Fixed Income Quarterly Review
Fixed Income Quarterly Review, 12 / 2009
Chart 1: The Treasury Yield Curve
The prospects of an accommodative Federal Reserve as well as an uptick in the headline consumer price index led to rising Treasury rates in the fourth quarter of 2009. While rates rose across all but the shortest maturities, longer dated interest rates rose the most.
The 2-year Treasury yield rose 19 basis points, beginning the quarter yielding 0.95% and ending at 1.14%. The 10-year Treasury yield rose 53 basis points, starting the quarter at 3.31% and ending at 3.84%. The 30-year Treasury yield rose 59 basis points, starting the quarter at 4.05% and ending at 4.64%.
Chart 2: The Shape of the Yield Curve
The yield difference between 10-year U.S. Treasury rates and 2-year U.S. Treasury rates rose during the fourth quarter from 235 basis points at the end of September to 269 basis points at the end of December. With data reaching back to June 1976, the current yield gap is the largest on record. The historically average yield gap since 1976 has been 79 basis points.
Very steep yield curves are common during and around recessions as monetary authorities, such as the Federal Reserve, push short-term interest rates down to stimulate the economy. Longer-term interest rates adjust in anticipation of the consequences of low short-term rates. These consequences may eventually lead to higher inflation, but the near-term goal is an increase in economic activity.
Chart 3: Corporate Bond Spreads
Corporate bond risk, as measured by the yield spread of the Merrill Lynch Corporate Master index improved during the third quarter. Beginning the quarter 235 basis points above the Treasury market, corporate yield spreads tightened to finish the quarter 190 basis points above Treasuries. This is the tightest level for corporate bond spreads since October 2007.
After peaking at 641 basis points in November 2008, yield spreads have marched steadily, and at times quickly down. Since the Merrill Lynch Corporate Bond Index data has been available, the median yield spread has been 121 basis points.
Chart 4: Intermediate Term Bond Market Performance By Sector
The fourth quarter was a microcosm of the calendar year. Corporate bonds, on the back of a great deal of spread tightening, were far and away the best performers. Mortgage-backed securities were the second best performers for the quarter and the year. Government debt performed poorly for the quarter and year with U.S. Treasury debt actually turning in a negative return.
Considering the strength of the corporate bond market in 2009, it is fairly safe to speculate that another year of double digit returns in this sector is highly unlikely. However, corporate bond yields remain at relatively attractive levels compared to other bond sectors.
Chart 5: 10-Year U.S. TIP Inflation Expectations
Over the past 10 years, 10-year inflation expectations as measured by the U.S. TIPs market had been range bound between 1.5% and 2.5%. When the credit crisis broke out in the second half of 2008, fears of a widespread global downturn pushed inflation expectations sharply down. So sharp was the downturn that by December 2008, 10-year inflation expectations were down to 0.1%. As the credit markets began to heal during 2009, expectations for inflation sharply normalized ending the year closer to an historic norm of 2.4%. Should inflation expectations move too far above 2.5%, it would indicate greater concern that the Federal Reserve's monetary policy is too accommodative.
Chart 6: U.S. Dollar Index
The dollar index, a general dollar value as measured by the dollar exchange rate compared to 6 major currencies, has been in a steady state of decline since January 2002. After peaking at around 120, it has fallen gradually into the 70's, closing 2009 at 77.86. As with the inflation expectations, illustrated above, the credit crisis affected the dollar. As fear spread through the global economies, the U.S. dollars status as a safe haven currency pushed the dollar index up from 71.80 in March 2008 to 88.01 in February 2009. The easing of the credit concerns after the first quarter of 2009 has resulted in a resumption of the decline in the dollar. A falling dollar, even with a modest domestic economic recovery, could result in additional inflation as goods produced elsewhere in the world cost more in dollars.
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