Bond Market Commentary

April 2007

The Fed Holds Rates Amid Conflicting Forces

By Steve Davis

The 1st quarter of 2007 saw the Federal Reserve Open Market Committee continue to hold the Federal Funds rate at 5.25%. This benchmark short-term interest rate has remained unchanged for the past six meetings after 17 consecutive 0.25% rate increases.

On the inflation front, core CPI numbers again have risen to uncomfortable levels, 0.2% and 0.3% for January and February respectively. The core CPI number, which measures inflation minus volatile food and energy prices, had shown signs of moderating to comfortable levels in late 2006, but given higher recent levels, inflation remains a concern for the Fed.

In addition, oil prices rallied to close the quarter at the mid-$65 a barrel range as political tensions in Iran once again escalated. Oil prices tend to be highly correlated with inflation.

The Fed is facing conflicting forces, with higher levels of inflation and weaker levels of economic growth. But the Fed has indicated their primary focus remains on inflation rather than economic weakness. Although investors have been anticipating a rate cut to boost economic growth, a cut by the Fed is unlikely until inflation concerns subside.

The corporate bond market started the year strong, with gains for January and most of February as yield spreads over Treasuries narrowed. But the single-day 10% decline in China’s Shanghai Index in late February sparked world-wide market declines.

This event, combined with the turbulence in the sub-prime housing market, caused investors to become more risk averse by selling stocks and riskier bonds in favor of US Treasury securities. Though US stocks and the Chinese markets recaptured their losses from late February, corporate investors have remained cautious as bond spreads have not revisited their February lows.

As a result of the Fed’s inflationary concerns, long-term Treasuries rallied in the first quarter as the 10-year yield on Treasuries inched past the 2-year yield for the first time in months, reversing the inverted yield curve of the recent past. An inverted yield curve occurs when short-term yields are higher than long-term yields – normally, long-term yields are higher than short-term yields.

The yield on the 10-year Treasury ended the quarter at 4.65%, with the 2-year Treasury at 4.58%.