Stocks' Slide Invigorates Bonds

A bruiser of a wholesale inflation report briefly sent the bond market running scared this morning. But then it turned on its heels and headed boldly higher as some economists argued that the inflation report was more smoke than fire, and as stocks took a beating that sent money flowing into bonds.

The benchmark 30-year Treasury bond, which traded down as much as 17/32 after the release of the September Producer Price Index and which hadn't had a price gain since last Wednesday, ended the day up 27/32 at 98 4/32, trimming its yield 7 basis points to 6.26%. Shorter-maturity note yields shed anywhere from 7 to 9 basis points.

The PPI, the key measure of inflation at the wholesale level, rose 1.1% in September, more than twice as much as forecast and the largest increase since September 1990. The core PPI, which excludes volatile food and energy prices, rose 0.8%, twice as much as forecast and the biggest increase since last December.

Initially, traders reasoned that the strong advances in wholesale inflation might prompt the Fed to hike interest rates at its next meeting next month. But they reconsidered after some economists delved into the guts of the report and concluded that it contained enough special factors to make the Fed think twice.

The PPI was inflated by food, energy and tobacco prices, as expected. Food prices rose sharply due in part to crop destruction by hurricanes, rising oil prices and a one-time cigarette price hike. Car and truck prices also rose sharply, which was not expected, but they are still down on a year-on-year basis. The Bureau of Labor Statistics, which compiles the report, noted that excluding food, energy, tobacco and cars, prices rose just 0.1%. "Before anybody says that we just took all the fun out of life, remember that it is the underlying trend that is important to the Fed," First Union economist Mark Vitner said in a research note.

In addition, Jerry Lucas, government bond strategist at Merrill Lynch, points out that inflation is a lagging indicator. There are tentative signs that the economy is slowing, he says, pointing to slower job growth in the last few months. "As the economy starts to slow, because of strong growth in the past, you'll see inflation going up due to the time-lag effect." Still, Lucas conceded, overall the PPI "gives the Fed more active reason to consider tightening at the upcoming meeting." Increases in the prices of intermediate and crude goods could eventually push the prices of the finished goods that the PPI tracks even higher, he said.

Lucas said the friendlier-than-expected showing by the September industrial production report, also released today, helped the bond market turn around. Hampered by Hurricane Floyd, industrial production slipped 0.3%, vs. an average forecast it would rise 0.2%. As production eased, so did the capacity utilization rate, to 80.3%, indicating more slack in the industrial economy. The Fed, which releases the data, said production would have posted a slight increase without the effects of the hurricane.

But as the day wore on, it was almost certainly the continuing selloff in stocks that pushed the bond market deeper and deeper into positive territory.

Bonds rallied as stocks sagged for two reasons, said Richard Schwartz, senior vice president at New York Life Asset Management. First because some of the money that left the stock market found a home in the bond market. Second because "lower equity prices have the potential down the road to cause a slower economy" by tempering consumer spending.

Schwartz thinks the stock market has so much power to curb consumer spending by virtue of how large its total value has become relative to the real economy that a selloff of the magnitude stocks have experienced this week argues strongly against another rate hike by the Fed. The PPI may have temporarily increased the chances the Fed will hike on Nov. 16, "but the reaction of the equity markets clearly acted to reduce the likelihood of tightening," he said. It's "reasonably likely," Schwartz said, that the initial bond market selloff in reaction to the PPI took yields to the highest levels they will see this year.