greater than that of any European nation but thanks to the nation’s ability to plug the gap without much reliance on overseas investors, the issue of default has not hit home in Japan until now. The government today set a stringent three-year spending cap at ¥71 trillion ($782 billion). Bond yields slipped by three basis points to 1.175% as investors greeted the plan and the market tone was also lifted by a 1.2% decline in the Nikkei.

Canadian bills – Canadian yields slipped in a response to welcome inflation data for May. The pace of price changes faced by consumers during May rose at an annual pace of 1.4% compared to 1.8% in April. The recent threat to the central bank’s 2% central rate along with a revival of commodity demand has caused the Bank to lift interest rates recently. Today’s data helps sooth anticipations of more to come. 90-day bill prices were nevertheless static.

Australian bills – The let-down in the aftermath of the Chinese decision to float the yuan further hurt sentiment and sent regional stock market indices lower on Tuesday. Aussie bill prices rose to reflect greater uncertainty. Government bond prices rose sending yields down by four basis points to 5.38%.

Source: Tuesday FX Interest Rate Monitor