Bond Brief: Retail Retreat

More signs of consumer strength revive fears of the Fed and send Treasury prices lower.
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Updated from 10:50 a.m. EST

A strong retail sales report pushed Treasuries lower Tuesday as investors fretted that the report would encourage Ben Bernanke to be an inflation hawk in his upcoming testimony before Congress.

And in corporate bond news,

Cisco Systems

(CSCO) - Get Report

sold $6.5 billion in debt today, up from its previously announced $5.5 billion figure.

The amount was more than double the $2.7 billion daily average for corporate bond sales last year.

The benchmark 10-year note ended the day down 8/32 of a point to yield 4.59%, while the 30-year bond was down 17/32 to yield 4.59%.

The five-year lost 4/32 to also yield 4.59%; and the yield spread remained inverted between 10-year and two-year notes, with the two-year down 1/32 to yield 4.68%. (

Click here for more on the inverted curve.)

January retail sales surged 2.3%, according to the Commerce Department, vs. expectations for a modest 0.9% rise. This marks the greatest gain since May 2004.

Retail sales excluding automobiles jumped an equally impressive 2.2% -- the largest since December 1999 and vs. consensus estimates for a 0.7% gain -- as consumers spent on furniture, electronics, building materials, gasoline, clothing and general merchandise.

"Sales ex-autos was almost equal to the top-line number, so consumers really are out there spending," says Peter Cardillo, chief market analyst at SW Bach & Co.

"This couldn't have come out at a worse time, because we have the new

Fed

chairman testifying tomorrow ... It will raise anxiety over the Fed's interest rate outlook."

The market is now priced for 98% odds that the fed funds rate will be raised to 4.75% at the March Federal Open Market Committee meeting, according to research from institutional brokerage Miller Tabak. And there are 94% odds that the rate will hit 5.0% by the end of June. Only two weeks ago, odds stood at 24% for the overnight lending rate to hit 5.0% by the end of June.

News from the Commerce Department that December business inventories rose 0.7%, vs. estimates for a 0.5% gain, also weighed on Treasuries; leaving the inventory-to-sales ratio at a record low 1.25 months.

Federal Reserve Chief Ben Bernanke will deliver his semiannual policy report to Congress on Wednesday, offering his first public comments since taking the reins from Alan Greenspan.

Uncertainty over whether Bernanke will be an inflation hawk has generated plenty of market anxiety; and Tuesday's retail sales results heightened fears that he will be an enthusiastic rate hiker.

Despite Tuesday's strong economic reports, interest rate strategists at Barclays Capital believe that "Bernanke is likely to keep the message consistent with the Fed's recent rhetoric and find it unlikely that his testimony will roil the markets."

Jamie Jackson, a portfolio manager at RiverSource Investments, agrees: "The first thing he said after he was nominated was that his first priority was to ensure good continuity from the old regime."

As for the inflation picture, Jackson believes it is due to accelerate because it is only a matter of time before higher energy costs and low unemployment seep into core inflation.

"Even if the Fed's all-time favorite inflation measure is the core PCE, if that's all they had been looking at they would have finished tightening at 4%," he says. "The bigger question is not 'does Bernanke go to 5%,' but if you look a year or two forward the question is 'will he ease in 2007?'"

Upcoming numbers on foreign investment, housing, producer prices, regional manufacturing outlooks and confidence reports will be closely examined for evidence of unusual growth or contraction, and could further weigh on Treasury prices.

"The one savior here is oil prices coming back down," says Cardillo. "With the housing market cooling, the rate of consumer spending

and economic growth all depends on the price of oil."

In more Fed news, Federal Reserve Board of Governors nominees Kevin Warsh and Randall Kroszner received a warm reception from the Senate Banking panel this afternoon.

Warsh is a White House expert on financial issues and worked as an investment banker before joining the Bush administration's economic council. And Kroszner served on the Council of Economic Advisors during Bush's first term and under former president Ronald Reagan.

During their testimony, both men said that they supported the Fed's task of promoting long-term price stability.

"I don't think it's the role of the Federal Reserve to be second-guessing asset prices, but ... it's extremely important for the Federal Reserve to think about how to respond to such

asset price changes," Kroszner told the Senate Banking Committee.