Fixed income update

Update on Taxable Fixed Income Markets

The U.S. Treasury markets have recently seen some dramatic moves in the level of interest rates.  The interest rates moves have coincided with or have been a result of two major policy announcements from U.S. authorities.  The first hint of policy moves occurred at a speech by Federal Reserve Board Chairman Ben Bernanke at Jackson Hole, Wyoming on August 26, 2010.  At this speech the Chairman hinted at a possible second round of asset purchases and quantitative easing by the Federal Open Market Committee (FOMC) – the branch of the Federal Reserve that sets monetary policy.  This policy move was actually approved by the FOMC and Fed voting members on November 4th, 2010.  The policy move involves the purchase of U.S. Treasury notes and bonds by the Federal Reserve, using credits to accounts of the selling entities (and thereby the creation of new money in the U.S. financial system).

The second major policy announcement occurred the evening of December 6th, 2010.  President Obama announced that he had negotiated a compromise agreement with Congressional Republicans to extend the Bush tax cuts and to include other stimulus measures (payroll tax cuts, investment tax credits), and a further extension of jobless benefits.  The Congressional Budget Office has since estimated that this will expand the U.S. deficit by at least $800 billion over 10 years' time.

Using the Jackson Hole speech as a milestone, one can measure interest rate moves in the U.S. 10-year Treasury note, as well as 10-year yield levels around the globe, and a move in breakeven levels of Treasury inflation-protected securities, or TIPS.  They are as follows:

Date 10-Year Yield 10-Year TIPS Breakevens Bunds (German government bonds) Gilts (U.K. government bonds) Japanese government bonds Gold Thomson Reuters/Jefferies CRB Index (CRY) S&P 500 Index
August 26, 2010 2.48% 1.57% 2.16% 2.88% 0.94%      
December 15, 2010 3.46% 2.32% 3.03% 3.62% 1.27%      
Change 0.98% 0.75% 0.87% 0.74% 0.32% +12% +20% +18%

Source: Bloomberg

Treasury yields react to changing inflation expectations, changing growth expectations, and changes in credit quality.  It is obvious to us from the indicators above that the interest rate move of 98 basis points from the Jackson Hole speech to the time of this writing (3:00 EST U.S., December 15, 2010) is in part a reaction to a change in inflation expectations (one basis point equals one hundredth of one percentage point).  In our view, the Federal Reserve is clearly uncomfortable with the possibility of deflation (falling prices) and is taking extraordinary steps to move the U.S. economy to higher, but still comfortable, levels of inflation. For example, one can analyze changes in the TIPS breakeven inflation rate, which is the difference between nominal Treasury yields and TIPS yields on securities of comparable maturities and is useful as a real-time measure of market inflation expectations. The move in TIPS breakevens of 75 basis points, then, indicates to observers that this market is discounting future progress by the Fed in moving toward this goal.  The moves in the Thompson Reuters/Jefferies CRB Index, a major commodities index, and in the price of gold, also confirm this reaction.  The move in the S&P 500 Equity Index also indicates to us that the Fed policy move may have a positive effect on growth and that it may provide a form of liquidity stimulus capable of inflating stock prices.  Several Federal Reserve Board members have stated this as a secondary goal of the Fed's quantitative easing program.

The second potential policy move that adds fiscal stimulus -- the tax agreement -- has received an interesting reaction from the markets.  Ten-year yield moves on the U.S. Treasury note of 53 basis points (from December 6th to the present) have dwarfed TIPS breakeven yield moves of 14 basis points.  Stocks and commodities have moved very little as well.  In our view, the reaction to the possible fiscal stimulus may have more of a growth and credit deterioration aspect (many economists have increased GDP growth forecasts by 0.5%, for example), than an inflation discounting aspect.  As to the credit deterioration, so far U.S. credit default swap insurance premiums have not moved.   However, S&P and Moody's have said that the deficit expansion may induce a change to the U.S. credit quality status in the future.  International entities and market commentators have also questioned the fiscal prudence of this move.

In summary, the significant move in U.S. Treasury yields are discounting some elements of increasing inflation expectations, increasing growth expectations, and some potential deterioration in our credit standing (a smaller effect right now). We believe that, over long periods of time, yields on U.S. Treasury 5-year and 10-year notes have the potential to move near the nominal GDP growth rate.  That growth rate is currently often forecasted to be in a range of 4.5% to 6.0%.  We do not believe that a move of that size is possible right now.  The major negative effect would be in the housing sector.  Economists will tell you that the contribution to GDP from residential construction is very small right now.  They are correct.  However, a housing price decline resulting from a sharp move in mortgage rates would have a significant negative wealth effect on spending.  Additionally, it would further expose the contingent liabilities that the U.S. has in this area, such as Fannie Mae and Freddie Mac loss backstops, further potential takeovers of banks by the FDIC, and a potential further hit to healthy bank capital).  We believe that 4% on the U.S. Treasury 10-year note would be a possible danger point, and produce negative reactions from global equity markets.  It is also interesting that international yields have moved along with the U.S. Treasury curve.  This comes from the competitive effect of the fight for capital.  Increasing U.S. interest rates can draw money if they reflect better growth prospects (and not significant credit deterioration).  In our view, international interest rates will have to move to compete in the fight for global capital.

Paul Grillo
Senior Vice President,
Co-Chief Investment Officer – Total Return Fixed Income Strategy

The views expressed were current as of Dec. 6, 2011, and are subject to change at any time.

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The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock market.

S&P and Moody's are nationally recognized credit rating agencies. Credit ratings agencies express forward-looking opinions about the creditworthiness of issuers and obligations.

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