The re-emergence of European risks and domestic fiscal policy uncertainty helped Treasuries post their strongest weekly performance since last November.

Higher yielding segments of the bond market such as bank loans, high-yield bonds, and preferred stocks, backed by good fundamentals, are our preferred way to navigate a low-yield, range-bound market.

The bond market got reacquainted with two old, but influential friends last week: European risks and domestic fiscal policy uncertainty. It is not that these old friends, which can help support bond prices and lead to lower yields, had gone away, but the market has seemed to ignore their presence for most of 2013. Last week, the re-emergence of both helped Treasuries post their strongest weekly performance since last November. The strong week enabled high-quality bonds to post a good month of performance in February and partially recover losses from a difficult January [Figure 1]. As we highlighted in No Love for Bonds: Bond Market Perspectives of February 19, 2013, European risks and automatic government spending cuts (called sequestration) were two short-term challenges to help support high-quality bond prices and yields.


European Risks And Domestic Fiscal Policy Uncertainty
Elections in Italy resulted in a stalemate casting doubt on the implementation of further reform. A new set of elections, this summer or fall, is becoming increasingly likely. In the meantime, the European Central Bank (ECB) is unlikely to release support, if needed, while a caretaker government is in place, leaving uncertainty to linger. Former Prime Minister Mario Monti’s poor showing in which his party garnered only 10 percent of the vote was viewed as a rebuke of austerity policy by Italian citizens. While it is still likely for a pro-reform coalition to come together in Italy, election results show that European political risks remain high and may continue to support high-quality bonds.

Domestically, the inability of Congress to craft legislation to avoid sequestration spending cuts raises risks around a more impactful government shutdown. Sequestration spending cuts, which total approximately 0.5 percent of the economy in terms of dollars, will be spread equally over the remainder of 2013 and therefore will have a gradual impact on economic growth. By itself, sequestration appears manageable, but fiscal policy uncertainty remains high, as a government shutdown looms at the end of March if Congress is unable to agree on a fiscal-year budget. A government shutdown, which threatens to furlough additional workers and create significant payment delays on items such as tax refunds, presents a significant threat to the economy.

Often Treasury strength can be accompanied by weak or lagging corporate bond performance, but that was not the case in February. As Figure 1 illustrates, investment-grade corporate bonds and high-yield bonds either exceeded or kept pace with Treasury returns. In the case of investment-grade corporate bonds, their greater interest rate sensitivity was the primary driver of return in February. More impressively, high-yield bonds managed to keep pace with Treasury performance. The presence of a third bond market acquaintance explains the resilience of corporate debt in February.

Ben The Benevolent
The Federal Reserve (Fed), another old acquaintance of the bond market, appears to have once again limited the impact of the others. Fed Chairman Ben Bernanke’s semi-annual testimony to Congress last week (please see last week’s Weekly Economic Commentary - #Humphrey Hawkins for background) revealed his desire to maintain a steady dose of bond purchases. Bernanke’s comments highlighted the benefits of large-scale bond purchases, the need for continued purchases, and that positives continue to outweigh negatives. High-quality bonds weakened Tuesday and Wednesday during Bernanke’s testimony, as continued bond purchases are generally viewed positively for economic growth while increasing inflation expectations. High-yield bonds managed to slightly outperform Treasuries last week and in February, thanks to Ben the Benevolent.

Old acquaintances will continue to exert their influence on the bond market with the net result likely to be a continuation of a range-bound, low-yield environment. The 10-year Treasury yield dropped from recent highs but should remain near the middle of the one-year range [Figure 2] as European risks and fiscal policy uncertainty offset Fed stimulus. Over time, we expect fiscal policy risks to fade and the U.S. economy to gain momentum in response, which would result in modestly higher yields to finish 2013. In the meantime, higher yielding segments of the bond market such as bank loans, high-yield bonds, and preferred stocks, backed by good fundamentals, are our preferred way to navigate a low-yield, range-bound market.

Anthony Valeri has been with LPL Financial since June 1993. As Senior Vice President and Market Strategist, Valeri is a member of the Research department’s tactical asset allocation committee and is responsible for developing and articulating fixed income and general market strategy.