Yields rallied modestly this week, testing recent cycle lows once again as a quiet summer week was highlighted by Ben Bernanke’s Humphrey-Hawkins testimony and anticipation of the release of the EU bank stress tests. Bernanke’s comments about being ready and willing to act on monetary policy if the employment picture does not improve were offset by his reference to the unusual uncertainty surrounding the economy. Short-dated LIBOR moved a handful of basis points lower, a welcome sign for those monitoring funding pressures. Breakeven inflation finally widened this week after narrowing substantially over the past couple of months.

The stock market rallied for the week as strong corporate earnings and increased mergers and acquisitions overshadowed negative comments from US Federal Reserve chairman Ben Bernanke. Trading volume was relatively light in anticipation of the European bank stress test results. The S&P 500, Dow Jones Industrial Average, and NASDAQ indexes all rose approximately 2.5% for the week. Small-cap stocks outperformed large-cap stocks. In terms of style, large-cap growth stocks outperformed large-cap value stocks. The best-performing sector was materials and the worst-performing sector was health care. Out of 149 companies in the S&P 500 index that have reported quarterly earnings, more than 85% have beaten analysts’ estimates. The biggest surprises were Apple, Microsoft, Wells Fargo, United Parcel Service, Morgan Stanley and Ford Motor, while Goldman Sachs and Amazon were the biggest disappointments.

Investment grade primary activity trickled out this week as companies continued to beat consensus and recent economic releases confirmed Bernanke’s sentiment. The present milieu for spread products appears constructive as spreads continue to hold in during broader market sell-offs and tighten on any uptick. This confirms that most market participants have money to put to work and are hesitant to sell anything for fear of not being able to reinvest the proceeds. Notable deals this week included Goldman Sachs ($4.25 billion) and Morgan Stanley ($3 billion).

Investment grade corporates finished the week unchanged as market participants wait for the next piece of new information to hit the market in order to gauge market trajectory. Earnings thus far have surpassed expectations and future guidance looks promising. Strong technicals and improving fundamentals both point towards spreads grinding tighter in the new term. The Barclays Credit Index Option-Adjusted Spread (OAS) finished the week unchanged at +168 basis points. Financials also remained unchanged (banks -1, insurance +1); industrials tightened by one basis point, (basic materials -0, capital goods +1, telecom -0, consumer cyclical -0, consumer non-cyclical -1, energy -7); and utilities tightened by one basis point.

Agency mortgages posted another week of strong performance as Treasuries consolidated at the low end of the interest rate range. We experienced only limited fireworks from the release of mixed economic reports and Fed Chairman Ben Bernanke’s testimony to Congress. The consensus view remains for an accommodative monetary policy and rates on hold for an extended period. This view has translated into healthy demand for mortgages over and above available supply from mortgage originators. The lack of safe alternative investment options has fueled the technical imbalance, sending mortgage prices across the coupon stack to record levels. As a result, mortgage rates continue to gravitate lower, currently reaching 4.56%, which has heightened expectations of faster prepayments. Still, the lack of qualified borrowers has muted the refinance response supporting mortgage valuations. For the week, spreads narrowed on the lower coupons and stayed flat on premiums. The 30-year current coupon spread versus the 10-year US Treasury stands at 63 basis points.

We saw another push lower in yields this week for high grade municipal bonds. Yields fell anywhere from 1 to 10 basis points across the yield curve, led by the 6-10 year maturity range. As a result, the 10-year AAA MMD yield is at 2.57% - matching the all-time low reached in Q3 2009. The themes we’ve highlighted numerous times continue to apply: a relative scarcity of bonds in the secondary market, strong demand on any new issuance and continued flows of new money into the market. New issuance was light this week, totaling about $6 billion in negotiated and competitive issuance.

The major new deal this week: $1.3 billion in State of Illinois general obligation (GO) notes. The deal sold competitively on Tuesday in three maturities - April, May and June 2011. The notes are effectively a form of deficit borrowing for the state. The deal priced at levels well through the initial price talk. The 3% coupon notes maturing in June 2011 sold at 2.125%, which marks a huge concession (over 150 basis points) to other State notes trading in the marketplace. The deal was rated only by Standard & Poor’s, with an SP1 rating. Overall, the successful sale is at least a decently encouraging sign that the most budget-beleaguered US state has managed to maintain its access to the market despite its severe fiscal woes.

