The gap between US Treasury yields and surprisingly robust US economic performance — in which rates are low and growth surprisingly high — reflects the European sovereign crisis concerns. But with the ECB extending its balance sheet to ward off the doomsday scenario, rates should modestly rise as fears of European contagion ease in the US. Long duration asset classes fare the worst in a reversal of 2011 performance while credit risk sectors of the fixed income market outperform.
Despite the headwinds from Europe, US economic performance has remained surprisingly resilient. Yet, US Treasury yields remain stuck around the lows they hit last summer when the European crisis first began to again accelerate. The gap between US Treasury yields and surprisingly robust US economic performance — where rates are low and growth surprisingly high — reflects the European sovereign crisis concerns. The crisis at its core challenges the notion of what a "risk free" asset means. And even though the US lost its AAA rating during this same time, it still remains the best house in a bad neighborhood. Flight to quality flows benefit US Treasury yields keeping them low. Figures 8 and 9 below illustrate the "odd decouple" between US rates and economic performance.
Figure 8 highlights the level of the 10 year Treasury yield measured against the Citigroup Economic Surprise index. This index, rather than measuring the level of economic activity, measures instead the degree to which that level of economic activity surprised or disappointed relative to analyst expectations. Note that prior to last summer, the level and changes of 10 year Treasury yields tracked this index rather strongly (with a nearly 70% correlation in daily levels from January 2009 through last June). Hence, based on the strong recovery in US economic performance relative to expectations since the summer, we would expect rates to be substantially higher: the surprise index relationship alone suggests rates should be 100 basis points higher. Of course they are not and for good reason. Figure 9 nearby shows nearly all of this "gap" in US rates vs. economic performance can be traced to signs of funding strains in the European banking system.
As we detailed above in the "Dukes of Moral Hazard" theme, with the ECB extending its balance sheet to ward off the doomsday scenario, funding strains in European banks should ease. If recent relationships hold going forward — admittedly not a sure outcome — US rates should modestly rise to start 2012 as risk fears ease in the US over European contagion. Under such a scenario, long duration asset classes fare the worst in a reversal of 2011 performance while sectors of the fixed income market with credit risk outperform as risk appetite returns.
Figure 8: The Odd Decouple: US Rates vs. Economic "Surprise" Performance
Source: Bloomberg, Citigroup.
Figure 9: Mind the Gap: US Rates Track European Bank Funding Strain
Source: Bloomberg and BlackRock Financial Management calculations.
Municipal Bonds Have Outperformed
With myriad studies and media reports predicting a significant rise in debt defaults or bankruptcies among state and local governments continuing to go unsubstantiated, municipals were the best performing fixed income asset class for 2011. While the financial condition of state and local governments remains challenged, states and the vast majority of local governments have taken the actions necessary to balance budgets and ensure full and timely payment on their general obligation (GO) debt. In fact, most states were successful in balancing their fiscal year (FY) 2012 budgets on or ahead of the July 1 start. Additionally, as a result of its generally longer duration, municipal returns benefited in terms of price appreciation from falling long-term interest rates in 2011.
Indeed, as federal stimulus aid has virtually ended, state and local governments have augmented job cuts in an effort to balance budgets. New federal austerity and a slowing economy will have a negative effect on state and local governments, although we believe most will make the necessary fiscal adjustments. Although Jefferson County (AL) filed the largest bankruptcy on record, we believe municipal bankruptcies and defaults will remain rare. In fact, numerous states have taken actions to avoid such occurrences. As we have pointed out, the lack of bankruptcies and debt defaults among local governments remains notable given the severity of the"Great Recession." Our overall view remains largely unchanged, and is outlined in several key points
- The municipal marketplace remains a vast universe in which GO default is still very rare.
- New federal fiscal austerity will further constrain state and local governments, but financial flexibility remains.
- States will continue to balance their budgets by cutting spending and offloading costs to local governments. If the economy slows significantly, the divergence in credit quality between states and local governments will become more pronounced, as local property tax receipts have followed the decline in valuations.
For more information, the BlackRock Municipal Bond Management Committee publishes a monthly report and periodic comprehensive reports such as the State of the States and Local Governments report.
Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in non-investment-grade debt securities ("high yield" or "junk" bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories.
Index performance is shown for illustrative purposes only. You cannot invest directly in an index.
The opinions expressed are those of BlackRock® as of January 6, 2011, and may change as subsequent conditions vary. Information and opinions are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable. The information contained in this report is not necessarily all-inclusive and is not guaranteed as to accuracy. Past performance does not guarantee future results. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investment involves risk. Reliance upon information in this report is at the sole discretion of the reader.
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Prepared by BlackRock Investments, LLC, member FINRA.
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