Bonds Shift Into Neutral, Ending a Lousy Week - TheStreet

Bonds Shift Into Neutral, Ending a Lousy Week

Bond market looks to next week for economic news as quiet Friday session creeps to a halt.
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After this week's bout of selling, the bond market put itself on automatic pilot today, kicked up its feet and coasted into the weekend. Treasuries ended the day virtually unchanged, as there were no economic releases or significant activity in the dollar to direct the market.

With bond yields resting near two-year highs, the market appears to be at a crossroads. For the selling to continue, according to analysts, it's going to take some decidedly unfriendly economic news. For a turnaround to occur, the market needs evidence that the economy is slowing. But the first test of that won't come until Thursday, with the releases of the third-quarter

Employment Cost Index

and

GDP

reports.

The 30-year Treasury bond was quoted lately at 96 31/32, up 1/32, leaving the yield unchanged at 6.35%. The market ignored the 170-point

Dow

rally as well.

"This market has finally gotten itself priced at a reasonable level versus a 5.5% fed funds rate," said Jim Kochan, fixed-income strategist at

Robert W. Baird

, expecting the Fed will raise the funds rate to that level Nov. 16. "Until we see evidence that it's going

higher

than that -- or that it won't reach 5.5% at all -- then I think we're stuck here."

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The fed funds target is currently 5.25%, last raised by the Fed on Aug. 24. The bond market has sold, in part, during the last week due to a growing perception that the Fed has fallen behind in its efforts to fight inflation.

The evidence isn't overwhelming.

But economists have recently argued that official statistics didn't portend rising inflation in 1994, when the Fed began a cycle of gradually raising the funds target. (In Feb. 1994, the core

Consumer Price Index

had actually fallen to a 2.8% year-over-year rate of increase compared with 3.6% a year earlier.)

If the market is any indication, the 30-year bond, which reacts negatively to prospects of higher inflation, has tacked on 10 basis points this week. Today it sits at its highest yield since Oct. 22, 1997.

"The Fed is slowly falling behind the curve here," said Scott Graham, co-head of government trading at

Prudential Securities

. "There's all the anecdotal data: the

Philly Fed

survey is showing prices paid on the rise. We continue to see inflationary news. They need to tighten and they probably need to maintain a tightening directive."

The Fed next meets Nov. 16 and, currently, the fed funds futures contracts listed on the

Chicago Board of Trade

are pricing in a 64.3% probability of a rate hike. Yesterday, the November fed funds contract was pricing in a 68.5% chance of a rate hike.

The quarterly reports will provide two of the earliest clues as the Fed meeting approaches. The consensus estimate for GDP, according to

Reuters

, is for a 4.4% growth rate in the third quarter. The economy bounced back after a 1.6% rate in the second quarter, when businesses allowed inventories to run down. A build-up in inventories, increased production and a slight decrease in the trade deficit will all likely enhance the GDP figure.

The ECI -- one of the market's most important wage inflation indicators -- is forecast to rise 0.9% compared with a 1.1% jump in the second quarter. The tightness in the labor market is expected to pressure compensation costs. On a year-over-year basis, the ECI was rising at a 3.2% clip in the second quarter, compared with 3.5% in the second quarter of 1998.

"We should have a fairly sizable gain in the wages/salaries component," said Anthony Karydakis, senior financial economist at

Banc One Capital Markets

. "Any gain in excess of what the market has priced in would not go over well. People are already getting edgy and I believe the Fed will have no patience for a large ECI gain."