Risk aversion returned to the capital markets last month, as investors struggled to understand the fate of European monetary union. The fear was most evident in the exodus of Euro-denominated assets out of European banks and into the U.S. dollar. Spanish banks bore the brunt of the capital outflow, with an estimated 100 billion Euros leaving Spain. As a result, the dollar appreciated more than 6.5% versus the Euro during the month. The U.S. bond market benefited directly from that dollar flow, with the yield on 10-year Treasury notes falling to 1.56% from the 1.94% level at which it started the month. The panic was magnified in the stock market as the S&P 500 lost 6% for the month.

Compounding investor worry, the May employment report showed that the U.S. economy added 69,000 jobs during the month, well below the already subdued estimate of 150,000. To be certain, the deceleration in job growth has caught us by surprise. It seems that the ongoing uncertainty surrounding domestic fiscal policy is slowing what was shaping up to be an accelerating recovery. Based upon that assumption, we have downgraded our growth assumption. We started this year with a forecast that 2012 GDP growth would register 2.75% to 3%. It now seems likely that GDP will come in closer to 2.0%. However, while we expected a slower rate of economic growth, we do not believe that the U.S. economy will slip into recession. Despite the downgrade of our growth forecast, our investment thesis has not changed. We deem interest rates to be artificially and significantly depressed and credit to be cheap. Moreover, with the cost to hedge quite low and the payoff ratio so attractive, our short-term interest rate hedge continues to be an integral component of the fund. In addition, we continue to find interesting opportunities in credit, especially in the municipal bond sector.

While May proved to be a difficult month for developed markets, the collateral damage sustained by emerging market investments in both equities and fixed income was even more substantial. The currencies of Brazil and India were down approximately 6% versus the U.S. Dollar, while the Mexican Peso plunged nearly 10% for the month. For equity investors, the loss was exacerbated by stock markets that were down by 4% to 6% for the month. Emerging market investments were the darlings of the brokerage community just a few months back, touted as offering a higher yielding alternative to developed markets with the added benefit of an appreciating currency. As we’ve discussed previously, an unhedged investment in emerging market debt generates fixed income-like return with equity-like risk. In other words, investors are not paid to take on the added risk.

Despite the red ink that flowed in the latter half of May, the month was not devoid of good news. Several measures of housing activity registered better than expected, including surprise increases in housing starts, existing home sales, and new home sales. Also of note, there were several credit positive events during the month, the most significant being the upgrade of Ford Motor to investment grade. Ford has suffered as a sub-investment grade credit since July 2005, which meant that their access to credit markets was limited and their cost of borrowing significantly higher. To celebrate their elevation to investment grade status, the carmaker issued $1.5 Billion in 5-year notes at a spread of 230 basis points above Treasury notes. That’s approximately 100 basis points tighter than where Ford paper traded just six months prior.

Another “fallen angel” returned to the market during the month, much to our surprise. Late in the month AIG came to market with $750 million in 10-year notes at yield spread of 325 basis points above Treasury notes. Surprisingly, since issuance, the paper has appreciated with the spread above treasury notes falling to 304 basis points. We did not participate in the purchase and are not anticipating holding AIG paper any time soon. In purchasing a bond, we need to feel comfortable that the borrower is willing and able to repay the bond at maturity. We’re not comfortable that AIG meets either of those criteria.

Looking past the noise of day-to-day market volatility, the investment climate has improved markedly since the end of 2011. The feared collapse of the global banking system has faded with European Central Bank’s Long Term bank funding operation and, while Greece was unable to avoid default, the write-down of Greek debt occurred without the messy contagion that was feared. Given that improved backdrop, investors have pushed the price of the S&P 10% higher through the end of March. Comparatively, the bond market correction has been marginal, at best.

