Treasuries Bull Ahead, With 6% In Sight
Treasuries muscled out a rally on the back of this morning's
Consumer Price Index
release, pushing the 30-year bond yield close to 6%.
The steady rally surprised some because unlike last week's
Producer Price Index
, which came in lower than expectations, the CPI hit the estimates dead on.
"I would be concerned about this rally," said Richard Schwartz, vice president in the stable value group at
New York Life Asset Management
. For the next six months, "I would say I'm constructive but we've had a pretty strong snap back pretty quickly and I'd say we've come a bit far a bit fast."
Just last Thursday, the 30-year Treasury bond ended the day at 6.27%. Today it closed at 6.01%, its lowest yield since July 28, comforted that the core CPI is only rising at a 2.1% rate. The bond's price rose 1 6/32 to 101 20/32. In the last few days it's looked like the market's back to its old tricks -- if it sees inflation, it panics. Otherwise, smooth sailing. Today's gains also came in spite of another strong
housing starts
report, a measure of the pace of consumer spending, and a sharp increase in
industrial production
, a key indicator in the long-dormant manufacturing sector.
"One of the key things the market has ascertained here is that with final prices remaining subdued even with this stronger economy, it strengthens the argument that we're still experiencing productivity gains," said Schwartz.
The CPI, the market's broadest measure of price inflation, rose 0.3% in July. The core rate, which cancels out food and energy prices, rose 0.2%, in line with expectations, according to
Reuters
. On a year-over-year basis, both the core rate and overall CPI are rising at a 2.1% rate. Most of the market expect the
Federal Reserve
to raise the fed funds rate by a quarter point to 5.25% next Tuesday, and this was the last release that could have fed fears of a 50-basis-point hike.
"I don't think this changes the markets' perception about next Tuesday: most people still feel we're getting 25," said Bill Hornbarger, Treasury market strategist at
A.G. Edwards
. But "this
and the PPI take 50 off the table. More importantly, it really raises the idea that that's going to be it" until the end of the year.
What the market is currently betting on is that inflation will remain under control even if the economy continues to expand -- witnessed by the narrowing in the yield spread between the two-year note and 30-year bond. Today the spread narrowed to 34 basis points, its narrowest since Aug. 26, 1998, from 37 basis points yesterday. The two-year note rose 4/32 to yield 5.67%. This indicates the market believes inflation is under control, though it's expecting an interest-rate hike next week.
While the Fed and an overall bearish tone helped push yields to their highest levels of the year last week, the market -- especially the long end of the curve -- turned optimistic at the end of last week, and is now accentuating the positive.
"It's encouraging," Hornbarger said. "Instead of being in a 'sell the news' mode, now it looks like we've turned into a 'buy the dip' mode. The data are a little more friendly toward bonds, and there's less people talking about significantly higher bond yields."
Just the thing Schwartz is worried about. He believes the market is understating the risk of inflation after this rally to the 6% level, and it's a bet that the strength in consumer spending and rebound in manufacturing could result in the Fed further hiking interest rates.
Industrial production rose 0.7% in July, less than the 0.8% estimate but the highest one-month reading since March. Meanwhile, manufacturing output rose by 0.6%, its largest increase since October. Capacity utilization rose to 80.7%, its highest level since last December.
The
Census Bureau
also reported that housing starts increased in July to a seasonally adjusted annual rate of 1.661 million, besting expectations for a 1.61 million increase. And building permits, a precursor to more housing construction, rose at a 1.632 million rate, ahead of the 1.61 million consensus.