Bond Rout Resumes Amid Rising Energy Prices

The damage was once again concentrated in long-term issues, since expensive oil could also stall the economy.
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Bond prices fell today as oil resumed its upward march, even as Treasury market participants continued to insist that the principal effect of higher energy prices will be to slow economic growth. The bond market normally rallies in response to signs that growth is slowing.

Continuing the recent trend, long-term yields rose more than short-term ones, indicating that bond investors are worried that the inflation rate could creep up as a result of higher energy prices. Bond investors set long-term yields relative to short-term yields depending on how much of a toll they expect inflation to take over time.

Bond market professionals noted that factors other than oil -- specifically the weakening euro and falling stock prices -- are also working to drive long-term interest rates up, while short-term rates hold relatively steady.

No market-moving economic data was released. The only potential market-mover, the latest

Beige Book

(

definition |

source

), was marginally bearish, discouraging the view that the

Fed might consider lowering the

fed funds rate in the next several months.

The benchmark 10-year

Treasury note fell 9/32 to 98 28/32, lifting its yield 4.1

basis points to 5.899%. Shorter-maturity issues fared better, their yields rising less.

But the 30-year

Treasury bond fell 22/32 to 104 1/32, lifting its yield 4.8 basis points to 5.958%.

At the

Chicago Board of Trade

, the December

Treasury futures contract shed 15/32 to 97 20/32.

Rising energy prices are good news for bond investors because of their potential to slow economic growth, bond market professionals insist.

"It's a tax -- that's all I'm thinking about oil,"

Fuji Securities

Treasuries trader Michael Pianin said, meaning that higher energy prices act like a tax on economic activity, diminishing it. Fed Chairman

Alan Greenspan allowed as much in his July 20

Humphrey-Hawkins address, Pianin pointed out. In that speech, Greenspan

said that higher oil prices had amounted to a $75 billion tax this year, probably contributing to a slower pace of consumer spending.

"Oil is a tax," concurred Jim Cusser, bond portfolio manager at

Waddell & Reed

in Overland Park, Kansas. "When you raise taxes, you get less of the thing you're taxing, in this case economic activity." The U.S. economy may be less oil-dependent than it used to be, but it still uses an awful lot of energy, Cusser observed.

Then why dump long-term Treasuries? In part because it's possible for slowing growth and accelerating inflation to co-exist, at least for a time. "Anybody who's worried about growth doesn't have to worry so much, but maybe they should worry about inflation," Cusser said.

"Oil going up is not good historically for the long end," Fuji's Pianin agrees. But at the same time there are other reasons to sell long-term Treasuries.

The main reason has been developing for months: Investors have become convinced that the Fed is finished hiking interest rates. Unless the Fed is in that anti-inflationary stance, bond investors are unwilling to hold long-term issues at low yields relative to short-term issues.

At the same time, the ailing euro has triggered some flight from long-term European government bonds, Pianin said. As those yields have risen, Treasury yields have risen in sympathy. "Spread relationships between their bonds and ours have been fairly stable," he pointed out.

Finally, short-term Treasury yields might be higher were it not for the U.S. stock market's recent struggles, Pianin said. Short-term Treasuries are a popular parking place for assets that have fled riskier markets.

Economic Indicators

The Beige Book, which the

Federal Open Market Committee will consider at its next meeting on Oct. 3, said economic activity "expanded at a moderate pace in August and early September, even though further signs of slowing growth were noted in several Districts." Labor markets remained tight, and reports of wage increases were widespread, but "there were few indications that higher wages were being passed through to consumers as higher productivity and competitive pressures held firms' prices in check," the tan tome said.

In other economic news, the

international trade

(

definition |

chart |

source

) report for August showed a widening of the trade deficit to a record $31.892 billion, from $29.846 billion in July. The deficit widened as imports increased 0.6% while exports fell 1.5%.

The wider-than-expected deficit will depress the third-quarter

GDP growth rate. Based on today's news, and on the assumption that higher oil prices will inflate the deficit further in September,

Barclays Capital

revised its third-quarter GDP forecast to 3.5% from 5%. But, import growth outpacing export growth indicates that the U.S. continues to rely on foreign investment to finance growth in excess of what can be produced domestically.

Also, the weekly

Mortgage Applications Survey

(

definition |

chart |

source

) detected slight declines in refinancing and new mortgage activity, in spite of last week's decline in mortgage rates to new lows for the year. The Refinancing Index dropped to 440.7 from 452.9, while the Purchase Index fell to 318.8 from 324.4.

Currency and Commodities

The dollar fell against the yen and rose against the euro. It lately was worth 106.48 yen, down from 107.02. The euro was worth $0.8478, down from $0.8510. For more on currencies, see

TSC's

Currencies column.

Crude oil for October delivery at the

New York Mercantile Exchange

rose to $36.70 a barrel from $36.51. It closed below Monday's 10-year high of $36.88, but visited a new intraday high of $37.80.

The

Bridge Commodity Research Bureau Index

fell to 226.99 from 228.26.

Gold for December delivery at the

Comex

fell to $272.50 an ounce from $275.40.