September was a continuation of the fear and anxiety that plagued the markets in August. Worries about a global slowdown and the fiscal situation in Europe drove a volatile month.

Fears of a double-dip recession have been growing as economic data has moderated. These fears were stoked after the September FOMC meeting when the Fed downgraded the state of the economy by stating that it saw “significant downside risks to the economic outlook, including strains in global financial markets” and announced a new plan intended to stimulate growth, dubbed “Operation Twist”. The plan will see the Fed sell $400 billion of its shorter-dated (3 years or less) Treasury holdings and buy longer-dated Treasuries (6 years or more) by the end of June 2012 with the intent of holding down long-term interest rates. Additionally, the Fed will reinvest principal payments from its agency debt and agency mortgage-backed holdings back into agency mortgage-backed securities. (It had been reinvesting those proceeds in Treasuries.) The Fed also expects inflation to settle and remain stable over the longer-term. As in the previous meeting, Richard Fisher, Narayana Kocherlakota, and Charles Plosser did not support additional policy accommodation.

The IMF also adjusted its global outlook down, revising its estimate for global growth in 2011 and 2012 to 4% from previous estimates of 4.3% Estimates for the US were revised from 2.5% to 1.5%.

On September 19th, S&P downgraded Italy (the third largest eurozone economy) from A+ to A, citing weak growth and political uncertainty. S&P’s outlook remained negative. But Greece remains the poster child for European trouble, as the country seems to be caught in an endless cycle of reform pledges to obtain financial aid. Despite pledges, the markets have provided an opinion that there seems to be no way out that does not involve default. One- and two-year Greek debt is trading at close to fifty cents on the dollar. Greece is currently in a race to obtain an €8 billion slice of aid that would help prevent an October default. Several eurozone governments (including Germany) have approved the expansion of the size and powers of the EFSF bailout fund and continue to monitor Greek progress on its budget gap as a precondition to receiving the aid.

Anxiety abounded with the banking sector as Moody’s played an active role in downgrading many large institutions. On the 14th, two French banks (Societe Generale, Credit Agricole) were lowered one notch due to exposure to Greek debt and other weak eurozone countries. A week later Bank of America, Citigroup, and Wells Fargo experienced downgrades. Moody’s cited that the current fiscal situation made it less likely that the US would step in to provide aid to these banks if it were ever to be needed. Moody’s also downgraded eight Greek banks two notches due to a deteriorating environment in that country.

In addition to economic developments in the US and Europe, Q3 corporate earnings will begin to be released this month. Look for the stock market to scrutinize not only Q3 figures, but any guidance that will be given for the upcoming quarters. Earnings season will unofficially kick off on October 11th with Alcoa.

Economic Indicators

Employment

Many fears were realized when the BLS released its Employment Situation report on Sept. 2nd. The report indicated that job growth stalled completely in August with no change in nonfarm payrolls or the unemployment rate (9.1%). This fell well short of economist expectations, which were for moderate growth of 68k jobs. Job gains in July were also revised downwards from 117k to 85k. September employment figures, set to be released this week, are expected to show only a small amount of job growth (70k for the ADP report and 50k for the BLS). The employment components for most regional manufacturing surveys fluctuated around the breakeven mark, with most indicating very moderate growth. Weekly initial jobless claims rose above the 430k mark in September, before falling to 391k for the week ending 9/23, only the second time this figure has been below 400k in the last five months. The four week average stands at 417k, up from 411k at the end of August.

Manufacturing

The ISM Manufacturing survey clung to an expansionary reading of 50.6 in August, down from 50.9 in July but better than expectations of 48.5. This survey is significantly lower than the recent period of January – April 2011 when the survey figures were above 60. Industrial production also maintained modest momentum, growing 0.2% in August, down from 0.9% growth the previous month. Durable goods showed a modest decline in August, falling by 0.1%, slightly less than expected. Regional surveys indicated that momentum could be slowing. Surveys from New York, Philadelphia, Dallas, and Richmond were all in negative territory, indicating contraction, with a majority showing negative readings for New Orders and Shipments. One bright spot was the Chicago PMI report, which unexpectedly rose from 56.5 to 60.4. Economists had expected a decline. Key components such as Production, New Orders, and Employment all showed significant gains, with Employment reaching a four month high.

Prices

Import prices fell 0.4% in August but are up 13.0% since August 2010. The decline in August was smaller than economists had expected. Producer prices were unchanged in August while core prices (ex. food and energy) were only 0.1% higher, less than the expectations of 0.2%. While import and producer prices remained tame, consumer prices continue to rise, with CPI up 0.4% in August while core consumer prices rose 0.2%. The rise in headline prices was boosted by increases in gas and food, which rose by 1.9% and 0.5%, respectively. The price components in the manufacturing surveys continue to show rising prices, although some figures showed them rising at a slower pace. The Empire Manufacturing, Philly Fed Index, and Dallas price components all rose. Other surveys showing moderating (but rising) prices included ISM Manufacturing (from 59.0 to 55.5) and Chicago (from 68.6 to 62.3). The Fed continues to believe that inflation will remain tame, and the recent selloff in commodities may help contain the headline numbers.

