November 2010

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Fixed Income Market Recap
November could be characterized as a month in which old news, thought to be resolved and impotent, reemerged to the detriment of the capital markets. With attention focused on the Federal Reserve and its well broadcast plan to reduce rates through a second round of quantitative easing (QE2), investors had positioned their portfolios for a continued fall in rates. When the anticipated rate decline failed to materialize, traders were quick to shed holdings of Treasury notes, pushing interest rates more than 40 basis points higher mid-month trough-to-peak. Exacerbating the rate rise was an unexpected, but welcome improvement in domestic economic activity. Just as the Fed’s public handwringing spooked investors into pushing the 5-year treasury yield down to nearly 1% during the month, improvement in employment, retail sales, and manufacturing served to reverse that trend, launching the 5-year note yield 50 basis points higher on an intra-month basis.

Economic Overview
While investors were caught off guard by the unexpected volatility in Treasury notes, even greater volatility was evident in the Municipal bond market. A reemergence of state and local debtor solvency concerns gained steam throughout the month, culminating during the week of the 14th, during which investors staged a stampede out of the sector. Over the course of that week, $4.2 billion redeemed from municipal mutual funds; the single heaviest week of redemptions ever. Several high-profile, long maturity municipal bond funds were down between five and ten percent for the month.

Concurrent with heightened fears in the Muni market, investors again began to worry that the weaker peripheral countries of the Euro were at risk of default. Investors were cheered earlier this year with the bailout of Greece and what appeared to be a “more-than-sufficient” stabilization fund. However, as economic activity remained depressed throughout Europe, investors began to again worry that the weaker, peripheral countries were at risk of default. Such worry spiraled into reality with Ireland, as borrowers became unwilling to lend to the sovereign, ultimately forcing an EU bailout similar to what was extended to Greece. As was the case with the Greek bailout, a relief rally ensued and at the time of this writing, the as-yet-unrescued nations of Portugal, Spain, and Italy are enjoying a reprieve from default concerns. However, just as Ireland required a Greek-style bailout, we wouldn’t rule out a requirement of similar support for the three remaining peripherals.

Outlook
As we head in to the final month of 2010, we continue to believe that the economy will continue to improve, and that fixed income investors have overpriced government and government-related debt. As such, we will continue to significantly underweight the government sector, overweight corporate notes, maintain a weighted average duration well below benchmark, and employ interest rate hedges.

October 2010

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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.

Outlook
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.