BlackRock Liquidity Funds

Investment Commentary

July 2010

The Federal Open Market Committee (FOMC) did not hold a meeting during July, but the release of the minutes from the June meeting offered insights into the Committee's deliberations. The FOMC participants' forecasts for economic activity and inflation indicated that they expected the economic recovery to continue, but at a slower pace than originally anticipated. More than half of the participants generally saw the risks to their growth outlook to be tilted to the downside, while most continued to see balanced risks surrounding their inflation projections. Indeed, committee members "generally continued to judge the uncertainty surrounding their projections for both economic activity and inflation to be unusually high relative to historical norms." In his semiannual Monetary Policy Report to Congress, Federal Reserve Chairman Ben Bernanke reiterated that the FOMC "continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the Federal Funds rate for an extended period." He noted, however, that at some point, the Federal Reserve will need to reverse extraordinarily accommodative monetary policy to "prevent the buildup of inflationary pressures." As of the end of July, futures contracts for Federal Funds were not fully priced for a rate increase of 25 basis points until the third quarter of 2011. The Bank of England and the European Central Bank maintained their key interest rates at 0.50% and 1.00%, respectively.

On July 23, the Committee of European Banking Supervisors released the results of its European stress tests on a sample of 91 European banks from 20 EU member states. The majority of the banks within the sample were able to meet the required capital ratios after applying the predetermined macro-economic stress test scenarios. The market response to the results was generally positive. Credit default swap spreads of certain European countries decreased following the release of the results, and investment activity in debt obligations of peripheral countries and their respective banks increased moderately. Funding conditions for European banks improved throughout the month as increasing clarity and disclosure surrounding the European stress tests combined with the expiration of the European Central Bank's Long-term Refinancing Operation helped to assuage investor concerns. As a result, Libor settings in July fell as much as 14 basis points, and the slope of the Libor curve narrowed to 73 basis points from 82 basis points.

In July, the slope of the short-term municipal yield curve between 7 days to 1 year narrowed due to strong demand for longer-dated securities. One-year municipal note yields began the month at 42 basis points but rallied sharply to end July at 30 basis points. Seasonal note issuance was heavy with $4.9 billion in new issuance priced. Yields on variable rate demand notes traded in a tight range with the benchmark 7-day SIFMA index averaging 27 basis points for July, 2 basis points lower than the average for the previous month.

Contributors: Jacy Czajkowski and Steve Lewis, CFA

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