Despite fading systemic risks, economic fundamentals continue to take a back seat to the confusing message coming from the Federal Reserve. Investors have been on edge trying to guess what Chairman Bernanke and his fellow Federal Open Market Committee (FOMC) members are going to say or do. The events of the last few weeks offer a glaring example. Prior to the March thirteenth FOMC meeting, consensus opinion was that the Fed was on the verge of launching additional monetary stimulus. Despite a public debate among Fed presidents concerning the need for additional action, Bernanke, in testimony and interview, eluded that such action was imminent. Investors were shocked that no such action was announced as the meeting concluded and the summary statement was issued. Like a spoiled child denied, investors threw a tantrum and sold stocks and bonds, driving the price of both down sharply. Responding to the ensuing criticism Mr. Bernanke took the highly unusual step of launching a public relations campaign, in an effort to explain why the Fed has kept monetary conditions especially easy and the rationale for additional easing, should they decide to pursue QE3. The first stop was a prime time interview with Diane Sawyer on the ABC evening news. The Chairman’s message was that growth has been modest, unemployment too high, and that he doesn’t want to repeat the mistakes made by the Central Bank during the Great Depression. Overall, the interview did little to instill confidence. The next stop of the campaign was an engagement to teach an undergraduate business class at The George Washington University titled “The Aftermath of the Crisis.” The class offered a before, during, and after summary of the financial crisis including an explanation of why the Fed bailed out Bear Stearns and AIG, while allowing Lehman Brothers to fail. Clearly, Chairman Bernanke thought that detailing policy action to college students would provide a non-threatening venue to explain controversial decisions and, while it was, it did little to restore credibility. During the first seminar he was asked if the Fed was to blame for the housing bubble and he said it was not. At subsequent seminars, he defended quantitative easing and continued to defend the possibility that additional quantitative easing may be needed. With that, speculation that the Fed was on the verge of additional stimulus returned. So much so, that on the eve of the April 2nd release of the detailed minutes of the March 13th meeting, consensus had again shifted to the conclusion that the release would detail how and when QE 3 would be implemented; despite the knowledge that the summary released weeks earlier had already dispelled that notion. Nonetheless, the capital markets were sent into a tailspin again when the minutes failed to detail any immediate plans and instead offered a mildly upbeat report. As if Fed credibility hadn’t been damaged enough, Charles Plosser, the President of the Federal Reserve Bank of Philadelphia was quoted as saying just hours before the minutes were released “I think there’s a scenario where you could raise rates by the end of this year.” The year being 2012, not 2014! Keep in mind that these men and women gather in the same room every six weeks to discuss monetary policy.

Instead of explaining his case to impressionable college students and the former Junior Miss America, we’d like to see Bernanke confront someone with a firm grasp of money and banking. Just such an individual is Jim Grant, author of Grant’s Interest Rate Observer. Mr. Grant was invited to visit the Fed and express his criticisms to a representative of the Federal Open Market Committee. In a 3,700 word speech, Mr. Grant takes the Fed to task, writing that “What passes for sound doctrine in 21st-century central banking—so-called financial repression, interest-rate manipulation, stock-price levitation and money printing under the frosted-glass term “quantitative easing.” A quick “Google” search of keywords “Jim Grant crucifies the Fed” will take the reader to the entire speech, which is well worth the trouble.

As we’ve expressed on numerous occasions, we suspect that the Fed’s ability to maintain an artificially low interest rate is losing its effectiveness. With the economy well down the path of self-sustainability and inflation likely to push higher in the coming months, we expected that bonds will come under increasing price pressure.

The storm clouds of worry that hung over the capital markets at year-end yielded to cautious optimism in January. Evidence of the improved sentiment could be found across nearly all asset classes. The S&P 500 index rallied more than 4% and the SPX volatility index (VIX) closed the month below 20% for the first time since June 2010. In the fixed income market, U.S. Treasury notes were largely unchanged while credit markets of all quality rallied.


The initial catalyst for the improved market tone was a reversal of the near-panic that gripped the markets as 2011 came to an end. That relief rally was buttressed by better than expected economic fundamentals. A robust manufacturing sector translated into better-than-expected sales of aircraft, machinery, electronics, and automobiles. Even more encouraging has been the improving employment situation. Investors were cheered by the 1.6 million non-farm payroll jobs gained in 2011. The just released jobs report for January was even more encouraging, with the economy adding a much better than expected 243,000 non-farm payroll jobs. Even more surprising was the 641,000 increase in employment, as measured by the Household survey. Regardless of the measure employed, job growth is strengthening and the “naysayers” forecasting a return to recession are dwindling in number.


