Core Yield Hurts EUR

Includes: ERO, GBB, JYN
by: Dean Popplewell

by Dean Popplewell

Bernanke came, he saw, and did what was expected of him and that was nothing at all. Yesterday's testimony added very little to the Fed's policy debate because it simply reiterated June's FOMC decision that made clear that the Fed "is prepared to take further action as appropriate" and did not describe 'what' tools or 'when' timing. He highlighted the U.S. as in recovery, while indicating that economic activity appears to have "decelerated somewhat" in H1. He reviews September forecasts that call for modest growth, but reiterates that there are higher risks and higher degree of uncertainty than normal: mainly the Europe crisis and U.S. fiscal cliff.

In his following communique there was only one sentence that summed it all up and that was "forward-looking indicators on investment demand, such as surveys of business conditions and capital spending plans, suggest further weakness ahead." Bernanke failed to clear up any of the considerable uncertainty over the timing or shape of future policy, he just left the door ajar enough to keep QE3 expectations alive. The market is now anticipating the next move from the Fed to be in the direction of easier policy, most likely at the committee's September 12-13 sit down.

There has been little mainland Euro data of note during this morning's session. However, the UK has managed to fill the void with its unemployment rate (+8.1% vs. +8.2%), claimant count (+6.1k vs. +6.9k) and the BoE minutes. The 7-2 vote at the last meeting is a market surprise. A consensus was expected to be the outcome. The majority not only discussed the expanding of QE by +GBP50b vs. +GBP75b but also the merits of a rate cut. However, the Bank felt that a "further reduction in the Bank rate would not have any advantage over an expansion of the AP program." Looking at a cut certainly is a softening in their stance, and obviously the BoE must feel that other policy initiatives could in time "alter the assessment of the effectiveness of such a rate reduction." A lower band on rates or even negatives rates are becoming the new norm to dissuade parking or hoarding of unused cash.

This morning's German sale of +EUR5b of 2-year Schatz yielded a negative return for the first time (-0.06%), highlighting the overall flight to quality theme dominating the government markets. This result is also limiting any potential gains in the periphery's. Spain faces another liquidity test tomorrow when she comes to the market with 2's, 5's and 7-year paper, most likely at yields considered unstable in the long term. The persistent concerns about debt sustainability in Spain and Italy, combined with investors reach for Euro core paper, can only keep the troubled peripheries yield curves steeper.

This morning's German Schatz tap results shows a 2.00 bid-to-cover, the strongest since January, with a hefty overall bidding of +EUR8.4b. Analysts note that taking down Schatz with such a negative yield now carries an implied optionality of Germany reintroducing the Deutsche Mark, or put another way, the capital loss, negative rates, should be more than compensated for by the reintroduction of the DM!

July 18

Rumors of an impending Austrian downgrade, Monti's comments yesterday on Sicily, and their potential to default and add to the Italian debt burden, coupled with negative Euro core-yields has the single currency again ending the Euro session on the back foot. All this is occurring ahead of Ben delivering his SA-MPR to the U.S. House of Representatives, following yesterday's testimony to Senate. OANDA's long EUR position has been pared ever so slightly this morning. It seems that they are content trading that contrarian position for now. The single currency is trying to work itself lower intraday despite being oversold on the hourly charts for some time. The techies do see some scope for a bounce and favor buying the dip scenario. However, the market feels it wants to explore a tad deeper, so do not be surprised if those rare EUR bulls keep stops losses tight because of the recent whipsaw price action!

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