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Friday December 10, 2010 - 16:18:29 GMT
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FX Briefing - US yields are rising

FX Briefing 10 December 2010


European Council set to continue discussion on stabilisation mechanism

Production increase in Germany suggests strong final quarter

US president Obama and Republicans agree on tax-cut package


US yields are rising


The euro started to recover around the time of the ECB Council’s meeting at the beginning of December. The weak US labour report last Friday afternoon gave the euro additional impetus, and EUR-USD started this week at around 1.34. The euro’s strength was short-lived, however. During the course of the week, it slipped back to 1.32 again – about the same level as before the labour market report was published.


The political discussions about the future European stability mechanism and the potential role of so-called euro bonds, as suggested by Jean- Claude Juncker, the prime minister of Luxembourg, are still in full swing. The European Council, which is meeting next Thursday, will continue to focus on this matter too. However, at the moment there appear to be no ideal solutions to the acute problems in sight. Policymakers are hoping that the troubled countries’ austerity measures (combined with interest rate incentives) will ultimately reassure the markets. The rescue fund and the ECB’s bond purchases are meant to give national governments sufficient time and make sure that the monetary policy transmission mechanism keeps on functioning.


The fact that the ECB has stepped up its bond purchases and is continuing to conduct its refinancing operations as fixed rate tenders with full allotment until the end of the first quarter probably helped to stabilise credit spreads – i.e. the risk premiums on the troubled countries’ bond yields over the equivalent German bunds. The extension of the EU/IMF loan to Greece is to be agreed at the beginning of next week, which eased market pressure on Greece to some extent.


Macroeconomic developments in the core eurozone countries continue to be extremely encouraging. In October, German industrial production posted a sharp month-on-month increase of 2.9%. Production is thus 2.7% above the previous quarter’s average, which suggests a strong final quarter with growth of up to 1%. Despite the strikerelated shutdowns, the Banque de France has lifted its forecast for France to 0.6% compared with the previous quarter.


Because of all the ongoing discussions about the eurozone sovereign debt crisis, another, perhaps just as important, development has received little attention in Europe: the significant increase in US yields. As soon as the Fed’s quantitative easing measures had been passed, US interest rates began to climb. Yields on 10-year T-notes rose from 2.50% at the beginning of November to 3.20% currently. Last week, they shot up particularly sharply by 25 points. The short end of the curve posted a big increase as well: yields on 2- year Treasuries rose by around 10 points to over 0.60%.


The world-wide increase in yields, during the course of which yields on JGBs have climbed 30 points to about 1.20% and those on 10-year German bunds by around 50 points to 3%, was probably triggered mainly by developments in the US. And it is quite plausible that the general upward trend over the last few weeks has accelerated the widening of spreads in the European bond market (normally markets which lack liquidity react more strongly to pressure to sell).


It is remarkable that the US bond markets are starting to fall at the very time that the Fed is embarking on its asset purchases. That does not mean that QE2 is having no effect; it does mean, however, that the markets had already anticipated the purchases (“buy the rumour, sell the fact”) and now that the programme has been installed are concentrating on the macroeconomic outlook instead.


The steepening of the yield curve shows that economic scepticism is subsiding in the US. The economic data suggest sound, but not abundant, growth of 2.5%; despite slow progress in the labour market, private consumption is likely to make a respectable contribution to growth. In 2011, economic growth is set to pick up steam. The tax-cut package negotiated between the White House and Senate Republicans at the beginning of the week is also fuelling hopes that growth will accelerate in 2011. The first upward revisions of US growth forecasts have just been made.


The bipartisan compromise envisages extending the Bush administration’s tax cuts of 2001-2003, which were due to expire at the end of the year, for a further two years. Thus President Obama and the Democrats are abandoning their goal of revoking the tax cuts for the 2% wealthiest US households. They are swallowing this bitter Republican pill because it also enables them to maintain the tax relief for “normal citizens” which also expires at the end of the year. Furthermore, some tax breaks from the Recovery Act, particularly for families with children, still remain in place, including tax credits for tuition fees.


Additionally, some tax breaks for companies, such as tax credits for research and development expenditure were also extended. In order to boost purchasing power, the payroll tax is to be reduced by 2 percentage points for one year in 2011; the period in which jobless benefits can be claimed was also extended. Furthermore, all investment expenditure in 2011 can be written off in full. Inheritance tax is being reinstated, which will generate higher revenues, but the Democrats are still battling with the fact that taxation of luxury property is lower than it used to be. The total cost of the measures is estimated at between $700 billion and $1,000 billion over 2 years; the tax cuts will probably have the biggest in impact in 2011. All protagonists are expecting them to have a positive effect on growth and employment. Little has been said about the effect of the new package on the budget: it is likely to keep the deficit ratio at around 10% of GDP.


Stephan Rieke +49 69 718-4114



Economics Department

+49 69 718-3642

[email protected]

Foreign Exchange Trading

[email protected]

Matthias Klein

+49 69 718-2175

Matthias Grabbe / Klaus Näfken

+49 69 718-2146 / -2683


This report has been prepared by BHF-BANK Aktiengesellschaft on behalf of itself and its affiliated companies (together "BHFBANK Group") solely for the information of its clients.


The information and opinions in this document are based on sources believed to be reliable and acting in good faith, but no representation or warranty, express or implied, is made by any member of the BHF-BANK Group as to their accuracy, completeness or correctness. Opinions and recommendations are given in good faith but without legal responsibility and are subject to change without notice. The information does not constitute advice or personal recommendation, for which the duty of suitability would be owed, but may facilitate your own investment decision. Moreover, you should seek your own advice as to the suitability of an investment matter mentioned herein. Investors are reminded that the price of securities and the income from them can go down as well as up and that the past performance of an investment or a market is not necessarily indicative for future results.


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All rights reserved. Please mention source when quoting from it.





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