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  • The Wages of Fear. “When you can be blown up at any moment, only a fool believes that character determines fate.” While that might sound like an apt description of today’s credit markets, it was film critic Pauline Kael’s description of the source of this month’s title, “Le salaire de la peur,” a 1953 thriller starring Yves Montand. Fear returned to financial markets in July following a long stretch of financial complacency highlighted by historically low levels of volatility. Many policy makers had been warning of such concerns, and one market—high yield—that caught the attention of the Fed saw significant declines at the end of July.
  • Fear of Wages. The Fed increasingly relies on a lack of wage inflation to validate its persistent zero-interest-rate policy. Wage inflation measures clearly show this lack of inflation justifying even more dovish expectations surrounding the Fed’s policy in the bond markets. However, forward-looking wage measures show clear indications of future acceleration. We expect those to eventually show up in wage inflation, challenging the market’s complacency on rising rates, particularly in the front end. The Jackson Hole symposium on labor markets will be a key focus.
  • Has the Fed become more dovish or hawkish? Both. That appears to be the confusing takeaway from recent Fed communications. Along with the recent slate of economic data, Fed statements have contributed to rising market uncertainty. Such an outcome is bad for financial asset performance and represents another potential catalyst behind recent increases in financial-market risk.

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As of 7/31/2014. * Yield to Maturity. Yield to worst. Securitized Assets: ABS (Overweight, MTD -0.16, YTD 1.15, YTM 1.26), CMBS (Overweight, MTD -0.24, YTD 2.65, YTM 2.27), Non Agency RMBS (Neutral), § Emerging Market: Hard Currency (Neutral, MTD 0.40, YTD 9.10, YTM 5.14), Local Currency (Neutral, MTD -1.06, YTD 4.87, YTM 6.58), Corporate (Neutral, MTD -0.35, YTD 5.88, YTM 5.16), **Treasuries: Short (1-3 years) (Underweight, MTD -0.08, YTD 0.33, YTM 0.54), Intermediate (4-10 years) (Neutral, MTD -0.43, YTD 2.74, YTM 2.01), Long (10+ years) (Neutral, MTD 0.55, YTD 12.75, YTM 3.18). As of 7/31/2014.

1They are also strongly coincident indicators, meaning neither HY leads stocks nor vice versa. More technically, we can see that statistical measures of precedence of information (called Granger Causality Tests) show precedence of information of VIX to HY, but these measures fail to find similar results when testing VIX to HY CDX (a liquid HY derivative index), suggesting that the leading
behavior of VIX for HY is an artifact of illiquid and stale pricing in bonds.

258.2%, 15.1%, 5.0%, 15.8%, 7.4% and YTD in 2014 4.1% from the Barclays US Corporate High yield Index.

3Unlike interest rate or credit risks, there is no universal measure of what constitutes “liquidity risk”. One measure, however, illustrates the relative differences in liquidity and suggests the potential differences in liquidity “costs”. “Turnover” measures the size of transaction volumes relative to the market value of total outstanding issues. The market for US Treasuries, for example, on this front stands as the most liquid: it turns over approximately 10Xs a year. In contrast, the corporate debt market (both HG and HY) turns over once every 2 years. By this measure US Treasuries are 20Xs more liquid than corporate debt. Source: SIFMA.

The sector performance and yields listed are represented by, respectively: Barclays US High Yield Index, S&P Leveraged Loan Index, Barclays US Securitized ex-MBS Index, Barclays US Mortgage Backed Securities Index, Barclays US Corporate Investment Grade Index, Barclays Global Aggregate ex-USD Index, JP Morgan EMBI Global Diversified Index, Barclays US Inflation Protected Securities Index and Barclays US Treasury Index. The reference indices are represented by the Barclays US Aggregate and the Barclays Municipal Bond Index.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets, in concentrations of single countries or smaller capital markets.

The opinions expressed are those of BlackRock as of July 1, 2014, and may change as subsequent conditions vary. Information and opinions are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable. The information contained in this report is not necessarily all-inclusive and is not guaranteed as to accuracy. Past performance does not guarantee future results. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investment involves risk. Reliance upon information in this report is at the sole discretion of the reader.

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