Fixed Income Markets: Experiencing Historic Lows Prepared: June 7, 2012 Overview How low can they go? This seemed to be the question the fixed income markets tried to answer on June 1st. Ten-year yields on U.S., German, French, Austrian, Finnish, and Dutch bonds all dropped to record low levels on this date. The sharp movement appears to be a continuation of the flight to safety move that the markets have been experiencing since March. Given this broad global movement in rates, this paper summarizes our thoughts on such things as: What led to this decline in yields What this action likely means for the value of Treasury bonds What might change the trajectory of rate declines What is likely to occur next How we got here Rates have been volatile so far this year. Prior to the week ending June 1st, the ten-year yield had been in a trading range of 1.85%-2.05% since November 2011. Along came a series of events that included back-to-back strong economic releases, the implementation of a Long Term Refinancing Operation (LTRO) that was deemed successful in averting a banking crisis in the eurozone, and a statement by the Federal Reserve (the Fed) that neglected to mention further easing measures. This trifecta of positive news pushed rates to a five-month high of 2.37% by mid-march 2012. However, within a few weeks, economic releases became mixed. Europe returned to the headlines with concerns over Spain missing its budget target, and the Fed released a series of statements assuring the markets that further easing measures were still a possible option. The result has been a reduction in rates to the previous trading range levels of 1.85%-2.05%. Yields have been struggling to push upward ever since as investors search for confirmation of any strength of domestic economic recovery and some resolution to the eurozone crisis. Flash forward to the last week in May when the markets saw significant volatility in yields. Downward pressure on rates was evident throughout the week. The ten-year Treasury began the shortened Memorial Day holiday week at 1.75%. With Greece out of the headlines until elections occur on June 17th, Spain took center stage with renewed concerns over strategies to recapitalize their banks. In the U.S., disappointing Institute of Supply Management (ISM) manufacturing data, construction spending, pending home sales, and domestic vehicle sales took their toll on rates by ten basis point increments each day. Below consensus Purchasing Managers Index (PMI) readings in Italy and China added fuel to the fear of weakening economic growth globally. By May 31st, ten-year Treasury rates were down to 1.57%. The flight to safety zenith came on June 1st in the form of discouraging U.S. employment data announcing the slight upward move of the unemployment rate to 8.2%.
Page 2 Yield (%) Current valuation The ten-year Treasury yield closed June 1st at 1.47%. Also setting a record was the negative 0.96% term premium on U.S. Treasuries. The term premium is a model created by economists at the Federal Reserve to assess the current valuation of U.S. debt. A negative reading indicates investors are willing to accept yields below what is considered fair value. Although Treasuries are at their most expensive levels on record, yields on U.S. debt are still as much as 20 basis points higher, on average, than the yield investors can achieve in most benchmark bond markets globally. This situation helps supports demand for Treasuries. 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0 1Y 2Y 3Y 6M Source: FactSet; data: June 1, 2012 U.S. Treasury Yield Curve 5Y 10Y 15Y 20Y Now What could change It is still possible for the downward trajectory of rates to reverse course. Given the magnitude of the bond price rally and yield decline, we are likely to initially see an additional 10-15 basis point reflex yield increase. In the fixed income markets, prices and yield have an inverse relationship when bond prices are up, yields fall. 30Y One Week Ago One Month Ago One Year Ago The European Central Bank (ECB) has a couple of options available that could also bring rates back up. First, the ECB could agree to a reduction in policy rates, which would weaken the euro (supporting the economy) and reduce the cost of ECB borrowing (thus supporting banks). Second, the ECB could announce a new extended LTRO that could address bank liquidity. This second option would be fairly simple to implement given the relatively low cost and ability to enact as early as next week. Another possibility that could push rates upward would involve Spain issuing new debt that could be injected directly into their banks, which could then be used as collateral to borrow from the ECB. This Spanish option may comfort the markets, reducing fear of how Spain will recapitalize their banks. Over the next month, rates could also get a lift from any above-consensus strength in upcoming domestic economic releases in manufacturing, productivity, and retail sales. Another solution that could potentially have the greatest impact on the markets on a global scale would be the European Monetary Union (EMU) simply deciding upon one of the three options on the table. This potentially would be perceived as a more widespread solution to their crisis. The three options might include: Some form of Eurobonds with pooled debt issuance for the sovereigns in the EMU Using the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) to recapitalize European banks directly A eurozone-wide deposit guarantee for the European banking system Within the next two weeks, we will have the results of the Greek elections. A pro-bailout vote in Greece may help reassure markets that a breakup of the monetary union is not imminent. This may potentially reduce the flight to safety move that forced rates so low.
