By Michael Wallace
Last week was defined by liquidation of Treasury issues with longer-dated maturities, along with a drop in risk aversion as the air raids over Afghanistan met with initial success and little effective resistance. The Treasury curve flattened, stocks returned to pre-attack levels, the dollar rebounded and gold plunged.
But the later part of the week told a different story. By Friday confidence was tested again by FBI warnings of imminent threats on the home front and a fresh outbreak of Anthrax contamination by an NBC Nightly News employee based in New York City.
This schizophrenic theme will carry over into this week, which may be characterized by similar swings in the perception of risk at home and abroad. Ongoing bombing raids of Taliban and al Qaeda strongholds, popular backlash in moderate Muslim countries and possible use of special forces on the ground will keep tension high -- and the Treasury curve resisting any corrective flattening. Further targeting of Anthrax spores at U.S. media or some unthinkable broader blow to public confidence will only add to the volatility.
This schizophrenic theme played out in last week's economic data as well, with September retail sales plunging 2.4% -- the steepest drop in nearly a decade. But a preliminary reading of the University of Michigan's report on October consumer sentiment exhibited emerging signs of hope: news of the government's economic stimulus efforts, with the promise of more largesse in the pipeline, may have helped boost the reading to 83.4% from 77%. The uptick in inflation at the wholesale level was quickly forgiven.
Data for the coming week will be highlighted by another likely drop in September Industrial Production (S&P MMS predicts a decline of 0.9%) and Capacity Utilization (to 75.4%) Tuesday. Housing data may also suffer from the shocks and aftermath of September 11; the National Association of Home Builders releases its October housing index on Tuesday and September Housing Starts will be released Wednesday. MMS expects the volatile jobless claims figure to climb to 480,000 from 468,000 Thursday, while the August trade gap may narrow to $28.8 billion on Friday and CPI should remain muted.
Federal Reserve Chairman Greenspan will have another opportunity to guide expectations on the economy and policy on Wednesday after opaque comments on policy transparency the past week. Greenspan will testify on monetary policy and the current economic situation before the Joint Economic Committee (JEC) at Capitol Hill on Wednesday from 10:00 am EDT. He last urged patience and temperance on the next round of fiscal stimulus, but it appears that the House Ways and Means Committee is prepping a package exceeding $100 billion, which would then go the full House and Senate for a vote. Any resultant policy friction next week could hinder the long end of the Treasury curve.
Following the retail sales plunge, S&P MMS downgraded its U.S. gross domestic product estimates to -1.3% from -0.8% in the third quarter and -2.3% from -1.5% in the fourth, at the same time compressing its Fed funds forecast to target 2% by the Nov. 6 meeting of Fed policymakers, rather than by the end of the year. And yet, 80% of participants in the MMS Weekly Economic Survey still expect the Fed to ease by only a modest quarter point next month.
In terms of the Treasury curve, technical indicators suggest that as long as the yield spread between the 2-year note and the 30-year bond holds above +250 basis points, a further widening of the spread to a re-test of the +274 basis point level of September appears inevitable. Gloomy data, rising paranoia, and ground force risks make it premature to flee "safe" assets.
Wallace is chief market strategist for Standard & Poor's Global Markets