PRINTMarket Update -- In the Markets
July 7, 2008
Here's a brief summary of what transpired in the economy and the financial markets during the past three months. We hope you'll find it a handy reference.
Growth
The domestic economy remained weak during the second quarter after growing at a 1% rate in the first quarter. Continued weakness in residential construction and consumption were again the primary culprits, while growth was aided by exports amid further declines in the value of the dollar. Most preliminary growth estimates for the second half of 2008 include expectations of a modest boost from fiscal stimulus, followed by weakness again in the fourth quarter.
Inflation
Rising food and gas prices pushed up headline inflation during the second quarter while core inflation moderated slightly from the more elevated levels seen earlier in the year. The core PCE deflator declined for the fourth consecutive month in May hitting 3.1% on a year-over-year basis. CPI was up 4.2% in May while core CPI was up 2.3% on a year-over-year basis. Despite the easing of core inflation data, inflation expectations rose sharply, with one-year inflation expectations hitting a 26-year high of 5.2% in May, according to the University of Michigan Consumer Sentiment survey. Producer prices, meanwhile, rose 7.2% from a year ago in May, just slightly below the 27-year high of 7.4% reached in January.
Jobs
The job market contracted further in the second quarter, with non-farm payrolls declining by more than 60,000 each month and the unemployment rate rising to 5.5% from 5.1% at the end of the first quarter. Total job losses for the first half of the year now total 438,000 according to the Bureau of Labor Statistics, and though the pace of payroll declines slowed in the second quarter, the Department of Labor's tally of jobless claims continued to rise. Initial claims rose above 400,000 in the last week of June and the four-week moving average rose above 390,000, its highest level in nearly five years (excluding hurricane Katrina-related claims in 2005). Continuing claims rose above 3.1 million in the second quarter, up more than 20% from a year ago.
Income
Growth in wage and salary income slowed in the second quarter as labor markets softened. Average hourly earnings as reported by the Bureau of Labor Statistics rose 3.4% on a year-over-year basis in June, down from 4.1% a year earlier. Personal income growth, which had declined from 5.9% to 4.3% in the first quarter, rebounded in the second quarter according to the Department of Commerce as federal rebate checks were sent out.
Manufacturing
The manufacturing sector remained soft during the second quarter, reflecting weakness in the auto industry and building materials, but stronger export demand helped lift the ISM Manufacturing index back above 50 in June. The new orders component, however, remained below 50 for the seventh consecutive month. The Federal Reserve reported that industrial production declined in both April and May, and that capacity utilization slipped below 80%.
Retail
Retail sales growth grew in the second quarter as consumers spent more money at gas stations and used their federal rebate checks to buy clothes and electronics. Excluding autos, sales rose 1.2% in May, following a 1% increase in April, according to the Census Bureau.
Housing
The housing market remained deep in recessionary territory during the second quarter, but started to show some hints of stabilization. The pace of existing home sales arrested its recent sharp declines, holding steady near its recent lows in April and May. The months supply figure declined modestly from its recent high, indicating that the inventory of unsold homes was gradually being worked off. New home sales also improved from recent lows. Housing starts continued to decline in the second quarter, hitting a seventeen-year low, while home prices also continued to decline. The S&P/Case-Shiller composite home price index hit a new low in April, registering a 15.3% yearly decline in home prices.
Confidence
Consumer confidence sank precipitously during the second quarter, reaching its lowest level since 1992 according to the Conference Board's monthly survey. A combination of high food and gas prices, a wrecked housing market, tough credit conditions, falling stocks, and a softening labor market weighed heavily on consumers during the period. At 50.4 in June, the confidence reading was less than half the level recorded just a year earlier. The expectations component of the survey fell to 41, the lowest ever recorded in the survey's 40-year history. The University of Michigan's Consumer Confidence index followed a similarly steep decline, reaching a 28-year low in June.
The Fed
At its April 30 meeting, the FOMC voted to cut its target overnight lending rate by 25 basis points to 2%, bringing the cumulative year-to-date level of easing to 225 basis points. Amid surging commodities prices, rising inflation expectations, a weakening dollar, and signs that strains on the financial system were beginning to ease somewhat, Fed officials began to signal through various public outlets that any more easing would be increasingly unlikely. The committee voted on June 25 to hold rates steady, and wrote in its policy statement that "although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased."
At the end of the quarter, Fed funds futures had priced in expectations of at least one rate hike before the end of the year.
