Bond Environment, 2Q12 (i)

Here’s the first part (of two) of the April bond market analysis prepared for clients by the firm of my friend and mentor, Denis Jamison.  The second will appear tomorrow.
The alarm clock sounded for bond investors in the March quarter.
On the strength of some positive readings on the economy, markets discounted the possibility of additional Federal Reserve easing.  More accommodative policies by the European central bank reduced the risk of a credit crisis in Spain and Italy. Accordingly, doomsday speculators pulled money from the U.S. government bond market. The result was a dip in bond prices. With little coupon income to cushion the fall, investors suffered big losses.
Long term U.S. Treasury bonds recorded a negative 6% total return. Other sectors fared better; mortgages returned about 0.6% for the quarter while corporate bonds gained about 2.5%. The investment dynamics of these sectors differ somewhat from those of the government bond market. Mortgages are big beneficiaries of the Fed’s zero short-term interest rate policy while corporate securities are helped by the improving financial strength of U.S. business, especially the banks. Yield spreads between corporate bonds and U.S. Treasuries narrowed sharply during the quarter. Whether this can continue, remains to be seen.
Bond prices snapped back sharply after a ho-hum employment reading for March (reported on April 6th)
…and on renewed concerns about Spain’s fiscal position. However, investor focus on these transient economic and credit risk factors obscures the underlying reality of the government bond market. The current low yield level has made these securities more risky. Their price sensitivity to any given change in interest rates has increased. For example, a full coupon thirty year bond priced to yield 3% is about 10% more volatile than a similar full coupon security priced to yield 4%. In addition, there is significantly less coupon income now than in prior periods.
The fixed income markets are anesthetized by a cocktail of promised zero short-term interest rates, a flood of liquidity being provided by central banks around the world and quiescent inflation.  So, it is likely we will continue along the bottom of this interest rate trough for some time.  That doesn’t mean, however, that the bumps and dips won’t provide large swings in total returns for bond holders.
Back on track?
For the U.S. economy, that’s probably true. Despite disappointment regarding the March employment numbers, by any reasonable measure, the U.S. economic expansion is where it should be. Based on the March workplace survey by the U.S. Labor Department, about 132.8 million folks are employed versus 130 million a year ago. That’s a 2.1% year on year gain. A respectable increase considering that the public sector – particularly state and local governments – reduced payrolls. Only 22 million people worked in the public sector in March – 600,000 less than a year ago. In addition to the increase in total workforce, those employed are taking home more money. Average weekly earnings are up about 2.6% over the last twelve months.
Thanks to the employment gains and higher earnings,
retail sales have fully recovered from the recession lows.  They are running ahead 6.5% on a year over year basis. Auto sales are now averaging between 14 and 15 million units on an annualized basis compared with less than 10 million units during much of 2009.  GDP – the broad measure of total goods and services being produced in the U.S. economy – grew at a 3% rate during the final quarter of 2011. While that pace of expansion is unlikely to be sustained, it is reasonable to expect growth will exceed the 1.6% pace set during the full year of 2011. Most economists predict something between 2% and 2.5% growth this year.
Most of the risks to this moderate expansion scenario don’t hold up well under close examination.
Some argue that the recent growth spurt is being fueled by the large increase in reported consumer debt – consumer credit expanded 6.9% in the final months of 2011. However, most of that increase reflected an expansion of government education loan programs which replaced private sector programs that were not included in the consumer credit totals. Basically, the consumer is not overextended. Gasoline prices are also a concern to many. However, auto fuel efficiency has increased and gasoline usage is down. Price changes at the pump will have a much more muted impact on consumer spending. Given this backdrop, it isn’t surprising that many Fed governors are beginning to question the need for a continuation of the current monetary stimuli being provided by the central bank. However, financial markets now appear to be addicted to these opiates. This may be the real risk facing both investors and the working public.
Stay tuned for the concluding section of the Jamison report tomorrow.

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