October 2010

Fixed Income Market Recap
Dominating attention through the month was the Federal Reserve with the Fed and Wall Street trading-desks attempting to out-game each other. Clearly, the Fed has not handled the idea and implementation of QE2 very well. When the concept was first floated, interest rates fell as the Fed had certainly hoped. Then, concluding that the easing was fully “priced-in”, traders sold bonds and pushed rates back up to the pre-announcement level. The Fed countered by hinting that QE2 would be bigger than first suggested. Rates tumbled and the cycle repeated itself. In our opinion, QE2 is a flawed strategy. The back and forth on interest rates and the public debate among Fed governors and presidents only serve to confuse and alarm consumers. Nonetheless, the Fed has committed and it’s their move. In 2001, the yield on the 30-year bond fell 40 basis points in two days on the news of the elimination of the security as a funding vehicle. With the interest rate spread between the 10-year and 30-year Treasury’s close to a record wide, a strategy of focusing purchases on the very long end of the yield curve could have a similar effect and force the entire term-structure lower. At least temporarily. Back in 2001, the 30-year rate rose back to the pre-announcement level one month later.

Economic Overview
Buried amidst the monetary policy rhetoric, recent economic activity has showed some sign of improvement. Specifically, Retail Sales grew at a faster rate than was expected. Similarly, recent news on housing sales and new home inventory hinted that the worst may be behind us. However, the employment picture has yet to signal that job creation is imminent. While employment is a lagging indicator, the naggingly high unemployment rate is likely to continue to be an impediment to acceleration in economic growth. With the holiday selling season rapidly approaching, it will be telling to see if consumer spending will hold up. If it does, the possibility exists that it could be enough to ignite a virtuous circle with enough momentum to make a meaningful dent in the unemployment rate. If such an outcome were to materialize, talk would quickly shift from quantitative easing to the mountain of excess reserves sitting in the banking system.

Anticipating continued heightened volatility and mindful of the potential for extreme moves in the capital markets, we continue to maintain a defensive posture in the portfolio and have implemented long option positions to mitigate the impact of an extreme outcome.