The US Fixed Income Market
Interest rates skyrocketed last week after the US tax cut extension was announced. The 10-year and 30-year Treasury bonds widened 28 and 15 basis points, respectively, over the course of the week.
Fears of rising inflation expectations and concern that the US government is still not serious about cutting the deficit hit Treasury prices. The cut in Social Security payroll taxes is expected to help stimulate additional consumer spending and in turn provide faster GDP growth, which is increasing inflation expectations. Even PIMCO, the advocate of the "the new normal" paradigm, capitulated and increased its GDP forecast. PIMCO now expects GDP to grow 3%-3.5% year over year in the fourth quarter of 2011, compared with its prior forecast of 2%-2.5%.
The decline in payroll taxes, extension of the tax cuts to higher-income households, and rejection of the plan put forth by the president's commission on deficit reduction are causing increasing concern that the US government still is not taking the country's financial status seriously. As such, investors are becoming increasingly nervous that the amount of new issue supply in the market will continue unabated as the deficit remains elevated for the foreseeable future.
Higher interest rates provided the impetus to fixed-income participants to put any remaining sidelined cash to work this week. One trader described market action on Tuesday and Wednesday as a "lift-a-thon" in reference to buyers lifting or buying bonds on the offer side. As interest rates increased, the demand for longer-duration bonds also increased as buyers were tempted by the higher yields. For investors who took our Sept. 28 recommendation to rotate into lower-duration securities, which we reiterated Oct. 5, we can see the attraction to rotate back into long-duration positions as the 10-year Treasury bond has widened 92 basis points and the 30-year bond has widened 76 basis points since Oct. 6.
The Morningstar Corporate Bond Index tightened 5 basis points last week to +155, recapturing a third of the recent widening from the most recent sovereign crisis. We maintain our expectation that the market will quickly recapture the rest of this widening as credit spreads in the United States continue their tightening trend.
The Europen Fixed Income Market
Corporate credit spreads in Europe were relatively steady, as tightening in industrial names was offset by continued widening in the financial sector. The rapid pace of tightening in credit spreads for Europe's periphery countries ended last week. In fact, it appears from the charts that for some countries, the rally is rolling over. For example, Ireland's credit default swaps widened to +560 from +535 the prior week, Portugal's CDS widened to +475 from +425, and Spain's CDS widened to +339 from +295. Even more worrisome is the widening in France's CDS to +104 from +91 and Germany's CDS widening to +54 from +46. While these levels for France and Germany are not of concern themselves, the markets' revaluation of the credit quality of the stalwarts of the eurozone is an indication of the heightened potential for contagion as a result of increasing interdependency in the European financial system.
While we do not expect any sovereign near-term defaults or restructurings, we expect the sovereign problems in Europe will continue. In fact, the pattern of widening credit spreads, liquidity crises, and subsequent bridge financing to provide short-term bailouts will probably continue. The best potential for a long-term resolution of the underlying issues will be when the Eurogroup releases the mechanism it is formulating to determine if a country is undergoing a liquidity crisis or is insolvent and the method to calculate the haircut that existing bondholders will have to suffer when a country is deemed insolvent.
