The short-end held in a tight range for the week with the two-year fluctuating between .35% and .36%. Longer-term rates were more volatile, but still ended right where they began the quiet week. Treasuries followed the dollar higher during its rally on Monday and Tuesday, but fizzled out as most issues tested the top end of the most recent trading range. Bonds will feel the pressure next week as the Treasury comes to market to sell $99 billion in coupon bonds.

Credit spreads held steady without much news. Ebay came to the corporate market for the first time in the company’s history selling $1.5 billion in bonds including a 10-year at 3.33% yield, 77 basis points over Treasuries. This trend of debt issuance by companies who have traditionally depended solely on the equity market to raise capital should continue as long as this rate environment persists. In the long run it will be a positive for companies with the ability to take advantage of the Fed’s extremely accommodative monetary policy.

TIPS were also quiet this week after rallying hard against nominal treasuries. Ten-year breakevens will probably hold around the 210 basis point area until we get a clearer view of what QE2 will look like.

Fed Staying Flexible

Although the debate over whether the Fed will buy more assets has essentially ended, the debate over the effectiveness of a new quantitative easing campaign continues and has brought back phrases like, “pushing on a string” and prompted renewed interest in technical economic terms such as “constrained optimization”. The Fed is not hiding its intentions to feed additional liquidity into the market in hopes of stoking higher rates of inflation, and the market has responded accordingly by pushing rates lower, the Dollar lower, stocks higher, commodities higher, volatility lower, gold higher and inflation expectations higher.

Forward curves, which price expectations for future rates, aren’t projecting a more normal rate environment until 2012. The markets, and the Fed, are counting on inflation to be the catalyst for the rise in rates in the medium-term future, but the Fed alone cannot bring about inflation. Housing is expected to weigh on consumer prices going forward, and although commodities are rising, the move is speculative in nature and is not sustainable without a boost in end demand. During the commodity boom that peaked in the summer of 2008 tremendous demand from China and India kept the fire burning despite the downturn in the US economy. The Chinese government has pared back fiscal stimulus, tightened lending standards domestically and raised benchmark interest rates, and India hasn’t turned into the commodity hog that we much of the market expected them to become, so end demand from the US consumer will need to recover in order for normal inflation to return.

The advocates for further monetary easing in the US claim that the potential damage does not outweigh the benefits of added liquidity, while those against it, including some current FOMC voting members, claim that they do. I tend to lean toward the latter of two because my view is that the Fed’s tools aren’t as powerful given the current credit environment and they tend to overestimate their own ability to draw back stimulative policy appropriately. Bernanke remains confident the committee will be able to tighten when it is appropriate and there is no doubt that we will get additional easing. But if the Fed opted for a QE program where they committed to a certain amount each month, say $100 billion, for an undetermined number of months, instead of a total QE2 amount, I would consider that a long-term positive for the market given the added flexibility the Fed would have to end the monetization.

Have a great weekend. 

Cliff J. Reynolds Jr., Investment Analyst