Feeling the Heat

Forget the weather. The real scorcher last week was the bond market -- and it may just stay that way

By Kim Rupert

Traders may have wilted in the heat last week, but the Treasury market was invigorated by signs that the meltdown in manufacturing is sapping the energy from other sectors of the economy. The catalyst for the rally was the more dour assessment of the environment in the Federal Reserve's Beige Book report released on Aug. 8. That, a red-hot 10-year note auction, and cool inflation readings drove Treasury yields sharply lower -- and prices sharply higher -- as the market perceived no quick turnaround in the economy and the potential need for more Fed stimulus into 2002.

With short-term yields at lows not seen in some eight years, and long-term yields at levels not touched since April, the bond market's ability to rally further will depend largely on key upcoming data, of which there is plenty during the weeks ahead. The FOMC meeting Aug. 21 will of course be much anticipated. While a quarter point rate cut is all but a done deal, the market will zoom in on the policy statement and what it suggests for future Fed action.


  On the data front are key reports including retail sales, industrial production, capacity, business inventories, consumer prices, housing starts, and consumer sentiment. Median forecasts from the S&P MMS Weekly Survey of Fed watchers largely suggest a bullish outlook for Treasuries as data across key sectors, including consumption, manufacturing, inventories, and housing as all are expected to decline. However, to get yields to push lower from current levels, the actual figures will have to be weak enough to satisfy the pessimistic views instilled by the Beige Book.

The retail sales report scheduled for release Aug. 14 will help quantify the anecdotal report from the Beige Book that sales were sluggish. The median forecast calls for a 0.1% decline, while the ex-auto figure is expected to rise 0.1%. Though economists surveyed suggest it might be more worthwhile to examine retail sales ex-autos and fuel (which many estimate at +0.4%), the market could be supported by the headline figures. But it would likely take more extensive weakness in the data, like the -1.0% estimates in our survey, to get a big move out of Treasuries.

Industrial production is expected to fall 0.3%, to post its eleventh straight decline. Housing starts are expected to fall over 2% to a 1.62 mln pace for July after their surprising 3% jump in June. Meanwhile, business inventories and trade are expected to contribute to downward revisions to Q2 GDP, while consumer sentiment is expected to dip slightly to 92.0.


  The Fed is unanimously expected to cut rates on Aug. 21, with all but one of our survey members looking for a quarter point move (the one forecasted a half-point cut). Most of our contacts doubt the Fed would return to its more aggressive approach, especially after having made the bold step in June to cut by only 25 basis points and given the amount of stimulus in the pipeline.

The key for the Aug. 21 announcement, however, will be the policy statement and its implications for the Oct. 2 meeting. While the medians show the FOMC holding steady at a 3.50% fed funds target, it's a very close call, with 45% of S&P's contacts projecting another 25 basis point cut to 3.25% in October. A few participants look for the Fed to end the year at 3.25% or even 3.0%, and to ease further in the first quarter of 2002 to 2.75%.

Rupert is a senior economist for Standard & Poor's Global Markets

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