Treasuries
U.S. Treasuries lost some of their luster and the yield curve flattened in the second quarter as credit conditions showed modest improvement from their crisis lows and central bankers in the United States and abroad stepped up their hawkish rhetoric. The yield on two-year notes passed the 3% mark for the first time since January 1 in mid-June, more than doubling its March lows of 1.35% before falling back to 2.62% by quarter’s end. The yield on five-year notes rose 89 basis points in the quarter, while ten-year notes saw an increase of 56 basis points in yield. The 30-year bond hit its highest yield since last fall before a late June rally pushed it back down to 4.53% by the close, just 23 basis points above its yield at the end of March. The slope between two and ten-year yields fell almost 50 basis points in the second quarter, ending the period at 135 basis points.
Bond Markets
Tightening credit spreads helped soften the impact from a sharp rise in Treasury yields during the quarter, leading to flat or slightly negative returns for most sectors of the bond markets. The Lehman Brothers Aggregate Index finished the period with a total return of -1.02%, while most non-Treasury sectors fared slightly better. Credit spreads tightened across asset classes, retreating from their credit-crisis extremes as the Fed's added liquidity measures and a recapitalization of financial institutions helped ease liquidity strains. While a dim economic outlook kept many market participants on the defensive, fire-sale prices on many high-quality investments were simply too cheap to ignore for even some of the most pessimistic investors.
Commercial mortgage-backed securities (CMBS), among the most battered sectors in the first quarter, led the pack among investment grade spread sectors with nearly 60 basis points of spread tightening and an excess return of 260 basis points over Treasuries. Corporate bonds also smartly outperformed Treasuries during the period, posting 158 basis points of excess returns. Asset-backed securities (ABS) enjoyed significant spread tightening as well, outperforming Treasuries by 78 basis points.
The high-yield market, meanwhile, rewarded investors with a total return of 1.76% in the second quarter, according to the Lehman Brothers High Yield index, as opportunistic buyers snapped up deeply discounted debt, helping the High Yield index produce excess returns of almost 400 basis points relative to Treasuries.
Some further data about the U.S. bond markets are shown in the charts below.
| RATE MARKET OVERVIEW | ||||||
| Closes... | ||||||
| 6/30/08 | 3/31/08 | 12/31/07 | 9/28/07 | 6/29/07 | 6/30/06 | |
| Fed Funds Target | 2.00% | 2.25% | 4.25% | 4.75% | 5.25% | 5.25% |
| 1 Month LIBOR | 2.46% | 2.70% | 4.60% | 5.12% | 5.32% | 5.33% |
| 3 Month T-Bill | 1.74% | 1.32% | 3.24% | 3.80% | 4.81% | 4.98% |
| 6 Month T-Bill | 2.16% | 1.49% | 3.39% | 4.08% | 4.94% | 5.24% |
| 2 Year T-Note | 2.62% | 1.59% | 3.05% | 3.99% | 4.86% | 5.15% |
| 5 Year T-Note | 3.33% | 2.44% | 3.44% | 4.25% | 4.92% | 5.09% |
| 10 Year T-Note | 3.97% | 3.41% | 4.03% | 4.59% | 5.03% | 5.14% |
| 30 Year T-Bond | 4.53% | 4.29% | 4.45% | 4.84% | 5.13% | 5.19% |
