The world’s major central bankers encouraged a rally in risky assets after they slashed target interest rates and announced, in the case of the U.S. and Europe, open–ended bond–buying programs to prop up faltering economies. In early September, the European Central Bank (ECB) announced a bond program titled Outright Monetary Transactions (OMT) which involves purchasing, without limit, the debt of struggling governments in an effort to overcome a three–year debt crisis. A week later the Federal Reserve (the Fed) announced the third round of quantitative easing (QE3) since the onset of the credit crisis in 2008. The Fed, in a rare move towards greater transparency and quantifiable results, announced it will buy $40 billion per month in mortgage–backed securities until the labor market, which has struggled through the summer and into the fall, improves. Pursuing similar goals, China, Australia, and Brazil announced cuts to their key rates and Japan and the United Kingdom increased their bond buy–back programs. (See Figure 7).

Figure 7 – In third quarter central bankers around the world announced open-market pricing programs and interest rate cuts in an effort to prop up faltering economies.

The Fed’s efforts to push monies into riskier assets were successful, initially stirring up a large equity rally. Investors exhibited high demand for securities with an incremental yield above the base–line U.S Treasury, and consequently, spreads collapsed to the tightest level since 2008. Anticipating the Fed’s monthly purchases, mortgagebacked security prices rose and yields fell. Mortgage–backed securities have historically yielded 90 to 110 basis points over the 10–year Treasury. Following the first and second rounds of quantitative easing, the differential tightened down to 55 to 65 basis points for currentmonth settle. After the Fed’s recent announcement, spreads tightened to 25 basis points and have now moved flat to U.S Treasuries. (See Figure 8).

Figure 8 – The chart above shows a Fannie Mae 30–Year 3% Pass–Thru charted against the U.S. 10– Year Treasury Note. Following the announcement of the third round of quantitative easing (QE3) the mortgage spread collapsed and began to trade flat with Treasuries.

A supply/demand imbalance in the investment grade corporate bond market pushed spreads tighter. Yield–hungry investors flocked to riskier investments at a time when corporate bond issuance has dried up due to a multitude of reasons, including already cash–heavy balance sheets, decreased M&A activity and the fact that firms that wish to issue debt in the low–rate environment have already done so. Spreads tightened across the board for Finance, Industrials and Utilities, particularly in the last three weeks of the quarter, as they followed the equity rally. The finance portion of the corporate bond market rallied 100 basis points more than Industrials in the oneto 10–year space. A month ago, financials were the only place offering a degree of income, but investors have since chased much of the yield from the market. (See Figure 9).

Figure 9 – The chart above shows the spread change over the third quarter of 2012 for Financial, Industrial and Utility issuers. The negative number indicates tightening in the quarter.

But what was hailed as an end to the ‘flight to safety’ rally in the U.S following central bank announcements may have been premature. The equity rally weakened in the last week of the quarter. U.S Treasury bonds saw price gains after doubts surfaced over QE3’s ability to lift the labor market and antiausterity protests in Spain and Greece undermined ECB’s plan to ease debt costs in those countries.

On the municipal side, issuance was strong and well supported by demand despite headlines surrounding underfunded pensions and credit events in California. Following a pattern established in the last months of 2011, municipal yields remained attractive relative to the U.S Treasury. The municipal curve at the end of the period stood at 104.4% of the tenyear note.

For the quarter and year–to–date, corporates continued to outperform other fixed–income asset classes. The ten–year U.S Treasury was the weakest performing fixed–income asset class for the quarter despite the ninth–inning rally. (See Figure 10.)

Figure 10 – Total returns by fixed income asset class.

The outlook for fixed income assets through the end of the year is largely dependent upon the success of QE3 and meaningful policymaker action to prevent the U.S. economy from going over the fiscal cliff. It is too early to evaluate the impact on expectations that the Fed will continue buying mortgage–backed securities until the unemployment rate, which was at 8.1% at the quarter end, comes down. However, there is no reason to doubt that the monetary stimulus, combined with other improving measures like a strengthening domestic housing market and fewer worries about the breakup of the Eurozone, can achieve some degree of success over the upcoming year.

A resolution to the fiscal cliff issue will be shaped to some extent by the election returns, particularly if one party sweeps the national elections and gains the Presidency and control of both houses of Congress. Financial markets become nervous when one party controls everything, preferring split forms of government – one party to hold the House and the Senate and the other to hold the Presidency.

Our forecast is for minimal inflation. Although some concern exists that QE3 combined with previous rounds of monetary easing may ignite inflation, we are not of that opinion, at least not yet. While M1, M2 and M3 money supply are fairly high, the velocity of money is not accelerating much. The available cash is not being lent out into the system because there is insufficient demand for funding. When demand flips at some fulcrum point and the velocity of money accelerates, then the Fed will have to worry about soaking up the water in the basement (i.e. removing excess liquidity).

