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Goldilocks Bloodies Bonds

Liz Rappaport

To quote the title one of the best children's books around, the bond market had a "terrible, horrible, no good, very bad day."

Like poor Alexander in the story, bond traders woke up with gum in their hair, and the day only got worse. The sticky resilience of the U.S. consumer magnified what many bond traders have been grudgingly coming to terms with for days: no imminent rate cuts and a soft landing. The gum Wednesday was November retail sales figures, which showed a 1% increase, beating expectations for a mere 0.2% increase. Retail sales climbed 1.1% excluding auto sales, also well ahead of expectations.

The strong consumer dashes bond traders' expectations that deep declines in the housing market will spill over into consumption, sending the economy toward recession. The bond market has been almost "frantic to price in the easing cycle," says T.J. Marta, senior fixed-income strategist at RBC Capital Markets. In other words, the bond market has a lot to lose from strong economic data, and with thin holiday trading days ahead, Wednesday's move might have more significance than usual.

The 30-year bond slipped 1 1/8 to yield 4.68% while the 10-year note fell 21/32 to yield 4.57%, and the two-year fell 5/32 to yield 4.7%. Bond prices move inversely to yields.

As the days wear on before Christmas, the market will be more thinly traded, and investors are squaring up their bets with this week's data, says Michael Cloherty, head of interest rate strategy at Banc of America Securities. Wednesday's selloff puts the bond market back into a higher-rate range that could stay in place through the end of the year, he adds. The range would mean no sliding below 4.5% on the 10-year, for example.

As for the Fed's cycle, "the bond market took out a little less than half of an ease by the end of 2007 on Wednesday," Cloherty says.

The fed funds futures market more aggressively removed rate cuts from the near future, as traders bet Wednesday that the first cut won't come until June, according to Miller Tabak. The futures market now puts 4% odds of a cut at the January meeting, down from 30% on Dec. 1. The market puts 18% odds on a cut in March, down from 70% at the start of the month, and the market has reduced odds of a cut in May to 44% from 100% just last Thursday.

The bond market's bad day was punctuated by another large jump in mortgage applications, by 11.4% in the Mortgage Bankers Association's latest weekly tally. Even with the Fed's characterization Tuesday of the housing downturn as "substantial," evidence is mounting that the worst may be over.

Likewise, low risk premiums on high-yield bonds as well as the recent deluge of bond deals point to loose lending standards and lots of liquidity still in the financial system. Credit spreads, or risk premiums, on high-yield bonds slipped to 303 basis points over comparable Treasury bond yields. Spreads haven't crossed below 300 since February 2005 (the historic low was 240 basis points in 1997).

Also rubbing the gum in bond traders' hair was another slew of economists who increased their forecasts for fourth-quarter GDP growth. Several economists raised their estimates on Tuesday's dip in the trade deficit, but the retail sales figures provide even more juice.

Banc of America Securities' Peter Kretzmer writes that the retail sales data points to 3% consumer spending growth in the fourth quarter, which "adds to indications of above 2% GDP growth in the quarter." Kretzmer estimates GDP to grow between 2.25% and 2.5% in the fourth quarter.

Northern Trust's relatively bearish Asha Bangalore writes that the sales figures translate into "a slightly faster growth of real GDP" of 2% vs. her previous estimate of 1.6%. The consummate soft-landing bull, Michael Darda of MKM Partners, writes that retail sales puts fourth-quarter GDP growth in the "low 3s" as opposed to the "consensus expectation of growth in the low 2s."

The stock market was never pricing in a consumer-led recession, so it had less to gain when the strong retail sales rolled in. Indeed, traders are locked in on the price of oil, as they start to work out what the economic weakness in the manufacturing sector means for equities in the coming months.

"Manufacturing may make up a small part of the economy, but it is tied to 40% of the S&P 500 companies and their earnings," says Jeffrey Kleintop, chief investment strategist at PNC Advisors. "Energy prices offset some of the positive for the consumer," says Kleintop. Oil rose 35 cents to close at $61.37.

Stocks turned up slightly on news of the retail sales but weakened later in the day. The three major indices ended up a fraction. The Dow Jones Industrial Average finished at 12,317.50, while the S&P 500 closed at 1413.21 and the Nasdaq Composite closed at 2432.41.

Major averages were aided by strength in Home Depot (HD Quote), up 1.1% after announcing the purchase of 12 home-improvement stores in China, and Apple Computer (AAPL Quote), which jumped 3.4% after Morgan Stanley raised its price target to $110 from $90.

Meanwhile, the Dow Jones Transportation Average's declines reflect concerns about manufacturing weakness. The index slipped another 0.5% Wednesday, after falling 1.2% Tuesday. Shares of railroad company CSX(CSX Quote) slipped 4.5%, and FedEx(FDX Quote) fell 1.3%.

Consolidation in the airline sector couldn't help the Transports either. Shares of Continental Airlines(CAL Quote) surged 4.4% on news that it continued its talks with United Airlines(UAUA Quote), whose shares gained 4.7%.

Shares of AirTran(AAI Quote) jumped 4% on news it made a takeover bid for Midwest Air(MEH Quote), whose shares climbed 22.3%.

So the bond market finished its terrible, horrible, no good, very bad day capitulating a bit to Goldilocks. But in this data-dependent world, that old fable might be stale again by tomorrow -- or certainly by Friday, which brings the always-crucial consumer price index report.