Fixed Income Quarterly Review
Fixed Income Quarterly Review, 6 / 2009
Chart 1: The Treasury Yield Curve
Signs that the worst of the financial crisis may be behind led to hope of a recovery and a rise in Treasury yields during the second quarter. The rise in rates across all but the shortest maturities came in the form of improving growth and accelerating inflation expectations.
The 2-year Treasury yield rose 32 basis points, beginning the quarter yielding 0.79% and ending at 1.11%. The 10-year Treasury yield rose 87 basis points, starting the quarter at 2.66% and ending at 3.53%. The 30-year Treasury yield rose 80 basis points, starting the quarter at 3.53% and ending at 4.33%.
Chart 2: The Shape of the Yield Curve
The steepness of the yield curve, as measured by the yield difference between short-term and long-term interest rates, can give clues to market expectations for the future of the economy.
The yield difference between 10-year U.S. Treasury rates and 2-year U.S. Treasury rates increased during the second quarter from 186 basis points at the end of March to 242 basis points at the end of June. This increase was caused primarily by rising long-term yields.
The current steep yield curve incorporates rising inflation and growth expectations as well as the Federal Reserve's efforts to keep short-term interest rates low for an extended period.
Chart 3: Corporate Bond Spreads
Corporate bond risk, as measured by the yield spread of the Merrill Lynch Corporate Master index improved drastically during the second quarter. Beginning the quarter 586 basis points above the Treasury market, corporate yield spreads tightened 255 basis points to finish the quarter 331basis points above Treasuries.
So extreme was the tightening that Baa-rated corporate bonds, as measured by Moody's Baa corporate bond index, tightened by more in the second quarter of 2009 than any quarter going back to the third quarter of 1932. Aaa-rated corporate bonds, as measured by Moody's Aaa corporate bond index tightened more in the quarter than any period extending to the beginning of our available data in the first quarter of 1926.
Chart 4: Intermediate Term Bond Market Performance By Sector
The coupon income in the Treasury sector could not overcome the rise in interest rates. This contributed to the relatively poor performance of the Treasuries against other investment-grade sectors during the second quarter. The clear winner was the corporate sector. The powerful spread tightening from very wide levels ending the first quarter more than overcame the rising Treasury yields.
Even after such a spectacular quarter, the corporate sector trails the other three major investment-grade sectors over the 12-month period. Leading the year-over-year performance was the mortgage-backed securities sector. The mortgage-backed sector has benefitted from the Federal Reserves commitment to purchase $1.25 trillion of these securities in its attempt to keep mortgage rates low and ease the stress permeating the residential housing market.
Chart 5: U.S. Consumer Confidence… Very Low
One of the more dramatic elements of this current recession has been the rise in the unemployment rate. After reaching a cycle low of 4.4% in October 2006, the rate of unemployment in the United States has risen sharply and stands at 9.5% through the end of June 2009. The pace at which the unemployment rate has risen exceeds any upturn since the Bureau of Labor Statistics began measuring in January 1948.
On a more positive note, the unemployment rate is generally considered a lagging indicator of economic activity as it tends to rise even after the economy begins to improve. This occurs for a couple of reasons. As the economy improves fewer people are being let go from their jobs but more people begin to hunt for jobs as prospects for employment improve.
Chart 6: 30 Year Conforming Mortgage Rate… Also Very Low
The Bloomberg Financial Conditions Index (BFCI) was developed to track the level of stress and dislocation in the U.S. financial markets. This index is comprised of money market, equity market and fixed income market indicators. The index value shows the number of standard deviations the financial markets are from normal.
In the third quarter of 2007, the BFCI began to deteriorate as the credit crisis spread across most financial markets. The index dropped significantly after the fall of Lehman Brothers in September 2008. Throughout 2009 we have seen a significant improvement in the BFCI, which has returned to pre-Lehman levels. While far from normal, it is encouraging to think that the worst of the financial crisis may be behind us.
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