Chicago Manufacturers Ambush Bonds

Bond prices slumped today in reaction to the

Chicago Purchasing Managers Index

, the details of which shifted the focus of the national

Purchasing Managers Index

to be released tomorrow from prices to employment.

Affirming the sense that the manufacturing sector -- which went into decline almost immediately upon the start of the Asian economic crisis in July 1997 -- is firmly on the rebound, the Chicago index rose from 52.9 in February to 57.0 in March. That's its best reading since last April and the second consecutive increase. The index, which signals growth when it's above 50 and contraction when below, bottomed at 47.1 in January.

But more important, possibly, than the main index was a sub-index that measures prices paid by Chicago-area manufacturers. The prices index rocketed from 41.6 in February to 52.5 in March. That the index rose wasn't surprising; oil prices are up 44% from their mid-February trough. Still, the magnitude of the gain caught traders off guard.

For the bond market it was a one-two punch: not only does the manufacturing sector seem likely to rejoin the ranks of the growing sectors of an economy that to some analysts no longer seems needy of a generous 4.75% fed funds rate, but inflation, long dormant, started tossing and turning.

The fear,

Dresdner Kleinwort Benson

Senior Financial Economist Kevin Logan said, is that "it's over -- a sector that's been a drag is rebounding and may be rebounding sharply." Last year, with manufacturing lagging, the economy managed to grow 3.9%. "What's it going to be like if manufacturing's strong?" Logan asked.

The benchmark 30-year Treasury bond fell a full point when the report was released at 10 a.m. EST. It ended the day down 19/32 at 94 18/32, lifting its yield 4 basis points to 5.63%.

As important as the market reaction the report triggered is the tone it sets for tomorrow's session, when the more important March Purchasing Managers Index will be released at 10 a.m. EST. Like the Chicago report, the national report includes a collection of sub-indices, including a prices paid index and an employment index.

Market analysts said the big moves by the Chicago report lessens the probability of a strong bond market reaction tomorrow to a big move by either the main index or the prices index or both. The risk has shifted, they said, to the employment index, where a sharp rise would probably stoke fear that the March

employment report

, to be released on Friday, will show an increase in manufacturing payrolls after six consecutive months of decline. The average economist surveyed by

Reuters

is expecting a relatively benign March jobs report, with payrolls growing by 180,000, in what would be the smallest increase in five months.

"The market can't get hurt much by a higher price index tomorrow," said Tony Crescenzi, chief bond market strategist at

Miller Tabak Hirsch

. "The focus should really turn to the employment component." If it rises above 50, he said, "it could be an upsetting factor."

Not only does the prospect of growth in manufacturing payrolls threaten to produce a bigger-than-expected payrolls number, Crescenzi said, but because manufacturing jobs pay better than many other jobs, they also could skew the report's average hourly earnings component higher.

However it's also important to note that the Chicago index is more volatile than the national index, and only correctly predicts it about two-thirds of the time, Logan said. Plus, the national index increased in January, while the Chicago index fell. The Chicago index "might have been catching up a bit" in March, he said.

Extending the pattern of the last several trading sessions, the yield curve steepened as prices fell, meaning that short-maturity notes outperformed the long bond (their yields rose by smaller amounts).

Some market analysts are attributing this principally to the Kosovo crisis, which like any global security threat has been accompanied by a certain amount of investor preference for safety and liquidity, the essential characteristic of short-maturity Treasuries.

But others say it's simply another aspect of the rising fear of inflation which has been pushing all yields higher more or less continuously for two months now. Long-term yields almost always exceed short-term yields to compensate long-term investors for the damage inflation could do to their portfolios over time, so when inflation fears rise, so do long-term yields relative to short-term ones.

"I think it goes somewhat beyond Kosovo," Crescenzi said. "At a minimum, it reflects a less positive view of inflation," attributable not only to higher oil prices but also to "the abatement of strains in financial markets globally." Asia and Brazil are both on the mend, he said.

Of course, the prospect of rising inflation also increases the odds of a rate hike by the

Fed

. But short-term yields, which generally stay in the vicinity of the fed funds rate, generally don't move until there's broad agreement that a rate change is more or less imminent.