Page 3 Our outlook There are several important dates on the horizon for the eurozone, including: The French parliamentary elections on June 10th and 17th The Greek elections on June 17th Meeting of key leaders from France, Germany, Spain, and Italy in Rome on June 22nd A full European Union (EU) summit on June 28th and 29th We believe that since there are no EMU meetings scheduled before June 17th, an immediate solution will not be forthcoming. That leaves the ECB as the only institution which could perform some sort of stop-gap measure. Although the ECB left rates unchanged at their June 6th meeting, they left the door open for future cuts. We believe that the ECB is likely to cut rates sometime this summer if conditions continue to warrant policy action. Eurobonds will probably receive more attention in the coming months, but the political challenges do not favor action anytime soon. However, the more limited suggestion of a debt redemption fund proposed by Germany could be developed in less than six months. This option has greater appeal as it will likely not require many of the legal changes that a full-fledged Eurobond would necessitate. This may immediately reassure markets, causing a tempering of yields in some of the stressed countries, while potentially boosting high quality yields in the eurozone and U.S. The culmination of the global slowdown, events in Europe, and the weak U.S. jobs report has the markets again reviewing the possibility of an additional round of quantitative easing (QE). On June 7th, Federal Reserve Chairman Ben Bernanke gave his congressional testimony on the economic outlook. His testimony did not mention options for future monetary policy stimulus. It is difficult to imagine implementing a strategy that will reduce rates even further to stimulate borrowing and economic activity when that has already been accomplished via the recent rally in Treasuries. However, we have not seen a large rush to increase borrowing, other than student loans. In addition, two indicators of the previous QE2 and Operation Twist implementation have not yet been reached. The five-year forward breakeven rate (the difference in yield between the nominal Treasury yield and the Treasury Inflation-Protected Security (TIPS) yield) is still around 2.5%. These same maturity breakeven levels were below 2% just prior to the previous two QE program enactments. Also, the S&P 500 Index is only down 10% year to date. The S&P had been down 17% and 22% respectively prior to the previous two rounds of QE. 3.2% 3.0% 2.8% 2.6251% 2.6% 2.4% 2.2% 2.0% 5-Year Forward Breakeven Rate 2010 QE2: 1.84% Source: Bloomberg Finance; data: May 29, 2012 1450 1400 1350 1300 1250 1200 1150 1100 1050 1000 1324.14 QE2: -17% 2010 S&P 500 Index Source: Bloomberg Finance; data: May 29, 2012 Operation Twist: 1.97% 2011 2012 Operation Twist: -22% -6% 2011 2012 2.63%
Page 4 The recent weakness in the U.S. labor markets could simply be the result of increased activity during the warm winter. The unseasonably warm weather had the effect of pulling forward jobs to earlier in the year that would traditionally have been reported later in the year. Thus, the May employment report may not be indicative of a trend in rising unemployment. During his June 7th testimony, Bernanke cited the warm weather as the cause for recent weakness in the labor markets. This leads us to believe that the disappointing May jobs data alone is not enough to create a sense of urgency for additional quantitative easing. We expect Chairman Bernanke to make public comments clarifying the Fed s views on additional stimulus leading up to the June FOMC meeting. We believe that with the increased domestic economic impact of the eurozone crisis, moderating inflation expectations, and signs of global slowing, the bar for an additional round of quantitative easing has dropped significantly. Should conditions continue to get worse, this bar becomes even lower due to public pressure. While this may likely result in a relief rally in equities, Treasury yields may remain range bound as the upward pressure from an equity rally will be battling with Fed intervention to push rates down. This will possibly be a short-term phenomenon as rates eventually will be pushed downward by a determined Fed. Portfolio positioning Growth expectations in the U.S. and eurozone remain modest and it is entirely possible that the credit crisis in the eurozone gets worse before it gets better. Thus, a sustained selloff is unlikely in the absence of clarity on how Spain will recapitalize their banks, progress on the numerous options open to the monetary union for a longer term solution, and the potential for domestic growth. In addition, we have to comprehend the results of several upcoming key events, including the French elections, the Greek election, the EU summit, and the June FOMC meeting. We remain constructive on the U.S. economy. We believe consumer spending will remain positive due to the reduction in the price of oil, and because the Purchasing Managers Index (PMI) continues to be in expansion mode, inflation seems to be contained, and housing appears to be finding a floor. We believe the recent compromising language out of Germany bodes well for some form of intermediate-term solution to the eurozone crisis with a longer term move toward a fiscal union. We believe current risk free assets are overvalued and expect rates to revert to 2% by year end as confirmation of domestic economic growth (albeit modest) becomes fully priced in. We continue an underweight position in fixed income. Within this asset class, we favor credit and municipals over Treasuries. Valuations in the credit sector are attractive. Spreads have again widened to appealing levels. Corporations have fairly healthy balance sheets and default levels remain quite low. While the eurozone crisis continues to stew, we would recommend focusing on the higher quality issuers. Municipals have been seeing increased tax revenues and exercising massive budget cuts for nearly two years. The pending expiration of the Bush-era tax cuts continues to provide demand support for U.S. municipal bonds. We recommend focusing on high quality State general obligation (GO) bonds and essential service revenue issuers. Although valuations in high yield are attractive, we see volatility continuing to plague this asset class. Thus, we remain overweight to hedged debt due to the ability to participate in both long and short strategies within the high yield sector. In addition, hedged debt strategies have the potential to outperform during rising rate environments.
Page 5 Contributed by: Jennifer L. Vail Head of Investments for Institutional & Corporate Trust Head of Fixed Income Research IMPORTANT DISCLOSURES This commentary was prepared on June 7, 2012 and the views are subject to change at any time based on market or other conditions. This information represents the opinion of U.S. Bank Wealth Management. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or the forecasts will come to pass. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not responsible for and does not guarantee the products, services or performance of third party providers. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer term debt securities. Investments in lower rated and non rated securities present a greater risk of loss to principal and interest than higher rated securities. Investments in high-yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Hedge funds are speculative and involve a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem units in a hedge fund. 2012 U.S. Bancorp (6/12) privateclientreserve.usbank.com