Treasury rates were mixed this week, as the long-end underperformed on questions about near-term Fed action and a very tame inflation reading that came in line with expectations. The Treasury curve steepened 5 basis points as the 2-10 year spread finished the week at 2.275%, 32 basis points higher than the recent closing low of 1.95% on August 26^th.

Traders, who were hoping to get some more info on QE2 from the FOMC next Tuesday, shifted their attention to November’s meeting for more information on additional easing. The comments from Tuesday’s meeting will still be closely watched, but the Fed is unlikely to tip their hand in any serious fashion next week. Some reports claim that $300-$500 billion in Treasury purchases has already been priced into the market. If we don’t get QE2 in the form the market is expecting, look for the curve to flatten back below the 200 basis point level.

Inflation expectations, as measured by the 10-year TIPS breakeven rate, were more or less unchanged on the week, following two weeks of rising. The Bureau of Labor Statistics reported today that consumer prices rose .3% in August, which matched expectations and slowed TIPS buying. For the year the ten-year Inflation Indexed Treasury has underperformed its nominal counterpart by more than 5 percentage points.

Credit spreads were essentially unchanged for the second week in a row, with the Markit CDS Index CDX.NA.IG.14 finishing at 104 basis points, a point higher than last week’s close. Corporate issuance remains strong as issuers continue to take advantage of record low interest rates and relatively tight spreads while investors are clamoring for yield anywhere they can find it.

Irish Banking Problems Spread

News broke late last week that Anglo Irish Bank would be taken over by the Irish Government and split into two pieces and gradually wound down. The situation is not much different from what the FDIC does in the US, however, the size of the bailout relative to the amount of money Ireland has to solve their banking problem has raised some concern this week.

I report from Barclays sighting concerns over whether Ireland will be able to keep its banking system afloat without outside help fueled another spike in CDS spreads for Ireland’s sovereign debt this week. Irish 5-year CDS, which measures the cost of insuring Irish debt against default, rose about 45 basis points to 4.12%. This has brought ten-year bond yields to 6.30%, 2.9% higher than the German equivalent. Both Irish Sovereign CDS and Ireland/Germany spreads are at all time highs.

The cost of the Anglo Irish bailout alone has already reached €25 billion, or about 15% of Irelands annual GDP, and most estimates have that number over €30 billion soon. Much of the bailout’s cost hinges on whether Anglo Irish’s debtors will be made whole by taxpayers, or forced to take losses or an equity stake. Regardless of the outcome, the scale of the issue dwarfs the US baking problem in relative size, and rumors of negotiations between Irish officials and the IMF on an assistance program for the Federal government has the market questioning the standalone solvency of the country.

Compared to other weeks dominated by Eurozone problems, risky assets held in very well. The Euro finished just under multi-week highs and US stocks turned a blind eye to the news but next week might be different when Ireland auctions €1.5 billion in debt. We will have to see if Irish debt has cheapened enough this week for the market to absorb the paper.

Have a great weekend. 

Cliff J. Reynolds Jr., Investment Analyst