However, not everyone is ready to signal the “all clear” yet, with the loudest and most consistent doubter being Federal Reserve Chairman Bernanke. In what many deemed to be a foolish move, the FOMC released the interest rate and inflation forecasts of each Federal Reserve governor and president. From those forecasts, we found three inconsistencies. Immediately apparent is, despite Fed Chairman Bernanke’s proclamation to hold overnight rates at zero through 2014, it’s hardly a unanimous opinion. In fact, of the seventeen members polled, only six are forecasting such an outcome. Three of the forecasters are expecting a rate rise this year and six of them expect a rate hike sometime next year. Clearly, there is not a consensus within the Fed! Second, using a weighted average of the forecasts as the “best guess” forecast for interest rates, we believe that market-implied Fed Fund futures are too expensive, which is the rationale for why we have positioned them as part of our hedging strategy. Lastly, the Fed forecast, under each scenario is that inflation will rise to, but not above, 2.0%. Of the various measures of inflation, the Fed prefers the Personal Consumption Expenditure (PCE) core index, which rose 1.8% YOY in December. However, the entire PCE universe increased 2.4% year over year for the same period. Before the Fed can maintain inflation below 2% they’ll need to first get it below that level. Given the excessively easy monetary policy currently in place and the promise to stay accommodative for years, the Fed is asking investors to suspend conventional wisdom in accepting their inflation forecast.


At the press conference following the FOMC meeting Chairman Bernanke stumbled when questioned about the impact of the zero interest rate policy on purchasing power in an environment of 2% inflation. Scott Spoerry from CNN asked “…There are people out there who are going to say the Federal Reserve have finally just admitted it. Their policy is to destroy 2 percent of the value of my dollars every year.”


One would think the Chairman would be prepared for such a “curve ball” and have a concise answer prepared. Instead, a clearly frazzled Bernanke delivered an inarticulate and nearly indecipherable response. The last few sentences, as per the Federal Reserve website, are as follows:


“I think the argument that, you know, the value of your dollar, the declines at 2 percent a year is not really a very good one unless you’re one of those people who does their lifetime saving in the mattress. Most people invest in various kinds of instruments receiving rate of interest. And now it’s true as been pointed out that for the moment that interest rates are pretty low they’re still positive but over a longer period of time if you–even if you have money in a CD or some other investment vehicle, the interest rate will compensate you for the–for inflation. I mean the two will be tied together. And so, they really shouldn’t be, you know, levels of inflation this low, interest rates should pretty much fully compensate for the losses to savers. But I would reiterate that we are not unaware of the problems that low interest rates cause for savers, cause for pension fund contributions, insurance companies, and other parts of the economy and we do try to take that into account as we think about other ramifications of our policy.”


It’s the assumption at Halyard that despite public attestations to the contrary, Chairman Bernanke is expecting inflation to rise and that interest rates will rise to levels in line with the elevated inflation rate.

Prior to the open of trading on the last day of the month, the Federal Reserve took action to extend swap lines and lower the interest rate on loans to the European Central Bank. The market interpreted the action as being positive for the stock market and negative for the bond market. Unfortunately, the positive price action was not captured in the monthly performance. The reason being, much of the spread improvement came over subsequent days. It happens quite often when there is a big move on the last day of the month, sometimes in favor of the fund, and sometimes against it. The impact was felt across many fixed income funds, including some of the third-party managers held in the fund.

From an economic perspective, the trend of improving activity seemed to accelerate in November. Both manufacturing and consumer consumption were significant drivers of activity. Manufacturing continues to enjoy a renaissance as outsourced industries bring production back to the United States and demand from developing economies for U.S. industrial and technological production surges. Similarly, retail sales registered strong results for the month, rising 0.5% month-over-month in October, with automobiles, electronics, and department store sales leading the way. Retail sales for November, to be released December 13th, are expected to post another strong gain. The “Black Friday” shopping madness shattered revenue records as shoppers lined up at midnight to capture deeply discounted merchandise. The shopping spree, anecdotally, seemed to continue right up to the close of business on Sunday evening. Piper Jaffrey estimated that Apple sold fifteen I-Pad’s per hour during the weekend. That translates into one I-Pad sold every four minutes. There is the risk that consumers will demand “Black Friday-like” discounts for balance of the holiday shopping season or that sales will slow. We don’t think either outcome is likely, as retailers entered the holiday season with lean inventory levels.

The most surprising bright spot was housing. While sales of new and existing homes continue to occur at an anemic pace, home prices showed an unexpected rise, jumping a surprising 0.9% month-on-month as measured by the FHFA home price purchase index. While it’s unlikely that price rise will be sustained, we view it as another indication that the worst is behind us and the housing market has either bottomed or is close to doing so. Given the above outlined scenario, we estimate that Q4 economic activity will top 3% when the measure is released in January 2012.

