The Economy and Bond Market Diary (November 22, 2010)

The Economy and Bond Market

Economic news was mixed and the European financial crisis heated up again this week. Ireland appears to be on the cusp of a European Union-International Monetary Fund agreement that will shore up the Irish banking sector. Closer to home, the news of the week in the fixed income arena was in municipals. Municipals generally fly under the radar of most market participants but this week the sector was hit by significant volatility. A combination of heavy supply, concerns surrounding the extension on the Build America Bond program and the decreased likelihood of federal assistance at the state and local level contributed to the sell off. As the municipal market fell, mutual fund redemptions accelerated rapidly, totaling $3 billion which was the largest weekly withdrawal since 1992. By the end of the week the market was rebounding sharply and many seasoned investors consider this week’s dislocation to be an opportunity.

Strengths

• Retail sales rose 1.2 percent in October, well above expectations.
• Both the Consumer Price Index and Producer Price Index came in below expectations for October. Core CPI rose 0.6 percent on a year-over-year basis, which is the smallest gain ever recorded for that measure.
• Initial jobless claims fell slightly this week but the more exciting news was the four-week average fell to the lowest level in two years, indicating at least some stability in the job market.

Weaknesses

• The Federal Reserve’s QE2 policy has come under attack from both international and domestic sources, creating some level of politicizing of the issue.
• China raised its bank reserve ratio for the second week in a row as it steps up efforts to slow inflation and to offset some of the spillover from the U.S. QE2 program.
• The 30-year fixed rate mortgage rose 22 basis points this week while mortgage applications fell 14 percent to a four-month low.

Opportunities

• Inflation is unlikely to be a problem for some time and this gives central bankers and other policy makers around the world room for expansive policies.

Threats

• Inflation expectations as measured by Treasury Inflation-Protected Securities (TIPS) spreads have risen sharply over the past month. Inflation expectations will be key data points to drive Fed policy changes going forward.