Consumer

According to the University of Michigan, consumer confidence recovered slightly from the multi-decade low reading experienced in August. Confidence climbed to 59.4 in September from 55.7. The Conference Board Index also showed a tiny gain from depressed levels, rising from 45.2 to 45.4. Weak, but improving, consumer sentiment spilled over to purchases. Retail sales were flat in August and up only 0.1% with the volatile auto component removed. Personal income declined 0.1% in August while spending grew a moderate 0.2%.

Housing

Not much has changed in the housing market, with most signs pointing to a possible “bottoming out” of the market. Existing home sales and building permits rose in August, while new home sales and housing starts fell. On a more positive note, the S&P/Case-Shiller Home Price Index rose for the fourth consecutive month, with 17 of the 20 cities in the 20-City Composite showing gains. 18 of the 20 cities are still in the red over the past year. The report noted a continuing decline in the default rate, but cited declines in the state of the economy and consumer confidence levels that led them to believe that “the housing market is still bottoming and has not turned around.”

US Treasury Market

The month of September began with negative economic news before the Labor Day holiday causing the benchmark 10-yr Treasury note to lose 21bps in the first two trading days, moving in on the pivotal 2% level. The Employment Situation report was released the first trading day after the holiday, showing zero net jobs were added in August, causing investors to shun stocks in a panic sell-off and a flight-to-safety rally in Treasuries. The 10-yr note closed at 1.98%, nearing the lowest level in 60 years of 1.90% set in 1950. The lowest the 10-yr reached during the financial crisis was 2.08% on 12/18/08. Continued sovereign debt turmoil in Europe and dismal economic reports in the US resulted in the worst quarter since 2008 for stocks and the best performing for Treasuries as worldwide investors poured money into US Treasuries. The benchmark note closed beneath 2.00% 11 times in the 21 trading days in September.

The FOMC met for an extended two-day meeting on 9/21 as announced last month. The committee acknowledged that inflation appears to have moderated since the beginning of year, growth is slow, and the labor market remains weak. The announcement of no anticipated change in the Federal Funds rate through mid-2013 was no surprise. Several policy tools were contemplated by the committee to attempt to stimulate economic growth, including QE3, but the alternative with the highest odds became a reality, Operation Twist, referring to the intended reshaping of the yield curve to spur spending and encourage investing in riskier assets with higher yields. Operation Twist commands the Federal Reserve to purchase $400 billion in 6-30yr bonds and sell equal amounts in notes with maturities three years or less. Bond yields were in a freefall upon this announcement with the benchmark closing at 1.72% and the 30yr yield dropping to 2.78%. The desired curve flattening was witnessed with the 30-yr closing the month at 2.90%, down 70 basis points on the month.

The first purchase of longer term debt began October 3rd with $2.5 billion in 15 securities with maturities between 2036-2041. The action caused long-dated Treasuries to advance further.

Corporate Bond Market

The European banking system was the focus of the markets after the Labor Day holiday, turning the market negative and sustaining the volatility in the markets. Solvency of Greece and European banks was the focus for the month as concerns of those events kept investors in safer asset classes. Higher-rated corporate securities benefited from the flight-to-quality compared to lower-rated securities as safety trumped return for the second straight month. For the month of September investment grade corporate spreads widened ending the month at 137.92bps, up 23.5bps after closing at record high of 138.16bps on September 22nd, according to the Markit Investment Grade Index. In the past two months the index has widened more than 42bps in the midst of the volatility in the marketplace.

The Barclays Capital U.S. Corporate Index returned 0.26% for the month of September, underperforming similar duration Treasuries by 1.92%. The continued flight-to-quality in the marketplace led to the negative price return component of the total return, ending the month at -0.35%. The long (10+years) part of the index outperformed the shorter part of the curve returning 3.30% compared to -0.82% for the short end. The long part of the curve benefitted from the decrease in long Treasury rates caused by the Fed’s actions dubbed ‘Operation Twist’. From the sector perspective, Utilities performed the best returning 1.98%, followed by Industrials returning 1.01% and Financials with -1.47%. Financials underperformed as investors continued to view them as risky. That, coupled with actions by rating agencies, exacerbated the underperformance. Higher-rated securities performed better than lower-rated; AAA-rated securities returned 2.62% while BBB securities were even for the month returning 0.00%.

