The Stable Value Market Environment
First Quarter 2008
First quarter 2008 was an historic period as investors
faced unprecedented volatility culminating with the near bankruptcy
and subsequent bailout of Bear Stearns, the fourth largest US
investment bank. Flight to quality buying sent Treasury yields
lower as investors reacted to troubling news including large
subprime related write-downs, agency downgrades of bond insurers,
and failures in the auction rate securities markets. Credit
spreads continued to gap wider as institutional investors deleveraged
their balance sheets and sold securities to meet liquidity needs.
By mid-March, credit spreads widened significantly beyond their
historic highs as rumors about the condition of Bear Stearns
and other investment banks intensified risk aversion and further
constrained liquidity. The Federal Reserve took unprecedented
actions to provide liquidity and stabilize the market including
$30 billion to facilitate the sale of Bear Stearns to JP Morgan,
along with a 75 bps cut in the FF rate and the injection of
billions through special liquidity facilities including the
opening of the Discount Window to investment banks. Treasury
yields were down sharply across most maturities, with yields
on 2, 5, and 10 yr notes declining by 146, 100, and 61bps, respectively.
The Treasury curve steepened with the spread between two and
ten-year Treasuries ending the quarter at 183 bps, compared
to a positive slope of 97 bps last quarter. GIC yields, based
on the average compound rate for a $5 million contract, also
declined during the quarter, but to a lesser degree than Treasuries
as credit spreads widened to levels well above historic norms.
GIC yields declined around 80 bps in shorter maturities, while
yields on intermediate and longer maturities declined around
40 to 50bps. The difference between three and 10-year GIC contracts
ended the quarter at a positive spread of 144bps, up from 100
bps at the end of last quarter. Despite a more intense re-pricing
of risk within other investment grade sectors, GICs continued
to demonstrate solid relative value characteristics when compared
to high-investment grade alternatives. GIC spreads widened significantly
with the average five-year contract offering around 200 bps
over Treasuries at the end of March, up approximately 70 bps
since December. Moreover, the high contract offering, based
on FCM's weekly GIC statistics, yielded approximately 250 bps
over the corresponding Treasury, which is very favorable when
compared to spreads in the 200 bps range, before wrap fees and
commissions, on similar corporate bonds. The equity markets
ended the quarter much lower led by weakness in financial shares
with the DJIA, S&P 500, and Nasdaq reporting total returns
of -7.0%, -9.4%, and -13.9%, respectively. On the contrary,
investment grade bond funds reported solid performance with
the Lehman Aggregate Index returning 2.2%, as the effect of
lower interest rates on asset values more than offset wider
credit spreads for non-Treasury sectors.
Economic News: Recent data points to a
weakening economy and the possibility of recession. The current
consensus is for slightly positive GDP growth in the first quarter
of around 0.5%, down from the 0.6% growth experienced in the
fourth quarter 2007. The housing market continued to weaken
with housing starts falling 12% in March to a 17-year low, while
sales of existing homes remained near multi-year lows. The consumer
confidence index fell to its lowest level in five years in March
as declining home values, tighter lending standards, and softer
labor market continued to depress consumer optimism. This was
reflected in weaker retail sales, with sales excluding automobiles
increasing by only 0.1% in March, after a 0.1% decline in February.
Business investment also showed signs of weakening as orders
for durable goods, ex transportation, declined by 2.6% in February,
after a decline of 1.0% in January. After rebounding in January,
the manufacturing sector contracted in February and March with
factory activity, as measured by the ISM Index, remaining near
five year lows. The labor market continued to weaken as the
economy lost jobs for a third consecutive month in March, resulting
in payrolls declining by over 200,000 jobs during the quarter.
The unemployment rate increased from 4.9% in January to 5.1%
in March, the highest level since September 2005. Headline inflation
crept higher during the quarter, driven by higher commodity
prices, with the consumer price index (CPI) increasing 0.3%
in March, after no change in February. The more closely watched
Core CPI, excluding volatile food and energy prices, grew at
a more controlled rate of 2.4% in March, on a year over year
basis, up slightly from a 2.3% growth rate in February. The
FOMC cut its Fed Funds rate target by an unprecedented 200 bps
during the quarter, bringing the rate down to 2.25%. In its
March policy statement the committee acknowledged the difficult
market conditions: "Financial markets remain under considerable
stress, and the tightening of credit conditions and the deepening
of the housing contraction are likely to weigh on economic growth
over the next few quarters".
David J. Molin, CFA
