There can be only one comment to today’s bond trading activity; confusion – at least on the surface. All economic data indicate a growing economy. Rates responded in kind in the bond market’s early morning trading. The rate on the 10-year Treasury moved to 5.308% which was +.060% within just a few minutes after trading opened. Within the first ½ hour of trading the rate moved up to the day’s high of 5.316% or +.068 from Tuesday’s close.

Within minutes the 10-year Treasury reversed course. Bond traders and investors moved in for bargain shopping and that moved the price upward. When price goes up rates go down. The 10-year Treasury has moved to -.035% with the yield at 5.213%.

Traders and investors initially responded to Retail Sales by moving rates upward at the opening. Retail Sales were expected to be +0.6% to +0.7%. The Commerce Department reported total Retail Sales were double the expectations at +1.4%. Core-Retail Sales were predicted at +0.6% to 1.0%. While not double predictions, core-Retail Sales were +1.3%.

Import Prices helped the rate increase by being higher than the anticipated +0.2% to +0.3%. This measure of inflation was +0.5%

Business Inventories gave further rate increase argumentation at +0.4% while forecast at +0.2% to +0.3%.

While bad for rates, the MBA Purchase Application Index could be very good for readers of this blog. Both the weekly and 4-week moving averages were up, and up hard. The weekly number was 464.7. That is far higher than last weeks 433.6, and the highest since 10 January when the number was 472.8. The 4-week moving average was higher than it has been in over a year at 440.85.

Here’s to hoping that this trend continues. And here’s to hoping that the bond market continues to ignore this item.

That brings us to today’s puzzle; why are rates dropping when they should be much higher today?
Nick Godt of MarketWatch wrote a commentary on this a couple of hours before this post. He quoted Sal Guatieri, senior economist at BMO Nesbitt Burns who explained bond activity with this analysis, “That's odd, the reports are showing a pick-up in economic momentum. It certainly weighs against rate cuts. The backup in bond yields is also doing some of the Fed's work in containing inflation pressures."
MarketWatch’s Nick Godt went on to say, “Bonds normally drop [making rates increase] on strong economic data, which can lead to inflationary pressure. But the bond market has already been under pressure over the past two weeks, sending the 10-year yield to a 5-year high.
These levels have typically attracted bond buyers, keeping the yield in check.”

This blog has commented on Investor sentiment in the Mid-Term Outlook. It is possible that the price reached its bottom, while rates have met their top, and sentiment has turned.

MID-TERM OUTLOOK [13 June 2007]

There may be a few problems for rates for this quarter.

1.) Investor sentiment leans towards higher rates. The bond market has been in a selling mood since 10 May 2007

A few months back this blogger wrote that the bond market seemed to be looking for any excuse to buy bonds and thus drive rates lower. It appears that that trend has reversed itself. It seems now that the bond market is looking for any reason to sell, and correspondingly raise rates.

31 May 2007 one such example. There were six items published that day. Even though most of the economic items came in as expected, three did not. Of the three, two were lower than expected and should have moved rates lower. Instead rates continued their upward trend. Clearly, investor sentiment has turned bearish on buying bonds.

Investors are also bearish as they continue to be concerned with the FED’s ability to fight inflation. The confusion of the FOMC meeting on 21 March, and the subsequent release of the Minutes on 11 April, caused the bond market to issue a collective HUH?!?! Economists and FED watchers echoed the HUH!?!, and added a wha...?.

There has been one more Fed meeting on 09 May, and it caused rates to move up a bit. The FED action that has impacted rates more dramatically has been comments by FED officials since the last FOMC meeting. FED officials, most often Jeffrey Lacker have spooked the Bond market and pushed rates up in the last few weeks.

2) The housing bubble has ‘burst’. The question is, will housing continue to decline? Is it flattening? Or, is it on the verge of a rebound? The data over the last few months has been a resounding maybe to all three. IF homeowners start to see a rebound in housing their confidence will increase. As confidence increases, so will spending. Economic growth is moderate now with problematic inflation. Strong growth could renew strong inflation.

On 08 May 2007 the bond market responded to an unscheduled announcement by the National Association of Realtors (NAR). The NAR reduced its sales forecasts for 2007 and 2008, predicting that stricter lending standards would limit home buying. That only makes sense as stricter guidelines reduce the number of buyers able to get a mortgage. Given the already oversupply of houses, verses the very number of buyers we have a buyers market now. Reducing the number of buyers hits the real estate market with a double whammy.

Sales of existing homes will probably fall about 3% this year to 6.29 million from 6.48 million in 2006. Sales of new homes are projected to fall about 18% to 864,000, compared with a 14% drop predicted last month. Housing starts are expected to drop 19% to 1.46 million.

The results in May were mixed. New Home Sales were for April were up, while Existing Home Sales were down. At the same time, the Mortgage Bankers Association Application Index has been moving upward, indicating more people are looking.

When there are signs of housing market weakness it helps the price of bonds. Since it is a sing of a slowing economy it instills safe-haven interest.

3) The US and the global economy appear to in recovery. This has to be the shortest, least felt ‘recession ever experienced. (The 2.2% main stream media aside, there never was a recession, GDP never got below 0.0 %.)

Part of the growing global economy is China. On 12 June, the Chinese consumer price index for May was +3.4% in year-to-year analysis, according to data published by the [Chinese] National Bureau of Statistics Tuesday. Most of the gains were due to food prices, and haven't spread to a broad range of consumer goods. What we would call Chinese core-CPI was +1.0%. China’s food prices jumped 8.3% from a year ago.

Even though their core-CPI was low, the headline inflation rate is now higher than the interest rate banks pay on deposits, currently set at 3.06% for one year. That gives Chinese consumers a big incentive to spend or invest that money rather than let it sit in the bank.

Further, and of great Long-Term bearing on US interest rates – is how this will buying will diminish demand for US Treasuries. When demand for any commodity decreases, prices also declines. When bond prices deteriorate as they have, rates go up.

4) In February we wrote:

We have one great inflation fear in the mid-term; corn prices. With all the talk of alternate fuel and ethanol, corn futures have nearly doubled. Corn is a staple of many food products that we eat. Increases in corn prices will not just impact corn flakes, but pop/soda, beef, and pig, chicken, candy bars, just about anything we eat.

None other than the Western Hemispheres worse dictators; Fidel Castro agrees with us. (For once He understands economics.) An open letter signed by Cuban leader, titled "More Than 3 Billion People in the World Condemned to Premature Death from Hunger and Thirst," circulated in the media Thursday, 05 April 2007. See our post on that date.

Much of the afore-mentioned increase in Sino food prices are something we mentioned months ago in our Mid-Term Outlook. Attention-grabbing increases in prices for pork, for instance, are being caused mostly by supply shortages -- something that changing interest rates would be unlikely to affect, Mr. Zhou said. Grain prices have also been on the rise, but this reflects shifts in global supply and demand that Chinese authorities also have little ability to influence. Grain stockpiles in many countries have fallen to multiyear lows, even as increased production of biofuels such as ethanol has added a new source of demand.

Even the best estimates of corn based fuel say that it will never replace the need for fossil fuels. At best it can only reduce the demand some. It would be much better for us to reduce our demand on foreign oil and decrease the price at the pump by; 1.) Drilling where we know that there is oil, 2.) Build refineries, 3.) Eat food as food.

Steve Boxmeyer [612] 799 – 6858
steve@LendWithIntegrity.com