Stock Collapse Lifts Treasuries Out of CPI Hell

An ugly morning in the Treasury market was transformed into a banner day, as some of the money that cascaded out of the stock market found its way into bonds.

A much larger-than-expected increase in core consumer prices triggered a selloff in Treasuries first thing this morning. The benchmark 10-year Treasury note fell 22/32 after the 8:30 a.m. release of the March Consumer Price Index , and the weakness persisted for much of the morning.

But as the major stock proxies went from bad to worse, bonds clawed their way back. By the end of the day, with the Dow Jones Industrial Average down about 616 and the Nasdaq Composite Index down 355, the 10-year Treasury was up 13/32 at 104 19/32, cutting its yield 5.4 basis points to 5.877%.

Shorter-maturity issues rallied even harder, which is typical for a rally driven by weakness in stocks. The five-year note gained 7/32 to 98 30/32, cutting its yield 6 basis points to 6.143% and the two-year note added 5/32 to 100 13/32, dropping its yield 9.6 basis points to 6.265%.

The 30-year Treasury bond rose just 1/32 to 106 15/32, trimming its yield a fraction of a basis point to 5.793%. At the Chicago Board of Trade, the June Treasury futures contract gained 7/32 to 98 15/32.

Bond investors were betting that declining stock prices will help slow economic growth by tempering the pace of consumer spending. "More risk of more aggressive Fed rate hikes [because of the inflation data] is being overwhelmed by weakness or volatility in stock prices," said Michael Gregory, senior economist at Lehman Brothers.

The gains may not look extremely impressive, but they are in light of how much prices dropped at the open in reaction to the CPI, noted Mitch Stapley, chief fixed-income officer at Kent Funds. Today's action also compares favorably to the last time the CPI delivered a major upside surprise, on May 14, 1999, Stapley recalled. On that day, the Bureau of Labor Statistics reported a 0.7% increase in the overall and a 0.4% increase in the core CPI for April 1999 (those numbers have since been revised). Stocks fell sharply (though not nearly as sharply as today). Still, the then-benchmark long bond lost more than two full points.

As for today, the CPI rose 0.7% in March, the largest increase since April 1999. Economists polled by Reuters had forecast a 0.5% gain. But more importantly, the core CPI, which excludes food and energy prices, rose 0.4%, double the consensus forecast.

The bond market can ignore a bigger-than-expected increase in the overall CPI if it can be blamed on either food or energy prices, which are volatile. That was true of the March increase, which reflected a 4.9% increase in energy prices. And the result is made even less relevant by the fact that oil prices, the key determinant of energy prices, have fallen sharply in the month since data were gathered for the March CPI.

Increases in the core CPI are much more difficult to ignore. The March increase was the largest since January 1995, and it lifted the year-on-year rate of increase from 2.1% to 2.4%, the fastest pace since January 1999.

The year-on-year rate for the overall CPI stands at 3.7%, the fastest pace since August 1991.

The report reinforced the notion -- promoted yesterday by a stronger-than-expected March retail sales report -- that the Fed will have to raise the fed funds rate more aggressively in order to slow economic growth and keep a lid on inflation.

The action in stocks countered that by upgrading the possibility that economic growth will slow on its own, as consumers, chastened, start spending less. "As the Dow and the Nasdaq go lower, they start to take care of the wealth effect, and start to slow the economy down," said Mark Sauvigne, government bond trader at Chase Securities.

Stapley of Kent Funds expressed the dilemma this way: "There is clearly some inflation creep going on out there. But to what degree is the wealth effect going to be in play here? This is a textbook learning experience for the Federal Reserve."

Economic Indicators

In other economic news, real earnings fell 0.4% in March for the second month in a row, as the 0.7% increase in the CPI offset a 0.4% increase in average weekly earnings.

Industrial production increased 0.3% in March, vs. an average forecast of 0.2%. The capacity utilization rate, which measures anti-inflationary slack in the industrial sector of the economy, found more of it than expected. The rate fell to 81.4% from a revised 81.5% in February. It had been expected to come in at 81.7%.

The Consumer Sentiment Index rose to 110.2 on a preliminary basis in April from 107.1 in March. It peaked in February at 111.3.

Finally, business inventories grew faster than business sales in February for the first time since September. Inventories grew 0.5% while sales rose 0.3%. But sales continue to grow at a much faster year-on-year pace than inventories -- 11.8% vs. 5.4%.

Currency and Commodities

The dollar fell against the yen and the euro. It lately was worth 104.80 yen, down from 105.86. The euro was worth $0.9609, up from $0.9523. For more on currencies, please take a look at TSC's Currencies column.

Crude oil for May delivery at the New York Mercantile Exchange rose to $25.40 a barrel from $25.38.

The Bridge Commodity Research Bureau Index fell to 211.13 from 212.07.

Gold for June delivery at the Comex rose to $284.4 an ounce from $283.2.

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