Chandler Bond Market Review

Are Sovereign Yields Sustainable?

Since the end of the first quarter, risk assets, including equity, commodity, and credit based fixed income markets, have underperformed. Yields in safe haven sovereign governments, in particular the United States and Germany, have contracted to aggressive valuations over the short two month time frame while yields in Spain and Italy have widened materially. The U.S. Dollar has also strengthened, putting potential pressure on global competitiveness within the U.S. The improvement in the U.S. dollar is despite softening domestic economic data, most notably the downward trend in non-farm payrolls. It is our view that the primary catalyst for risk asset weakness and the commensurate flight to quality drop in domestic Treasury yields is being dominated by news and events out of Europe.

Select Sovereign 10 Year Bond Yields

At Chandler, we have long remained cautious regarding the market’s interpretation of efforts by European leaders and regulators to correct the imbalances accentuated by the financial crisis of 2008. The Euro currency was introduced over a decade ago primarily to promote political harmony within the region. The economic benefits, although at the time thought of as substantial, were not the primary motivator. After the introduction of the Euro, sovereign yields within the region began to converge despite the fragmented economic growth rates of each of the respective nations. In hindsight, it is easy to conclude that the convergence of yields within the EU was irrational considering the varying growth rates, global competiveness, and creditworthiness of each of the respective sovereign nations.

Despite the aforementioned differences with each of the countries within the euro zone, the European Central Bank (ECB) sets monetary policy for the region as a whole. Herein lies one of the most fundamental issues with the Euro common currency. European monetary policy is too easy for the Northern section of the Euro, most notably Germany, and too tight for the Southern European nations, most notably Spain and Italy (we are purposely excluding commenting on Greece in this article). Historically, a country’s exchange rate was an effective mechanism to stimulate global competitiveness via depreciating the home currency. The construction of the single currency Euro prohibits Spain or Italy (and other governments within the EU as well) from depreciating their currency at the expense of the other countries within the Euro to increase global competitiveness on a long-term basis. So the real question becomes if countries within the Euro zone are going to have a single monetary policy then should all of the countries also have the ability to access the capital markets at the same rate? The interest rate at which the European Union as a whole could access the markets would undoubtedly be higher than what Germany currently pays but lower than the current rates in Spain and Italy.

At Chandler, we believe Ten Year sovereign yields are at unsustainable levels over an intermediate time horizon in both the U.S. and Europe. On a long-run basis, the Federal Reserve strives to maintain core inflation of around 2.0%. Purchasing Ten Year Treasury notes at the current yield of 1.56% almost assuredly locks an investor into a negative real return, if the investment is held to maturity as the rate of inflation exceeds the yield of the Treasury note. The Federal Reserve has a dual mandate of full employment and stable prices. The unemployment rate remains too high and the pace of new job creation is insufficient to bring the level down.

As we have highlighted in the past, Federal Reserve Chairman Bernanke is an expert on the depression of the 1930s and thus will continue to utilize unorthodox policies to fulfill the Fed’s dual mandate. The recent deterioration in higher risk assets, in particular equity markets and commodity prices (see chart below), is putting downward pressure on inflation jeopardizing the 2nd tenet of the Fed’s dual mandate of stable prices. If the Federal Reserve chooses to utilize the balance sheet again, an important element for investors to consider is whether the anticipated additional measures expand the Fed’s balance sheet (Quantitative Easing) or simply change the composition of the underlying holdings (Operation Twist). An outright increase in the size of the Fed’s balance sheet is consistent with increasing the risk of inflation and hence will likely lead to higher U.S. yields, if implemented. Additionally, measures taken in Europe to bring down the yields of Spain and Italy will lessen the demand for safe haven assets and thus exert pressure on both U.S. and German sovereign yields.

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We are looking for more concrete actions from the ECB and European governments to drive the direction of risk assets in the 2nd half of 2012. Recent actions taken by the ECB, in particular the Long Term Refinancing Operations (LTROs) in December 2011 and February 2012, have been inadequate. Unlike the Federal Reserve, which took credit risk onto its balance sheet, the ECB continues to act as a financing conduit thus leaving the credit risk of owning European sovereign debt with the purchasing institutions. As the European debt crisis has metastasized, engaging in outright quantitative easing is likely no longer enough. On a long-term basis, we believe one of the only viable options for the European Union is a Euro bond mechanism that pools the financial resources of the region as a whole. It is our expectation this “long-term” solution will take a substantial amount of time to implement. Although the Federal Reserve remains poised to take additional steps to assist the US economic recovery, actions by the ECB will drive the price of risk assets in coming months.

William Dennehy II, CFA
Vice President, Portfolio Manager

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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