On a technical note, the Fed has eased interest rates twice in the last week. On November 30th, the Fed announced an expansion of their dollar swap trading with the ECB without indicating a cap on the program. On December 7th, it was announced that the size of the initial operation totaled more than $50 Billion. That’s far more than anyone was expecting. One could argue that it’s a Fed engineered ease for the European monetary system. Separately, it was disclosed yesterday that the Fed is participating in the Mortgage-Backed market through the purchase of newly issued securities in a technical operation known as a “dollar roll.” A dollar roll is similar to a Repurchase agreement or “Repo,” the Feds primary tool for easing interest rates. The operation involves the Fed buying securities while simultaneously agreeing to sell them back to the counterparty one month later. In effect, the Fed is injecting dollars into the monetary system, either temporarily or permanently, depending on what the Fed is trying to accomplish. With this latest operation, it seems as though the operation will remain in place, at least for the immediate future. The size of the operation hasn’t yet been disclosed, but this program could also be termed an easing. Finally, there’s growing talk that the Fed will cut the discount rate at the next FOMC meeting. Given that the Fed has not denied the possibility of the action, we assign a 50% probability to such an occurrence. The action is significant in that the Fed is further easing monetary policy as the economy is accelerating. We deem this to be an additional policy error that will be more problematic when the time comes to unwind it.

Financial anxiety remained elevated during September as evident in the hyper-volatility of the stock market, acute widening in credit spreads, sharp rally in the U.S. Dollar, and the continued flight to U.S. Government debt. Our opinion is that with stability returning to the stock market and bank rumors subsiding, the price of corporate bonds will swing from loss to profit.

A byproduct of the worry was the dramatic, broad-based market downturn in commodity prices, including oil and gold. The logic behind the commodity swoon was, if economic expansion slows, less discretionary income will be available for energy consumption and a corresponding fall-off of inflation would reduce demand for gold. Less apparent during the month was the significant widening in financial credit spreads. On the back of liquidity-related rumors, the yield-to-maturity for high profile names such as Bank of America, Morgan Stanley, and Goldman Sachs rose to more than 5% for maturities of three years and longer. The paradox is that those three names have been specifically identified by the Federal Reserve as entities that are systematically important. Deemed “too big to fail,” those entities are subject to heightened scrutiny from the regulators with the intention of ensuring that failure is not possible. Nevertheless, in reaction to rumors, investors ignored balance sheet fundamentals and, instead, invoked the “sell first, ask questions later” tactic. Exacerbating the price weakness was the lack of secondary demand from Wall Street. A central tenant of Wall Street reform, known as the Volker Rule, is the abolishment of bank-related proprietary trading desks. In theory, the absence of a trading desk reduces the risk to the financial health of the bank due to swings in the market value of the instruments traded. The unintended consequence of closing those desks is heightened volatility. Historically, trading desks have provided liquidity during periods of market stress and, arguably, lessened volatility. Their absence, as witnessed in August and September, directly contributed to the weakness in corporate bond prices. From a trading perspective, we at Halyard view the market inefficiency that tends to result from heightened volatility as an opportunity over the long-term.

A perplexing characteristic of the current state of the economy is continued expansion in Gross Domestic Product despite the naggingly high rate of unemployment. Without a doubt, overall unemployment remains too-high by any standard. A disaggregation of the unemployment statistics yields a surprising outcome. This recession and subsequent expansion has been especially harsh on the lowest income earners and not nearly so for college educated adults. According to the Bureau of Labor statistics, the unemployment rate for adults that dropped out of high school and those with a high school diploma but no college is 14.0% and 9.7%, respectively. Those high school graduates with some college education are unemployed at an 8.4% rate, while the rate for adults with a college education is only 4.2%. At 4.2%, the rate of unemployment among college educated adults, the largest of four categories, has steadily fallen and is now the lowest it’s been in 2 ½ years. Moreover, the category of college educated individuals has grown by 10 million in the last decade, while the category of those not graduating from high school has declined by nearly one million. Because college educated individuals earn significantly more than their less educated counterparts, they have been the driver of economic growth during what has come to be called the jobless recovery. But that’s no solace for the approximately 50 million Americans with no college education, and especially the 5.2 million individuals in that category that are unemployed.

Looking forward, we are cautiously optimistic that the coming holiday selling season will be supportive of job growth and economic expansion. With that view, we have maintained our current position of overweight credit, minimal interest rate sensitivity, and hedged with options on short-term interest rates.