Treasury yields headed modestly higher this week on the heels of better than expected payroll data and the prospect of looming supply next week. The yield curve reversed its insatiable steepening trend as the 2-year/10-year spread flattened by 4 basis points. The market took notice to swap spreads, with the 10-year swap spread trading at just 3 basis points which is its lowest level ever. Treasury inflation protected securities outperformed nominals this week, reversing several weeks of underperformance.

The stock market rallied this week on better-than-expected jobs’ data, analysts’ upgrades and increased mergers and acquisitions activity. The S&P 500 index rose every single day of the week, finishing up approximately 2.7%. The NASDAQ and Dow Jones Industrial Average also finished the week higher at 3.6% and 2% respectively. Trading volume continued to remain relatively light. Small-cap stocks outperformed large-cap stocks despite volatility falling 17 out of the last 18 days. In terms of style, large-cap value stocks kept pace with large-cap growth stocks. The best performing sector was materials and the worst performing sector was telecommunications. In mergers and acquisitions news, several deals were announced this week involving companies such as AIG, Pfizer, Merck, CF Industries, Nucor and Novell. In the headlines this week, same-stores sales for the month of February beat analysts’ estimates, led by teen retailers such as Abercrombie, Aeropostale and American Eagle Outfitters. Stronger sales were attributed to better-than-expected holiday sales and improved margins on the spring collection. Shares of Abercrombie (ANF) and Aeropostale (ARO) rallied over 14% and 6% respectively on the positive news.

Investment grade primary activity continued its pace from last week with an assortment of issuers hitting the market. Notable deals this week included Goldman Sachs ($2bln) and Time Warner Inc ($2bln). New issue concessions have diminished but the growing amount of cash on the sideline have caused investors to put money to work at levels that are normally deemed “tight”.

Investment grade corporates tightened week-over-week as fears of sovereign risk in Europe have abated somewhat. Greece was able to raise funds in the bond market which is a good sign for their ability to repair their fiscal situation. The Barclays Credit Index Option-Adjusted Spread (OAS) finished the week at +154, tighter by three basis points. Financials tightened by eight basis point (banks -3, insurance -9); industrials were unchanged, (telecom +6, consumer non-cyclical -1, basic materials -3, capital goods+1, energy -2); and utilities tightened by one basis points.

A tale of two mortgage markets! Dislocation in the higher coupon mortgage market helped support production, current coupon mortgages weather scaled back purchases by the Federal Reserve. Two weeks ago, Freddie Mac and Fannie Mae announced plans to purchase seriously delinquent loans from outstanding mortgage pools. As expected, aggressive speeds from this week’s prepayment report confirmed Freddie Mac’s desire to clean-up their delinquency pipeline in one fell swoop. In contrast, Fannie Mae relative to their smaller cousin plan is to spread out the prepayment pain over the next few months. The impact has been a short-term collapse in premium coupon prices as these securities have a higher percentage of delinquent loans than newly originated lower coupon mortgages. Seasoned vintage mortgages also appear spared the carnage as underlying borrowers with positive homeowners’ equity are less likely to default. An immediate beneficiary of this faster-than-anticipated return of principal has been lower coupon mortgages as investors reinvest the proceeds back into the sector. For the week, the 30-year current coupon versus 10-year spread narrowed by 5 basis points to 65 basis points.

Yields on municipal bonds moved lower across all maturities over the last week. For example, as they stood on Thursday afternoon, yields on State GO bonds maturing in 3 years were just 0.79%, which is 59% of the yield on a comparable maturity Treasury note. Friday morning’s post-Employment Situation Report Treasury market trading only served to stretch relative valuations further. Treasury yields moved higher on better-than-expect job loss data, while market action in municipals was light and strong demand remains, leaving municipal yields little changed. Year-to-date, $10.5 billion has flowed into municipal bond mutual funds, with much of that flowing into short and intermediate funds. Year-to-date, the broad municipal bond market has returned 1.7% on a total return basis, with the intermediate range of the market outperforming.

