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Market Update

Fork in the Road for the Bond Market

There is strong disagreement about the direction of U.S. interest rates.

U.S. Bond Market Rallies�
The broad U.S. fixed income market's rally continued through August, prompting some to warn of a "bond-market bubble." Proponents of the bond-market bubble theory point to the record low yields, the country's gigantic deficit and debt burden, and the volume of bond buying by retail investors (whose interest in an asset class can often signal its peak) as proof of their argument.

Conversely, sound bites from Jackson Hole and less-than-reassuring economic statistics have others suggesting the U.S. is falling into a prolonged economic slump, with the implication that yields can go lower. Subscribers to this theory discount any strength in economic data as remains of last year's stimulus spending and see Federal Reserve chairman Bernanke's suggestion that the U.S. central bank "will do all that it can" to ensure a continuation of the economic recovery as well-intentioned but lacking ammunition as rates approach zero.

The Morningstar US Core Bond Index, our broadest measure of the U.S. bond markets (includes government-, corporate-, and mortgage-backed bonds), rose 1.3% in August, and is up 7.7% for the year. The Morningstar US Treasury index rose 2.0% in August--for a fifth consecutive monthly gain--and is up 8.7% for the year through August.

�While Europe Is a Mixed Bag
Global government yields on the whole trended lower as European bond markets continued to exhibit divergent behaviors. German debt, for instance, is trading at historically low yields; bonds of Greece and Ireland, meanwhile, suffered downgrades due to those countries' debt burdens.

The Morningstar German Government Bond Index rose 3.9% in August and 10.4% for the year, while the France Government Index posted equally impressive returns.

In sharp contrast, The Morningstar Greece Government Bond Index fell 3.3% in August and is down close to 20% for the year to date. The Ireland Government Bond Index yield differential to Germany has risen to 3.4%, while the Greece differential now stands at more than 10%, the highest since the European Union and International Monetary Fund combined for a EUR 750 billion bailout package in May.

Credits Hold Steady
Global credits overall saw small increases in yield spread premiums as most markets appear to be approaching at least a short-term equilibrium that's more consistent with long-term historic averages. The yield spread premium on the Morningstar US Corporate Bond Index rose 0.03% in August to 1.75%. The 10-year average yield premium on the index is 1.85%. The index average yield of 3.38% is the lowest in more than 10 years and has delivered a total return of 9.6% for the year to date. The corporate financial sector--the hardest-hit in the financial crisis--remains the furthest from long-term averages. The yield spread premium on the Morningstar Corporate Financial Index remains over 2.1% while the Industrial and Utility Indexes have settled at approximately 1.6% and 1.9%, respectively.

Strong returns and stable yield spread premiums were also the story in European credits. The Morningstar UK Corporate Index has risen over 10% on the year with yields spreads premiums stable at 1.4%. Emerging market bonds kept pace for the most part with U.S. Treasuries, leaving the yield spread premiums little changed

What's Next?
The strong disagreement about the direction of U.S. interest rates can be attributed in part to the distortive effects of unprecedented central bank intervention. The $1.25 trillion purchase of mortgage-backed securities was successful (in most minds) in pushing down mortgage rates to support housing. Without the support, however, are mortgage rates headed higher? Will the declaration to buy Treasuries with cash from the Federal Reserve balance sheet push risk-free rates lower? The central bank was no doubt sincere in the proclamation that the Federal Open Market Committee "is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly," but many still question the bank's ability to deliver.

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