Fixed Income Quarterly Review
Fixed Income Quarterly Review, 3 / 2009
Chart 1: The Treasury Yield Curve
The Federal Reserve, having put the overnight Fed Funds rate in a range between 0.00% and 0.25% at their December 16th, 2008 meeting, has effectively reached the end of their interest rate policy rope. The Federal Open Market Committee met twice during the first quarter and kept the range-bound Fed policy of 0.00% to 0.25% funds. In January, the Fed turned to a different tool to provide stimulus to the economy called "quantitative easing". Quantitative easing is where the Federal Reserve targets and purchases U.S. Treasury and agency debt as well as mortgage-backed securities to keep longer term rates low and stimulate the economy.
The 2-year Treasury yield rose 3 basis points, beginning the quarter yielding 0.76% and ending at 0.79%. The 10-year Treasury yield rose 45 basis points, starting the quarter at 2.21% and ending at 2.66%. The 30-year Treasury yield rose 85 basis points, starting the quarter at 2.68% and ending at 3.53%.
Chart 2: The Shape of the Yield Curve
A standard view of the shape of the yield curve, or term structure of interest rates, is the yield difference between a 10-year Treasury note and a 2-year Treasury note. This relationship is typically positive and reflects future economic optimism. A negative relationship can reflect a negative outlook for economic activity, a condition in place in early 2007.
The yield difference between 10-year U.S. Treasury rates and 2-year U.S. Treasury rates increased during the first quarter from 144 basis points at the end of December 2008 to 186 basis points at the end of March 2009. This was largely due to longer dated yields rising more than shorter dated yields. The Federal Reserve has a greater ability to affect short-term interest rates than long-term interest rates with their control over the Fed Funds rate. As the stress in the bond market relinquished somewhat during the first quarter, long-term interest rates rose to reflect marginal economic optimism.
Chart 3: Corporate Bond Spreads
Corporate bond risk, as measured by the yield spread of the Merrill Lynch Corporate Master index improved modestly during the first quarter. Beginning the quarter 604 basis points above the Treasury market, corporate yield spreads tightened 18 basis points to finish the quarter 586 basis points above Treasuries.
To underscore the stress still existing in certain sectors of the corporate bond market, the financial sector (not shown) actually widened a lot beginning the quarter spread 688 basis points above Treasuries and ending the quarter spread 840 basis points over Treasuries.
Corporate bond spreads provide a significant pickup in yield to Treasury bonds and reflect concern over weak economic conditions.
Chart 4: Intermediate Term Bond Market Performance By Sector
The rise in U.S. Treasury yields overcame the Treasury coupons resulting in a small negative total return for the quarter. U.S. agency and investment grade corporate bonds performed in line with each other and slightly better than Treasuries as yield spread tightening in these sectors allowed for slightly positive total returns. Mortgage-backed securities had the best performance by far during the quarter as a result of direct purchases in the open market of these securities by the Federal Reserve.
What is most remarkable about sector performance over the past twelve months is the massive underperformance of corporates. In spite of some signs of stabilization in corporate bond spreads, multi-decade spread widening has greatly hindered the performance of this sector. Signs of improvement in the credit markets should help the relative performance of this sector.
Chart 5: U.S. Consumer Confidence… Very Low
A clear and present statement of the impact the current economic malaise has had upon the U.S. economy can be seen in the consumer confidence index. The index reading of 26.0 for the month of March is slightly higher than the February all-time low of 25.3. The index, which measures the consumer's assessment of present and future prospects for the economy, is released monthly and dates back to 1967. The median reading over the life of the index is 98.0.
The only encouraging aspect of this index is that it tends to be correlated with the unemployment rate. The unemployment rate is a lagging indicator of economic activity. Economic activity should be improving as the employment situation, and therefore the consumer confidence numbers find their bottoms.
Chart 6: 30 Year Conforming Mortgage Rate… Also Very Low
As grim as the consumer confidence numbers may currently be, there are a few glimmers of light. The U.S. government's efforts to bring key interest rates down is having a positive effect upon household mortgage rates. Over the course of this decade, 30-year fixed rate mortgages have been in a range between approximately 5.50% and 6.50%. As a result of the Federal Reserve's efforts to purchase mortgage-backed securities and U.S. Treasury notes, the U.S. National Conforming 30-year Fixed Rate Mortgage, according to Banxquote, ended the first quarter yielding 4.70%. This has a positive effect upon household affordability as it makes supporting a home loan easier. Many Americans are now also able to re-finance their existing loans and reduce their current monthly payment.
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