Buyers are actively looking for tax-exempt bonds, but not finding many options. Light new issuance this week was led by the Georgia Municipal Electric Authority (MEAG) nuclear power plant bond and the State of New York Dormitory Authority issue. But of the nearly $3 billion in bonds sold by MEAG, less than one-third were tax-exempt bonds. The rest were taxable Build America Bonds. The NY Dorm Authority sold $600 million, but again only half that amount came to market as tax-exempt bonds. New issuance is expected to pick back up next week, with a new issue calendar approaching $10 billion. The highlight will be the State of California bringing a $2 billion tax-exempt deal to market. This deal should test the retail investors’ appetite for general obligation bonds of the nation’s largest state still struggling with fiscal problems.

The high yield market has begun the month of March 2010 in solid form, with the market induced volatility of the Greek drama a distant memory. Market levels have rebounded nicely from the early February 2010 lows and the new issue market has picked up pace. Over the course of this week, new deals totaling over $5 billion have priced, including deals for HCA Inc., Reddy Ice and TimeWarner Telecom. The new deals have generally been 2-3x oversubscribed and most have traded up at break. Market liquidity is good and is expected to remain so for the near term. Earnings are largely out of the way and market participants are focused upon the economic data, especially the employment and retail data due out soon. The Moody’s global trailing default rate, which peaked at 13.5% in November 2009, has now declined to 11.6% and is projected by Moody’s to decline to a low 2.7% by February 2011. Few new defaults are expected over the coming months.

The CECE index of equities traded in Central Europe (Czech Republic, Hungary, and Poland) gained +5.3% this week, while the Russian stock index RTS went up by 8.5%.

German energy commissioner G?nther Oettinger signaled for the first time openness on behalf of the European Union towards the Russian South Stream gas pipeline, which is considered a rival to Europe’s Nabucco project and would also tap resources in the Caspian region. Oettinger said that South Stream, which is backed by Gazprom, would “increase capacity” and could be supported by the EU Commission if it meets the technical requirements for security. The stalled Nabucco project is intended to avoid a repeat of the Russian-Ukrainian gas crisis, which also had an impact on EU consumers, by bringing gas to Europe via Turkey (instead of through the Ukraine) thus lowering dependence on Russian gas imports. Oettinger’s comments were a first and immediately drew criticism from other commission members.

Yields in major government bond markets closed a quiet week mostly unchanged. On the policy front, both the European Central Bank (ECB) and the Bank of England (BoE) held rates steady at their policy meetings on Thursday, and as expected, the BoE did not increase the size of its asset purchase program. However, the ECB announced a tightening of its liquidity provisions, which was described as a ‘progressive normalisation’ of policy. And in Australia, the central bank fulfilled market expectations by raising rates a further 25 basis points to 4.0% and clearly signalled their intention to continuing tightening in coming months. In Japan, speculation mounted that the Bank of Japan would adopt further easing measures to boost bank lending at its next meeting mid-month. The week’s key news in non-US sovereign bond markets was the unexpectedly strong demand for a €5 billion, 10-year bond issue by the Greek government. This served to ease concerns about Greece’s capacity to access global capital markets, narrowing the spread of 10-year Greek government bonds over their German equivalents to slightly less than 300 basis points for the first time in over a month.   

On currency markets, Sterling saw the biggest moves on the week, coming under very heavy selling pressure due to mounting political uncertainty ahead of the forthcoming general election, although some better-than-expected service sector sentiment data sparked a partial rebound later in the week. Elsewhere, the US dollar received a late but minor boost from Friday’s better-than-expected US payrolls data, while the Australian dollar continued to edge higher in response to the hawkish tone of the central bank’s latest comments. The yen weakened against the greenback as yen funding rates slipped below dollar funding rates for the first time in about six months, increasing the attraction of the yen carry trade.  

Emerging market dollar-pay debt spreads widened this week. Weaker-than-expected economic data from the US and the ongoing uncertainties regarding Greece and the Eurozone contributed to the softer risk appetite.

In Israel the Central Bank kept its benchmark interest rate on hold at 1.25%, in line with expectations. In a statement following the announcement, they cited the lower-than-expected inflation releases from December and January as the main factor for not continuing the rate hikes which commenced in August 2009.

In Mexico, bi-weekly inflation data released was lower-than-forecast for the first half of February. Other data was mixed with a notable rise in the unemployment rate from 4.8% in December 2009 to 5.87% in January 2010. Local bonds were roughly unchanged and the currency marginally stronger this week.