The bond market decided to err on the side of optimism again today—optimism, that is, from a bond trader’s perspective. Whatever you call it, there was a fair amount of it in and around trading of the benchmark 10-year Treasury Note, which now yields 4.20%, the lowest in more than two months.

The continued decline in the 10-year’s yield is particularly striking in light of today’s report on consumer prices. The news on that front was less than encouraging in the battle to contain inflation. But the bond market was unimpressed and instead was in a buying mood. No mean feat in the wake of the consumer price index’s rise of a stronger-than-expected 0.6% last month, the Labor Department reports. Although there have been increases of that magnitude in recent history, 0.6% is the highest in five months, representing the top end of monthly increases for some time. Indeed, you have to go back to 1999 to find a higher monthly jump in CPI.
What’s more, core CPI is now surprising on the upside too. