Fixed income update
December 15, 2010
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:
10-Year TIPS Breakevens
Bunds (German government bonds)
Gilts (U.K. government bonds)
Japanese government bonds
Thomson Reuters/Jefferies CRB Index (CRY)
S&P 500 Index
August 26, 2010
December 15, 2010
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.
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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IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
Mutual funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.
Interest payments on inflation-indexed debt securities will vary as the principal and/or interest is adjusted for inflation.
International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.
Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.
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 U.S. 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.
The Thomson Reuters/Jefferies CRB Index is designed to provide timely and accurate representation of a long-only, broadly diversified investment in commodities through a transparent and disciplined calculation methodology.
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