Bonds Take Advantage of European Rate Cut

Market watchers are now beginning to look at the upcoming CPI and PPI data.
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This afternoon's surprising 50-basis-point rate cut by the

European Central Bank

inspired another strong rally in the Treasury bond market, but parental warnings were slapped all over it, thanks to cautious economists. Their rationale is that today's ECB cut will help reflate the European economy and as a result, strip the U.S. economy of some of the positive aspects that have held down inflation.

Regardless, the prospect of lower interest rates in Europe makes our higher-yielding Treasury securities more attractive to buyers. It enabled the long end to match the lower part of its recent range, last seen in late February, and the short end to break through to an even lower level. The 30-year bond has rallied 23 basis points since last Thursday -- and that includes two abbreviated sessions.

Lately the 30-year bond was up 25/32 to trade at 97 3/32, as the yield dropped to 5.449%, the lowest level since Feb. 23. Prior to the rate cut, bonds spent the day grinding steadily higher. The two-year note was lately yielding 4.866%, its lowest level since Feb. 11. Volume was still light, but better than recent days.

GovPX

volume was down 25% when compared to the average second-quarter Thursday.

Even though bonds are entering a historically strong seasonal period, after this rally, Richard Schwartz, who manages $22 billion in fixed income for

New York Life Asset Management

, doesn't believe there's "all that much upside left."

"It's kind of a tight labor market and we've got strong consumer demand," he said. "I don't know that we're necessarily overbought, but the market doesn't generally move in straight lines in rapid fashion. It tends to give back a little bit after the rally."

Technicals, however, look solid. The market broke through a key level on the futures contract at 122 20/32, according to two analysts. When this happened, it caused technicians accustomed to selling at this level to cover their shorts and begin buying to avoid losing more money. Add the forced buyers to those with a genuine interest, and you've got a free-for-all. The June bond contract closed today at 123 10/32, up 1 10/32.

"The market only had a 25

point cut built in," said William Lloyd, head of market strategy at

Barclays Capital

. "We reached those certain levels where people who were short had to buy. A lot of today's rally is just the technical market reaction."

Looking past this year, improvement in the European economy would erode some of the positive price measures that have helped sustain a low inflationary environment in the U.S. Lower interest rates in Europe will improve the purchasing power of consumers there, according to two economists, and increase demand for our exports. Though this rate cut may temporarily have a positive effect on domestic interest rates, the

Federal Reserve

isn't going to move rates lower -- it's constrained by the current rate of

GDP

growth and the tight labor market.

"It's likely to put additional pressure on our resources," said Paul Kasriel, chief U.S. economist at

Northern Trust

. "It will increase demand for our labor even more, and the compensation costs are going to be rising faster than productivity."

Schwartz countered that rate cuts take a long time to feed through to the economy, and even more time to effect change in the U.S. economy.

"The European economy has room to expand before it becomes inflationary," said Schwartz. "Their market can do well and our bond market can do well. I don't think over the long run we'll see a significant rise to inflation."

Two upcoming economic releases, the

Producer Price Index

and the

Consumer Price Index

, could exacerbate selling pressure for the next few sessions. The core CPI, an important inflationary measure, is expected to show a 0.2% increase in March when it's released Tuesday. The overall CPI is expected to rise 0.3%. The Fed worries most about the core CPI, which has been held in check. Friday's PPI release is considered the lesser of the two data. The March PPI is expected to rise 0.3% due to the recent increase in oil prices, while the core should remain unchanged, according to forecasts.

"I don't think that today's news means that we won't re-enter the range we've been in in the past," said Mike Cloherty, senior market economist at

Credit Suisse First Boston

. "I don't think it's a fundamental break. It does look like we'll have a little bit of a lower range on the two-year and possibly the 30-year."