By Matt L. Peden, CFA, Vice President, Investment Officer 

Throughout the second quarter, difficult economic news persisted placing a dark shadow over the capital markets. Economic growth in the U.S. continued to moderate with many market pundits debating whether or not the U.S. was officially in a recession. First quarter GDP, a measure of domestic economic output of goods and services, came in at a very modest 1.0%. Concurrently, inflationary pressures (especially in commodities such as oil and food) continued to surge. This pressure hampered consumers’ discretionary spending - the vital cylinder within the country’s economic engine. As the quarter resumed, the word “stagflation” crept into the economic vernacular, a descriptive term often used when inflation is coupled with a stagnating economy or recession. Augmenting the difficult environment was the stress within the financial system and the housing market. Lending standards tightened and home prices fell while the financial health of both Fannie Mae and Freddie Mac were in question by quarter-end.

During the first six months of 2008, the broad bond market, as measured by the Lehman Brothers Aggregate Bond Index, posted a slight gain of 1.13%. The second quarter proved to be more difficult than the first, generating a return of -1.02%. Although bond returns were very modest on an absolute basis during the turbulent six months, bonds have fulfilled their role within asset allocations, providing investors downside protection, diversification and return benefits. Bonds outpaced their broad equity market counterpart, as measured by the S&P 500® Index, by 1.71% during the second quarter. Over the past year, the broad bond market has outperformed the broad equity market by an astonishing 20%.

One can not be enviable of the Federal Reserve’s (“the Fed”) position, attempting to delicately balance anemic economic activity with inflationary pressures. Bernanke, as Fed Chairman, and the other FOMC members have their work cut out for them. During the first quarter, the Fed cut rates by 200 basis points for credit and economic stimulus purposes. The Fed cut the fed funds target rate by an additional 25 basis points during its April 30 meeting, reducing the key interest rate to 2.00%. Many thought this reduction would bring the Fed to a neutral position for a period of time, but subsequent Fed comments regarding inflationary concerns caused investors’ expectations to swing towards a rate hike over upcoming periods. These expectations drove short-term rates to higher levels. At its June 25 meeting, the Fed left the fed funds target rate unchanged (the first time since August 2007) as fear and risk aversion had reentered the market during the latter part of the quarter. While inflation concerns were still present, the Fed realized that current factors such as stricter lending standards, a weak financial system, higher mortgage rates and higher unemployment had tightened financial conditions and liquidity in the marketplace. That being said, the Fed, along with many other global central banks, remains keenly focused on reducing inflationary pressures, even at the potential expense of economic stimulus.

Movement of the U.S. Treasury yield curve signaled concerns over inflation. The yield curve flattened as short-term yields rose more than long-term rates as investors anticipated that the Fed would have to raise rates sometime during the year. The most significant movement was the yield on the 2-year U.S. Treasury (the issue most sensitive to Fed policy) which moved up over 100 basis points during the quarter. The yield on the 10-year U.S. Treasury increased by 56 basis points to close the quarter at 3.97% while the yield on the 30-year U.S. Treasury rose 23 basis points to 4.52%.

Performance among bond sectors was a reversal from the first quarter, a period when U.S. Treasuries dominated performance. During the second quarter, corporate bonds outpaced U.S. Treasuries as historically wide spreads narrowed somewhat, especially in high yield corporate bonds which outpaced their higher grade counterparts. High grade mortgage-backed securities slightly outpaced U.S. Treasuries (on a like-duration basis) during the quarter, but home equity asset-backed securities continued to lag as home prices and collateral quality deteriorated. Emerging market debt, both on a local currency and U.S. dollar-denominated basis, also outpaced U.S. Treasuries for the period. Rising interest rates provided a headwind for all bonds, especially those with longer durations.

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