Treasuries lagged risky assets during a week without a major economic release other that the weekly jobless figures. The selloff in govys was exaggerated in the longer end, which steepened the curve a few beeps.

Credit spreads were essentially unchanged for the week, with the Markit CDS Index CDX.NA.IG.14 finishing at 103 basis points, a point lower from last week’s close.

The story in MBS is little changed. High LTVs are keeping prepays sluggish and allowing premiums to remain high. As the Fed slowly exits the MBS market passively, spreads should remain very tight due to the market’s appetite for anything with spread at these low yields.

Breakeven yields widened about 16 basis points, equating to about 1% of outperformance for the ten-year TIP over the nominal ten-year Treasury.

The ten-year Treasury posted its worst week since April 2, rising in yield by 8.8 basis points to finish at 2.79% despite troubles in Europe grabbing some headlines. Slight movement in inflation expectations is partly to blame, along with the risk trade coming back a bit this week, but the stock market and bond market still appear to be reflecting different worlds.

Low Yields

It was mainly deflationary concerns that brought the spread between the two- and ten-year Treasurys down from 2.912% on February 22 to 1.958% on August 28, a period in which the S&P 500 was down 5.49%. Now although curve steepness is generally considered a leading indicator, with a steeper curve being more positive, it doesn’t tell the entire story over this period.

The second half of Q1 and the first half of Q2 2010 were dominated by speculation of the Fed unwinding their securities portfolio and perhaps even moving towards a higher Fed Funds rate. This moved short term yields higher in March and April as investors prepared for the Fed’s choke hold on yields to end, and flattened the curve from record high levels. Although the curve continued to flatten from there, the environment changed in a major way. Short-term yields cratered as economic data worsened and the Fed found a new dedication to maintaining emergency levels of liquidity that culminated in August with QE 1.5, (reinvesting principal payments in Treasurys).

The entire market realizes the Fed is heavily involved in the bond market, and they are meeting their goal of keeping rates very low. “Bond Bubble” speak is widespread, but this week’s 30-year Treasury auction was 1.73 times oversubscribed and cleared at a 3.82% yield not because investors are rushing into Treasurys to get rich quick but because credit and equity risk is unattractive to them and they feel 3.82% for 30 years is adequate compensation for avoiding those risks. The turnaround in rates, whenever it happens, is likely to be just as sudden as this most recent move lower and such a scenario will reward more liquid investors standing ready to reinvest at higher rates.

Have a great weekend. 

Cliff J. Reynolds Jr., Investment Analyst