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fixed-income-update-2012-08-08

Fixed Income Update 2012-08-08

After a three day sell-off in "Safe Haven Bonds" which have seen 10yr Bund yields rise 23bp and 30yr US Treasury prices fall 5 points from Thursday's highs some reflection needs to take place.

On Friday I said that the peripheral bond markets needed to reflect that the ECB President was leaving all the hard work up to the politicians and that still remains the case- so why the optimism that the ECB will sail to the rescue of Spain or Italy.

Draghi had made it pretty clear that any bond buying carried huge conditionality.

Optimism came surprisingly on Friday with the announcement from Spain's Prime Minister Rajoy that Spain could look at requesting aid from the EFSF/ESM once he knows what the ECB conditions would be. Seems odd that Spain's announcement that it may indeed need a bailout would lead to a rally in its own bond markets.

Of course some of the optimism to peripheral bond holders is that the ECB President said that if the ECB made bond purchases it would address investor concerns that it would take seniority over the current investors. How it would do that is as of yet uncertain, but the obvious way would be the EFSF/ESM to indemnify the ECB against any losses it incurred. How this would work with the Finns who already seek collateral for any loans made by the EFSF is a major stumbling block however.

But it still doesn't get over the fact that the ECB will only start buying bonds once the sovereign state has requested aid from the EFSF/ESM with all the conditionality that that incurs. Neither the current Spanish or Italian administrations would survive a request for aid from the EFSF. Because that would require Spain or Italy losing its sovereignty.

There is a possibility that the EFSF could be formally requested to buy bonds of a sovereign state without a full bailout request being made, but even that would require a Memo of Understanding (MoU). Whether the MoU would be sufficient to trigger the ECB seems unlikely and would certainly face opposition from the German, Dutch and Finnish members of the ECB council.

And the ECB hasn't even formulated its methodology of intervening in the markets, that is likely to be months away although some are speculating that there will be some announcements at the next ECB Press conference in September.

And all the time the German Supreme court is deliberating on the constitutionality of the ESM. Most experts expect that the Court will say "yes but...." and place more conditionality of the use of the ESM. That means less not more support for the periphery.

So as of yet there is no answer to the Euro zone crisis- far from it. There remain as many questions as before.

And all the time the European economy weakens and even more than expected. France's CB now expects a recession and the UK's BoE is revising down its GDP forecasts.

Yesterday German Factory orders fell 1.7% MoM but amazingly even this news was treated positively by equity markets as the quotes from analysts suggested that weak economic data, especially in Germany would focus politician minds on the need for action. So now we are under the same situation in Europe  as we were in the US recently when bad economic news just increased the expectation of QE from the Fed.

But the politician minds are currently on the beach and so are most of the European Fund managers and traders.

It is exasperating the moves in the market with little liquidity.  The sell-off in German Bunds this week came in a low volume days. Turnover in the 10yr Bund future over the last 2 days is only 120% of the total turnover for Thursday. Similar patterns are evident in US Treasury Bond Futures, and that is an even bigger surprise given the auctions of new 3yr, 10yr and 30yr debt this week.

The lack of liquidity is widening bid offer prices in peripheral debt markets. 10yr Italian BTPS are quoted on a 25c bid-offer and Spanish around 50c. That makes trading very difficult and has seen price movements staccato around. So it makes those markets a false market- if any investor wish to buy or sell in any size they would be punished by the market moves.

And what about those market moves- Spanish 10yr bond yields are rising again and currently sit at 6.86%

This is impacting Implied Interest Rate volatility. Cautious traders are keeping the cost of hedging interest rate risk high.

That in the end always will impact the Risk markets.

So whilst the long duration positioning of the portfolios has resulted in some significant losses, I am still confident that the positioning is correct as the recent moves have occurred on sentiment more than fundamentals.

That is why this is a buying opportunity for bond investors and not a reason to sell.

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