| 2s-5s Spread | 0.71% | 0.85% | 0.39% | 0.26% | 0.06% | -0.06% |
| 2s-10s Spread | 1.35% | 1.83% | 0.97% | 0.60% | 0.16% | -0.02% |
| 2s-30s Spread | 1.90% | 2.71% | 1.40% | 0.85% | 0.26% | 0.03% |
| 2 Year Swap Spread | 93.1 | 82.8 | 75.3 | 67.5 | 49.0 | 47.2 |
| 5 Year Swap Spread | 92.8 | 85.5 | 73.3 | 64.0 | 56.0 | 55.2 |
| 10 Year Swap Spread | 70.3 | 66.0 | 63.8 | 62.5 | 63.8 | 59.0 |
| Changes… | ||||||
| 3 Months | 6 Months | 9 Months | 1 Year | From High | From Low | |
| Fed Funds Target | -0.25% | -2.25% | -2.75% | -3.25% | -3.25% | 0.00% |
| 1 Month LIBOR | -0.24% | -2.14% | -2.66% | -2.86% | -3.36% | 0.08% |
| 3 Month T-Bill | 0.42% | -1.51% | -2.07% | -3.07% | -3.27% | 1.17% |
| 6 Month T-Bill | 0.67% | -1.24% | -1.92% | -2.78% | -2.91% | 0.97% |
| 2 Year T-Note | 1.03% | -0.43% | -1.37% | -2.24% | -2.37% | 1.16% |
| 5 Year T-Note | 0.89% | -0.11% | -0.92% | -1.59% | -1.76% | 1.13% |
| 10 Year T-Note | 0.56% | -0.05% | -0.62% | -1.06% | -1.21% | 0.66% |
| 30 Year T-Bond | 0.23% | 0.07% | -0.31% | -0.60% | -0.75% | 0.36% |
| 2s-5s Spread | -0.14% | 0.32% | 0.45% | 0.65% | -0.26% | 0.68% |
| 2s-10s Spread | -0.47% | 0.38% | 0.75% | 1.19% | -0.73% | 1.20% |
| 2s-30s Spread | -0.80% | 0.50% | 1.06% | 1.64% | -1.15% | 1.66% |
| 2 Year Swap Spread | 10.3 | 17.9 | 25.6 | 44.1 | -18.4 | 45.1 |
| 5 Year Swap Spread | 7.3 | 19.5 | 28.8 | 36.8 | -22.0 | 38.0 |
| 10 Year Swap Spread | 4.3 | 6.5 | 7.8 | 6.5 | -21.0 | 13.5 |
| Highs and Lows… | ||||
| 12-Mo High | Date | 12-Mo Low | Date | |
| Fed Funds Target | 5.25% | 9/17/07 | 2.00% | 3/31/08 |
| 1 Month LIBOR | 5.82% | 9/7/07 | 2.38% | 5/27/08 |
| 3 Month T-Bill | 5.01% | 7/24/07 | 0.57% | 3/19/08 |
| 6 Month T-Bill | 5.07% | 7/17/07 | 1.19% | 3/21/08 |
| 2 Year T-Note | 4.99% | 7/6/07 | 1.46% | 3/19/08 |
| 5 Year T-Note | 5.09% | 7/6/07 | 2.20% | 3/17/08 |
| 10 Year T-Note | 5.18% | 7/6/07 | 3.31% | 3/17/08 |
| 30 Year T-Bond | 5.27% | 7/6/07 | 4.16% | 3/21/08 |
| 2s-5s Spread | 0.97% | 3/6/08 | 0.03% | 8/7/07 |
| 2s-10s Spread | 2.08% | 3/6/08 | 0.15% | 7/2/07 |
| 2s-30s Spread | 3.06% | 3/6/08 | 0.25% | 7/2/07 |
| 2 Year Swap Spread | 111.5 | 3/6/08 | 48.0 | 7/5/7 |
| 5 Year Swap Spread | 114.8 | 3/6/08 | 54.8 | 7/3/07 |
| 10 Year Swap Spread | 91.3 | 3/6/08 | 56.8 | 5/19/08 |
| Lehman Aggregate Index: Major Components - Second Quarter 2008 | ||||||
| Sector | Credit Quality | Duration | Convexity | Avg OAS | Tot. Rtn | Exc. Rtn |
| Aggregate | AA1/AA2 | 4.68 | -0.19 | 1.29% | -1.02% | 0.64% |
| Treasury | AAA/AAA | 5.15 | 0.53 | NA | -2.10% | NA |
| Agency | AAA/AA1 | 3.65 | 0.05 | 0.69% | -1.48% | 0.07% |
| Corporate | A2/A3 | 6.27 | 0.75 | 2.65% | -0.69% | 1.58% |
| MBS Fixed Rate | AAA/AAA | 3.81 | -1.27 | 1.27% | -0.49% | 0.52% |
| CMBS | AAA/AA1 | 4.79 | 0.32 | 2.88% | 0.18% | 2.60% |
| ABS | AAA/AA1 | 3.32 | 0.20 | 3.53% | -0.80% | 0.78% |
| High Yield* | B1/B2 | 4.51 | 0.18 | 7.08% | 1.76% | 3.93% |
| Municipal Bonds* | AA3/AA3 | 7.83 | -0.39 | NA | 0.63% | NA |
| Global Agg Ex-USD* | Hedged |
5.76 | 0.64 | 0.41% | -2.15% | 0.27% |
| Unhedged |
-3.96% | 0.28% | ||||
Source: Lehman Brothers
Global Family of Indices. Excess returns represents returns over duration-matched
Treasuries. |
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