The high-yield market rally began in early June 2010 after the sovereign-induced volatility of May, and continues unabated with the market moving higher almost daily. Since June 11th, the Merrill Lynch high-yield BB/B index is up 4.2% and new issues are rapidly devoured. The three primary deals this week (Interactive Data, Entravision, and Accuride) were all very well-received and traded up on average a strong 3% in the after-market. Interactive Data Corp. (IDC), a data services and pricing vendor, was acquired by a consortium of private equity firms led by Silver Lake Partners in a leveraged buyout. In order to fund the buyout, the sponsors issued $700 million of bonds rated B-/Caa1 with a coupon of 10.25%. The IDC deal was heavily over-subscribed as investors were attracted to the company’s stable and recurring cash flows and strong capital support from the private equity sponsors. The Entravision Communication (Spanish language radio stations) deal was $400 million in size with an 8.75% coupon. A veteran of the high-yield bond market, Steve Wynn, this week issued $1.3 billion of first mortgage notes on his Wynn Las Vegas property to refinance bonds maturing 2014. The Wynn deal traded up, though not as strongly as the other three deals this week. The high-yield market is cash heavy at the moment and investors cannot get enough of new deals that are appropriately priced and structured.

The CECE index of equities traded in Central Europe (Czech Republic, Hungary, and Poland) gained 2.2% over the past week, while the Russian stock index RTS went up by 4.3%.

Rating agency Standard & Poor’s cut Hungary’s credit rating to negative from stable after the collapse of talks with the International Monetary Fund (IMF) and the European Union (EU), and Moody’s threatened to do the same. In 2008, the creditors provided Hungary with a $25.9 billion rescue package, which served to reassure investors. Recent talks with the government were suspended without the IMF and EU endorsing Prime Minister Orban’s plans to control the budget. The rating agencies believe that “without an EU/IMF program to anchor policy, Hungary is likely to face higher and more volatile funding costs”. A rating downgrade would raise the cost of borrowing at a time when the country is struggling to repair investor confidence after ruling party officials in June compared the country’s economy with Greece.

Ten-year government bond yields in Germany and the UK ended the week approximately 10 basis points higher following surprisingly strong economic data. The UK economy grew by 1.1% in the second quarter, the strongest in four years, and almost twice the consensus forecast of 0.6%. Growth was concentrated in the services, manufacturing and construction sectors. Germany’s IFO business climate index rose from 101.8 in June to 106.2 in July - the highest level in three years - and well above its expected level of 101.5. This news reinforced the perception that the eurozone and UK economies are being supported by export growth following weakness in the euro and sterling. Earlier in the week, eurozone consumer confidence was announced to have risen from -17 to -14 in July, while UK June retail sales (ex auto fuel) gained 1.0%, or 3.1% year-on-year. Eurozone industrial new orders gained 3.8% in May to post a 22.7% gain year-on-year. Nervousness ahead of the announcement of the results of the European Union’s bank stress tests was tempered by the perception that they might be less rigorous in terms of the banks’ holdings of sovereign debt. Japanese 10-year bond yields ended the week slightly lower (down by 2 basis points), slightly off their seven-year lows reached earlier in the week as concerns remained about Japan’s economic outlook, particularly regarding the strengthening yen.

In the currency markets, sterling received a boost from the stronger-than-expected second quarter GDP growth figures, gaining 0.8% versus the US dollar and 1.3% versus the euro over the week. The euro recovered from its mid-week decline to end only modestly weaker versus the dollar, following Federal Reserve Chairman Bernanke’s rather downbeat comments on the US economic outlook and the release of stronger economic data in Germany and the eurozone generally. The dollar gained almost 1% versus the yen amid evidence that Japanese investors were increasingly attracted to the higher yields offered by US Treasuries and amid some concern that the bank of Japan might be tempted to intervene in the currency markets in an attempt to weaken the currency.

Emerging market dollar-pay debt spreads tightened this week as risk markets were more stable on the back of better-than-expected economic data and strong US corporate earnings announcements.

In South Africa, the central bank kept its benchmark interest rate at 6.5%, broadly in line with expectations although some analysts had expected a 50 basis point cut. The statement following the announcement mainly focused on inflationary risks from wage and higher administered process. Local rates were a little higher and the currency strengthened following the news.

Hungarian assets weakened following a breakdown in talks between Hungary and the IMF due to differences in the measures needed to meet fiscal targets. News on Friday that Standard & Poor’s had downgraded the country’s outlook from stable to negative, as well as Moody’s putting Hungary on review for a downgrade also added to the negative price action.