Back to fundamentals

After the drama of the Cyprus bailout, it was back to focusing on economic fundamentals in the sovereign market on Friday.

The eurozone economy has been mired in stagnation for some time, and the latest Markit PMIs confirmed that things are likely to get worse this year.

Figures for both the manufacturing and services sectors were disappointing, and signalled that the currency bloc is likely to post yet another period of contraction in the first-quarter.

Italy and Spain showed little sign that they are picking up, which was no surprise. However, it was the French surveys that were particularly worrying for the eurozone.

The average reading for the manufacturing index over the first-quarter was 43.6, the lowest since Q2 2009, while the services index 41.3 reading in March was the lowest in over four years. With French economic performance heading in a negative direction, the eurozone core is looking increasingly fragile.

The dismal news might have been expected to trigger risk aversion on French sovereign credit, but shortly after the release of the French PMI, the government sold €2bn of 10-year bonds at an average yield of 1.94%.

This was the lowest yield on record and the first time French 10-year debt was sold for less than 2% (though it has gone lower than 2% in the secondary market).

French sovereign CDS were 8bps tighter at 74bps on Friday, with news that the government is considering selling state assets to help compress spreads.

Investors clearly see France as relatively safe, despite its declining economic fortunes. Of course, the dominant presence of the ECB in the background has supported all eurozone sovereigns, both core and peripheral.

Speaking of the periphery, Italy is still nowhere near forming a government, and the potential for further instability could easily trigger another bout of volatility in the weeks and months ahead.

Italy's CDS spreads have come back slightly from the wides of 305bps, but at 290bps they are still wider than where they started the year and nearly 70bps wider than the tight levels reached in mid-January.

Mario Draghi was asserting the potency of the Outright Monetary Transactions programme at his monthly press conference, though he offered precious little detail on how the mechanism would work. There is a reasonable chance we will find out before the end of the year.

The US economy has outpaced its European counterpart over the last few months and this is unlikely to change before the end of 2013, but the optimism was dampened today by a disappointing non-farm payrolls report. Just 88,000 jobs were created during March, way below the 190,000 expected.

This probably means the Federal Reserve will continue to support the economy - the condition of the labour market is the central bank's key indicator. US credit markets have held up relatively well this year, with the Markit CDX.NA.IG more than 30bps tighter than the Markit iTraxx Europe.

However, Japanese credit spreads have outperformed all regions by a considerable margin, in part due to expectations of monetary activism from the Bank of Japan. And the central bank delivered this week with the announcement of a radical shift in policy.

The Bank's balance sheet will be expanded dramatically in an attempt to reach a 2% inflation target in the next two years. Markets welcomed the extra liquidity, though the jury is out on the policy's efficacy in boosting growth.

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