The Federal Housing Finance Agency sued 17 banks over subprime mortgage bonds. The suit alleges that losses incurred by Fannie Mae and Freddie Mac on private-label mortgage–backed securities were a result of misrepresentations on the part of the banks. The suit puts in jeopardy settlements talks in progress with Attorney Generals from the 50 states. The FHFA filed the lawsuits prior to the expiration of the 3-year statutory limit. The bonds and stocks of banks faced downward pressure after news of the lawsuits broke. Further pressure was felt in the financial sector as Moody’s lowered the credit rating of Bank of America, Citigroup, and Wells Fargo. The report cited that it was less likely for the US government to step in and provide assistance to the banks due to the current fiscal conditions.

Municipal Bond Market

September marked the one year anniversary of banking analyst Meredith Whitney’s report alleging a dire fiscal condition of state and local municipalities, which was the precursor to her appearance on 60-minutes in December leading to a massive sell-off on such fears. The hundreds of billions of dollars of defaults she predicted would occur in 2011 have yet to materialize. To-date, there has been only $1.1 billion in defaults, according to Bank of America Merrill Lynch, less than a quarter of the amount in 2010. Experts in the municipal bond industry were quick to dismiss her call last year, and gave recounts of her misjudgment on CNBC last week in an effort to calm retail investor’s uncertainties.

Municipal bonds have actually performed exceptionally well this year. September marked the sixth straight month of positive returns, a winning streak not seen since 2002. Munis are even performing better year-to-date than Treasuries, which have benefitted from a drastic flight-to-safety trade in recent months. The rise in Treasury yields has caused abnormally high muni/treasury ratios. After the FOMC announcement, the 10-yr ratio reached 114% and the 30-yr rose to 122%, the highest since April 2009. The averages have been 94% and 104% over the last year, respectively. Despite the relative cheapness to taxables, municipal yields remain at absolute low levels leading issuers to take advantage of the attractive borrowing environment. Three out of five municipalities delayed or cancelled infrastructure projects in 2011, in an effort to reduce spending to balance budgets, according to a survey from the National League of Cities. This supply/demand imbalance has helped push muni yields down. The third quarter saw an increase in issuance over the first two quarters. Issuance is expected to increase in the fourth quarter though still remain significantly depressed from last year’s totals.

President Obama is working on two bills that threaten to limit the amount of tax-exemption on municipal bond interest. The $447 billion American Jobs Act would cap the tax benefit of tax-exempt interest at 28%. The “Debt Reduction Act of 2011” proposes automatic triggers for reductions in spending and tax preferences, including interest income on municipal bonds, if a debt-to-GDP limit is breached. This would be extremely complicated to account for due to the uncertainty in tax planning every year for muni bondholders and unpredictable issuance costs for state and local municipalities. Therefore, most market participants feel the bill has little chance of passage. Capping or eliminating the tax-exempt status of municipal bonds would reduce demand and increase the cost to issuers, making it a double-whammy to the market in a time where fiscal strain is already extremely high. It has been observed that the market has thus-far ignored the bills and they are assumed to be Dead-on- Arrival.

General Investment Disclosures

This publication has been prepared by BondWave LLC. This publication is provided for informational purposes only. Neither the information, nor opinion, nor prices in this publication constitute a solicitation to buy or sell any financial instrument. This publication is not intended to provide personal investment advice. The securities discussed in this publication may not be suitable for all investors. Investors should independently evaluate each issuer, security, or instrument discussed in this publication and consult with their investment advisor before making any investment decisions. Information contained in this publication has been obtained from sources believed to be reliable, but BondWave Advisors does not represent or warrant that such information is accurate or complete. The information in this publication is not intended to predict actual results, which may differ substantially from those reflected. Past performance is not necessarily indicative of future results. Any opinions in this publication provided by BondWave LLC are as of the date of this publication and are subject to change. BondWave LLC has no obligation to update its opinions or the information in this publication.

BondWave disclaims liability arising out of the use of the information and opinions contained herein.

About BondWave Yield Curves

The yields shown in the charts specified as BondWave curves are based on the known and applicable MSRB/TRACE trades for that same date (as reported by MSRB for municipal securities and TRACE for corporate securities, as applicable). Trades must have a minimum par value of $50,000 to be included and the resulting curves are based on the par-weighted values of the yields.

Please be advised that the yields reflected are only presented to provide an indication of the bond market on the date specified and are not indicative of the expertise of BondWave or any recommendations provided by BondWave. Because the yields are based only upon the securities that traded over the applicable period, such yields may not be indicative of what is currently available in the marketplace or the yields of other municipal or corporate securities that did not trade on such dates. Municipal and corporate security yields are based in part on certain assumptions and as a result, an investment in such securities may not result in performance comparable to the quoted yields. Past performance is not necessarily indicative of future results.

© Copyright BondWave LLC (2011). All rights reserved. No part of this publication may be reproduced in any manner without the prior written permission of BondWave LLC.

 

 

 

(c) BondWave Advisors

www.bondwave.com