Fixed Income Quarterly Review
Fixed Income Quarterly Review, 06 / 2006
Chart 1: The Treasury Yield Curve
The Treasury yield curve rose across all maturities during the second quarter.
The 2-year Treasury yield rose 0.34%, beginning the quarter yielding 4.81% and ending yielding 5.15%. The 5-year Treasury yield rose 0.28%, beginning the quarter yielding 4.81% and ending yielding 5.09%. The 10-year Treasury yield rose 0.29%, beginning the quarter yielding 4.84% and ending yielding 5.13%.
This parallel shift in interest rates indicates a "wait and see" attitude by the participants in the Treasury market. A slowdown in economic activity should see the longer maturity yields move down, possibly leading to an inverted yield curve. The degree to which inflation responds to the Fed's restrictive policy is also a factor.
Chart 2: The Flattening of the Yield Curve
The shape of the curve, defined by the yield difference between long-dated Treasury notes and short-dated Treasury notes remains flat to slightly negative. The yield distance between a 10-year Treasury and a 2-year Treasury began the quarter barely positive at 0.02% and ended the quarter barely negative -0.01%.
A shallow or slightly inverted yield curve is common. The spread between 2-year and 10-year Treasury notes has been between 0.20% and -0.20% about 25% of the time in recent decades. Inversions beyond -0.20% are less common and have been associated with economic slowdowns and future interest rate cuts.
Chart 3: Intermediate Term Bond Market Performance By Sector
Treasury notes and agency notes were the best performing sectors in the investment-grade bond market during the second quarter as investors sought high credit quality bonds. Mortgage-backed securities were the worst performers.
For the trailing 12-month period, corporate bonds turned in a noticeably poor performance as spreads have widened amid concerns over a slowing economy. Agency notes and mortgage-backed securities performed the best as prepayment rates declined on home mortgages. Rising interest rates reduced the level of home owner refinancings.
Chart 4: Corporate Bond Spreads
Corporate bond spreads moved out during the second quarter. The spread over Treasuries of the Merrill Lynch Corporate Master index widened from 0.89% to 0.97%.
As the Federal Reserve has removed its accommodative monetary policy, investors have shifted their preference for risky investments to less risky investments.
Chart 5: Oil and Gold
The bull market in commodities, while volatile, seemed to remain in place during the second quarter. Gold was up 6% during the quarter and 42% over the trailing 12 months to $616/oz. Oil, measured by West Texas Intermediate grade was up 12% for the quarter and 42% for the trailing 12 months to $74 per barrel.
A broader measure of commodity inflation, the CRB, which consists of 17 equally weighted commodities was up 4% for the second quarter and 15% for the trailing 12 month period. This indicates a substantial rise in input prices that, along with higher energy costs, could prove inflationary.
Chart 6: Year-Over-Year Average Hourly Earnings Increase
One area of concern that could pressure the Federal Reserve to keep interest rates elevated is the rise in hourly earnings. Hourly earnings grew at 3.9% for the 12-months ending June 2006. This is reaching earnings levels last seen in the late 1990s. Wages are the largest cost component for most corporations and the "pass through" of these costs from companies to consumers will be closely watched by the members of the Federal Reserve.
During the last period of 4% wage growth 1997 - 2000, the Federal Funds rate ranged from a low of 4.75% to a high of 6.50% with an average of 5.50%. The current Fed Funds rate is 5.25% with expectations for one more 0.25% hike.
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