Fixed Income Quarterly Review
Fixed Income Quarterly Review, 09 / 2007
Chart 1: The Treasury Yield Curve
A mid-quarter credit crunch induced a flight-to-quality with U.S. Treasury securities being the prime beneficiaries of the buying. Yields fell across the entire Treasury curve with short maturities falling the most.
The 2-year Treasury yield fell 88 basis points, beginning the quarter yielding 4.86% and ending at 3.98%. The 10-year Treasury yield fell 44 basis points, starting the quarter at 5.02% and ending at 4.58%. The 30-year Treasury yield fell 29 basis points, starting the quarter at 5.12% and ending at 4.83%.
Chart 2: The Shape of the Yield Curve
The shape of the yield curve, also known as the "term structure", measured by the number of basis points between the 2-year and 10-year Treasury yields increased dramatically during the quarter. The Treasury curve began the quarter with 16 basis points between 2-year yields and 10-year yields and finished with 60.
This dramatic increase in the shape of the yield curve is typically a good sign for future economic conditions. During the third quarter however, the steepening of the curve was driven by market participants moving aggressively into short-term Treasury notes and out of corporate bonds.
Chart 3: Corporate Bond Spreads
Corporate bond spreads widened dramatically during the third quarter. The yield spread on the Merrill Lynch Corporate Master index rose 49 basis point, beginning the quarter 100 basis points over Treasuries and ending 149 basis points over. This was the largest widening of credit spreads in many years. The third quarter of 1998, during the market turmoil created in the wake of the Long Term Capital hedge fund collapse, saw yield spreads widen by 57 basis points.
Chart 4: Intermediate Term Bond Market Performance By Sector
Concerns in the credit market, particularly involving sub-prime mortgages and asset-backed securities, took center stage during the quarter. This caused all non-Treasury, investment-grade bonds to underperform Treasury notes. This is typical of a credit crisis as investors seek the safety and liquidity of securities backed by the U. S. Government.
Treasury notes posted the best return for the third quarter followed closely by U. S. agency securities. Corporate bonds were the worst performing sector during the quarter with lower quality investment-grade corporate bonds trailing higher quality investment-grade bonds.
Chart 5: The U.S. Dollar
A concern for the members of the Federal Reserve, indeed all central bankers from the European Central Bank to the Bank of England and the Bank of Japan, is the steady drop in the U.S. dollar. A falling dollar impacts consumers of foreign goods and services by making those goods and services more expensive. Consequently, foreign countries find that their industries producing and exporting to the United States become less competitive as the value of their goods become more expensive in dollars.
If the U.S. economy is slowing down, interest rate cuts on the part of the Federal Reserve could put further downward pressure on the U.S. dollar. A falling dollar raises concerns about future inflationary pressures from imported goods and services.
Chart 6: Three Month LIBOR Spread*
The London Interbank Offered Rate (LIBOR) is the rate that banks lend to each other and is a key rate determining the pricing of short term money market securities. The 3-month LIBOR rate widened significantly to Treasury bills during the quarter as banks and other institutional investors became less willing to lend funds to each other, instead preferring to invest in the safety of Treasury bills.
The disruptions in the credit markets during the quarter were largely brought about by concerns in the asset-backed, derivatives and sub-prime mortgage markets. However, consequences of these concerns echoed through all credit markets, widening yield spreads everywhere including short term money market securities.
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