Fixed Income Update - Game Changing

The Philadelphia Fed survey was a shocker yesterday. The most reliable source of information on the US Manufacturing industry had plenty of weak components and now points to a contraction in the US economy -if confirmed in actual data this is a real game changer for the US Federal reserve and the US Financial markets.

The Employment index component pointed to job losses- not additions in the month of April. But to me the most shocking was the fall in Prices both paid and received currently and whilst Prices paid 6 months forward showed a slight rise in expectations, the respondents expect forward prices to rise only modestly six months forward.

This is what the Federal reserve will fear most- Deflation. This has to bring the chances of more QE occurring this summer, as opposed to my expectation of Q3.

It follows what is occurring in the Commodities markets. And, as I have been banging on for ages, means that  US Inflation expectations have to fall dramatically from here.

It would definitely mean lower US Interest Rates , and if the fear of deflation increases, 10yr US Treasury yields, after closing at an all time low yield of 1.70% last night, at even lower levels and mean a flatter yield curve.

At the moment, 5yr Interest Rates are fairly well anchored at around 0.70%-0.80% and this has reduced the level of historic interest rate volatility. That has lowered the level of implied Interest Rate volatility for 5yr Interest rate swaps, but the flattening of the yield curve with 10yr versus 5yr US Treasury yield differential falling 12bp this month alone is seeing increases in Interest rate volatility of longer maturity interest rates.

This again is a concern for the Federal Reserve because whilst longer term interest rates are falling it will not feed through fully into Mortgage Rates because borrowers have an option to redeem the mortgage early and this is now costing lenders more to hedge out. So the Fed's plan of keeping interest rate volatility low is now failing- meaning that the reasons for QE3 are growing.

And all the time there is the prospect of a greater banking crisis than has ever been seen before. Pictures of depositors withdrawing money from Spanish and Greek banks are all over the media and only fuelling the crisis more.

It makes Gold one of the few safe places to put your money when you do not have a clue as to what currency your Bank deposits could end up being in if the Euro fails. It is why Gold has seen a strong demand in the past week. Gold in Euros has risen from €1205 at the beginning of the week to now be at €1250.

Given the increase in bank credit spreads and especially in Spanish banks, EuroGold should rise to 1300/toz in the coming weeks ahead of the Greek elections.

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