July 2012

Against a mixed economic backdrop, confusing signals from Federal Reserve Chairman Bernanke, and ongoing brinksmanship in Europe, the 10-year Treasury note briefly touched an all-time low yield of 1.39% in July, before ending the month at 1.47%. Similarly the yield spread between the 2-year and 30-year Treasury notes narrowed to 223 basis points, more that 100 basis points narrower than the level at which it stood one year ago. Historically, yield curve narrowing is a reflection that investors expect inflation to fall in the future. However, in this instance, the narrowing has been artificially engineered by the Federal Reserve and their current “operation twist” effort.

The strong mid-month performance of the bond market was partly attributable to conflicting economic data. At the weaker end of the spectrum was the manufacturing sector. After enjoying a growth renaissance over the last few years, manufacturing clearly slowed during the second quarter and into July. Reacting to the European recession, manufacturers slowed assembly lines, hired fewer employees and reduced inventory. Similarly, the June sales report, released mid-July, reported that aggregate retail sales had experienced a third consecutive monthly decline, as sales of building materials, car parts, furniture, and electronics all slumped.

At the other end of the spectrum, the housing market continued to demonstrate encouraging signs of strength, both in terms of units sold and pricing. Also during the month, second quarter GDP was released and registered a 1.5% annualized gain, which was slightly more than was expected, while Q1 GDP was revised to 1.9% from 1.5%. In addition, the jobs market improved somewhat during the month. Non-farm payrolls registered a better-than-expected gain of 163,000 jobs during the month, which was exactly in line with the 163,000 reported by the ADP national employment index. That’s also consistent with the decline in the 4-week moving average of initial claims for unemployment insurance. That measure had briefly ticked higher in June, but has since fallen to the lower end of the range, indicating the pace of job losses continues to subside.

Despite the mixed economic data, trading for the month was dominated by Central bank rhetoric and, again, concern over the fate of the Euro. Mid-month, John Hilsenrath, of The Wall Street Journal, reported that the Federal Reserve was poised to undertake additional monetary stimulus. Mr. Hilsenrath is known as the reporter of choice when the Federal Reserve would like to communicate policy to the markets without doing so explicitly. Given his status, and the direct tone of the article, investors concluded that the Fed would announce QE3 at their August 1st meeting. The initial reaction was a sharp fall in interest rates, with the 10-year note briefly touching and all time low, before drifting higher at month end. Similarly, while in London, European Central Bank Chairman Mario Draghi made an off-the-cuff remark that the ECB would do “whatever it takes” to save the Euro. As with Bernanke’s comment, investors concluded that the ECB would announce aggressive policy action at the conclusion of their August 2nd meeting. Both conclusions were wrong. The Fed statement was essentially unchanged from the prior meeting, as was the ECB’s. During the post-meeting press conference, Chairman Draghi was peppered with somewhat harshly worded questions about what the committee planned to do to forestall the recession and assist Spain and Italy. He hinted that the ECB is exploring the possibility of buying short maturity sovereign debt, but offered no details. As expected investors, were displeased with the lack of a plan and drove Spanish debt and equity prices down on the day by three and five percent, respectively.

As we look forward, it seems likely that the economy will continue to grow at a sub-optimal pace until the so-called “fiscal cliff” issue can be resolved. As it stands, the expiration of the Bush-era tax cuts and the sequester-imposed spending cuts are estimated to trim as much as 4% from 2013 Gross Domestic Product, and would most likely tip the U.S. in recession. That extreme outcome has caused consumers, investors, and businesses to alter their behavior in favor of saving more and spending less. Given that President Obama is inflexible in his insistence on raising taxes on workers earning more than $250,000, a resolution is not likely before the election in November. As such we expect economic growth to continue at a sub 2% growth rate.