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Daily Market Report for 29 July 2014: Euro Is Unlikely To Outperform Dollar On Policy Divergence

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Fed shifts from buying bonds to debating how soon to raise interest rates, while the euro area needs more stimulus

Federal Reserve moves to end its debt purchases as U.S. bond market bulls have found a new ally: European Central Bank President Mario Draghi.

Equities market well reflected the optimism on the future economy. U.S. government debt gained 3.4% this year, the biggest year-to-date return since 2010. The MSCI World Index of equities in developed nations returned about 6.8%, while the Bloomberg Commodity Index of 22 raw materials added 2.7%.

Hence, Treasuries offer higher yields than government debt in Europe this week. That’s largely due to Draghi, who pushed the region’s borrowing costs to record lows after announcing an unprecedented set of stimulus measures last month including negative interest rates to prevent deflation. With Fed Chair Janet Yellen trying to extricate the central bank from more than five years of its own extraordinary monetary policies to support the world’s largest economy, the relative advantage may help attract more overseas investors to Treasuries and prolong their biggest advance in four years. At 2.48%, 10-year notes yield more than twice as much as German bunds, the biggest premium since 1999.

Now, as the Fed shifts from buying bonds to debating how soon to raise interest rates, sustaining demand from foreigners who own almost half the $12.1 trillion of outstanding Treasuries has never been more important. Since 2008, the Fed has inundated the U.S. economy with more than $3 trillion of cheap cash with debt purchases aimed at suppressing borrowing costs and restoring demand crippled by the financial crisis.

And as Yellen tries to determine the best way to tighten monetary policy without slacking the labor market, In Europe, Draghi is pressing ahead with more stimulus as the ECB tries to fight with deflation. On June 5, it cut the deposit rate to minus 0.1%, becoming the first major central bank to take one of its main rates negative. The ECB also announce that the central bank will start working on a quantitative easing style plan to purchase asset backed debt and introduce a program to encourage banks to lend, which may reach 1 trillion euros.

U.S. yields will climb as speculation starts to build over when the Fed will need to start raising rates when the ECB is boosting stimulus. There’s now a 65% likelihood the Fed will start lifting rates by July 2015, according to the Fed fund future.

Across Europe, the government borrowing rates have been dropping to record lows in the wake of the European Central Bank’s decision to cut the key interest rate below zero and introduce a multi billion euro lending package.

Spain also saw borrowing costs fall on Monday as investors drew comfort from a report on upgrading Portugal’s credit rating. Yields on Portugal’s 10-year government bonds, which move inversely to prices, dropped by three basis points to 3.59% as Moody said it did not expect problems with the problem lender to have a material impact on the government’s ability to meet its obligations. Moody lifted Portugal’s rating one notch to Ba1, a level below investment grade, with a stable outlook mainly because of the center right government’s strong commitment to fiscal consolidation despite repeated setbacks from adverse rulings by the country’s constitutional court.

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