The Stable Value Market Environment
Second Quarter 2010
David J. Molin, CFA
During the quarter, volatility returned to the
fixed income markets as contagion fears resulting from the sovereign
debt crisis in Southern Europe and concerns over the health
of the global economy drove investors out of riskier asset classes
and back into the safety of US government securities. As a result,
Treasuries rallied throughout the quarter, sending yields lower,
and credit spreads on risk assets widened with investment grade
corporate spreads moving out by around 40 bps. By quarter's
end, Treasury yields were significantly lower across most maturities
with the largest moves focused in the mid to long end of the
curve as yields on 2, 5, and 10 yr notes decreased by 41, 77,
and 89 bps, respectively. As a result, the Treasury curve flattened,
but remained historically steep, with the spread between two
and 10-year Treasuries ending the quarter at 233 bps, compared
to 281 bps last quarter. Following suit, GIC yields, based on
the average compound rate for a $5 million contract, ended the
quarter lower, but to a somewhat lesser degree as credit spreads
over Treasuries widened. In the end, GIC yields declined around
50 to 60 bps across intermediate to long maturities and the
GIC yield curve flattened with the difference between three
and 10-year contracts ending the quarter at a positive spread
of 234 bps. GICs continued to demonstrate solid relative value
characteristics when compared to high-investment grade alternatives
with the average five-year contract offering around 85 bps over
Treasuries at the end of June. Moreover, the high contract offering
based on FCM's weekly GIC statistics yielded approximately 120
bps over the corresponding Treasury, which is considered to
be favorable when compared to spreads in the 100 bps range,
before wrap fees and commissions, on similar corporate bonds.
During the quarter, the broad equity markets experienced sizable
losses with the DJIA, S&P 500, and Nasdaq reporting negative
total returns of 9.4%, 11.4%, and 11.8%, respectively. The Barclays
Capital Aggregate Bond Index reported a strong total return
of 3.5% for the quarter as index performance benefited from
the sizable drop in yields, which more than offset spread widening
in non-Treasury sectors.
Economic News: The economic recovery appeared
to lose some steam during the quarter with most economists projecting
more modest near-term growth as the economy transitions away
from the short term benefits of inventory builds and government
stimulus. Going forward, the sustainability of growth remains
the big question given the significant headwinds still facing
the economy including historically high levels of unemployment,
reduced household wealth, and lower availability of credit.
In addition, higher tax rates in 2011 and state and local government
budget cuts could further dampen growth prospects. Current consensus
is for GDP growth of 2.5% in the second quarter, down slightly
from the 2.7% growth experienced in the first quarter. During
the quarter, the recovery of the housing market showed signs
of faltering with declines in sales of existing homes and housing
starts reported in May and June, which was largely blamed on
the expiration of the government tax credit. The manufacturing
sector continued to expand during the quarter; however, the
pace of growth appeared to slow, with factory activity, as measured
by the ISM Index, falling more than expected in June. The consumer
confidence index declined in June to its lowest level since
March, largely due to more pessimism regarding the outlook for
the labor market and economy. The lower sentiment was reflected
in tepid consumer spending with retail sales falling more than
expected in both May and June. During the quarter, the deterioration
of the labor market continued to abate as the economy added
621,000 jobs, a significant improvement from the 261,000 jobs
gained in the first quarter. However, a large portion of the
job gains was related to the hiring of temporary government
census workers as private employers added a more modest 357,000
jobs during the quarter. The unemployment rate declined modestly
from 9.7% in March to 9.5% in June. During the quarter, inflation
growth at the consumer level turned negative raising concerns
over deflation with the consumer price index (CPI) decreasing
by 0.1% in June, after a 0.2% decline in May. At its June meeting,
the FOMC maintained its Fed Funds target at a range of 0%-0.25%.
The committee continues to anticipate that economic conditions
are likely to warrant exceptionally low levels of the federal
funds rate for an extended period.
The following chart illustrates
GIC yields for $5.0 million, five-year investment only, compound
interest contracts. The rates are net of expenses with no
commission payable.