The short–end of the yield curve is anchored by the Fed’s plan to leave the Federal Funds Rate at zero through mid– 2015. We may get the occasional small bout of inflation, as we have seen with the recent uptick in oil prices, and this could push long–term yields higher while also steepening the yield curve. But commodity inflation is frequently transitory. On the other hand, wage inflation which is about two–thirds of overall inflation, is much more persistent. Until we see wage inflation which is indicative of a much stronger economy, we do not anticipate inflation moving higher.

The lack of inflation also anchors to some extent the long–end of the yield curve. Even if there is the occasional whiff of commodity inflation, it tends to put a damper on spending and other economic growth as opposed to igniting inflation.

Our outlook for the fiscal cliff being successfully addressed has improved. We are still scaling the fiscal cliff, although recent developments have made us more optimistic that policymakers will achieve a degree of success once the presidential election is over. Neither political party wants the worst case scenario; both have stated that addressing the fiscal cliff should be the first agenda item after the election. According to some economists, to do otherwise risks shaving 3.5 to 5.0% from an already anemic GDP, effectively pushing the economy back into a recession.

The risk to the bond market is that there is significant success on the fiscal cliff issue through a combination of higher taxes and lower spending, and therefore, a reduction of the deficit by $3 to $4 trillion in line with the Simpson–Bowles goal. Such a reduction would be well received by the equity market and the economy in general, and would probably remove some flight to safety money from the bond market, resulting in higher yields, at least at the outset. But if the exercise fails and we go off the fiscal cliff, then we will see the flight to certainty ramp up again and the yield on the 10–year U.S Treasury will likely go back down to around 1.35%.

The sanctity of full tax exemption for municipal interest could be in some jeopardy. We anticipate that municipal yields will continue to drift with those of Treasuries unless there is increased supply coupled with decreased demand related to credit events. Given the uncertainty of the election and the current deficit conversations, there will be some discussion about, perhaps not eliminating, but limiting the amount of tax exempt interest that investors can deduct, effectively raising the tax rate at which it is beneficial to own municipal bonds. That could hurt the demand for munis, driving up the yield and pushing prices down. Presumably everything currently outstanding would be grandfathered in terms of its tax status, but that may not necessarily be the case. Regardless, the municipal market is going to take a hit if the sanctity of the full tax exemption of municipal bond interest is threatened. The tax exempt status of municipals has been threatened in the past, thus the probability of new legislature passing is probably remote. Despite this, serious conversation will occur regarding deficit concerns and tax reform by both sides of the isle and the tax status of municipals could be placed on the table.

Internationally well–received ECB action could be marginalized should individual Eurozone countries elect not to participate. In the previous issue of Market Outlook we indicated that the near–term probability of a resolution to the European debt crisis was a bit more likely than a sudden return to moderate growth in the U.S. economy (i.e. growth above 2%). Europe is beginning to solve its problems. The summer summit in Brussels disappointed the market, but the ECB stepped into the void. The ECB is the only entity viewed as having the horsepower and deep enough pockets to remedy the European debt crisis. ECB President Draghi’s September 6 announcement introduced OMT, the current bond buying program for those countries that apply. By getting out the ECB’s fire hose, President Draghi’s announcement pushed rates down, a backstop necessary to restore confidence in the European sovereign debt market. Assuming these countries agree to the ECB buying their debt, on the ECB’s terms, then the European debt crisis has improved much sooner than the U.S fiscal cliff dilemma.

That said, troubled Eurozone countries are not particularly eager to agree to a bailout because the austerity programs asked of them will be painful. While the psychological impact associated with the threat of the ECB’s ability to extract such agreements has pressed yields down and relieved a great deal of pressure, yields will rise again unless the countries in need of a bailout agree to the terms and conditions. Spain and other countries will simply have to bite the bullet. It is just a question of how tough the terms of the deal are and how much they will negatively impact the Eurozone economy. The bond market will hold up because the ECB is there to back it up, but the equity side may languish until growth resumes and GDP picks up. In our opinion, resistance from individual countries is likely to be a short–term phenomenon. Going forward we are more confident that OMT has the opportunity to significantly allay fears of a possible Eurozone breakup.

The perceived bubble in the bond market is not a given. The bond market is very expensive because of the flight to safety. Currently the bond market is being driven by technical factors more so than fundamental factors. Until that reverses, we do not have a bubble, it is simply where the market is. Unlike the equity market, the bond market has terminal value. The equity market can go up indefinitely as long as there are earnings to support the advance. However, the bond market can stay expensive much longer than the equity market because the bond market has a theoretical bottom and can serve as a safe haven for investors wary of volatility.

It is important for investors to be defensive – stay in the intermediate portion of the curve and use caution as it relates to credit quality. At some point the bond market will change directions but, because the Fed intends to hold rates low until 2015, unless something changes dramatically, the market will remain status quo until then. We do anticipate some volatility in the longer part of the curve but we do not anticipate violent swings.

BBVA Compass is the trade name for Compass Bank, which is a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, and are NOT bank guaranteed. May LOSE value, are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).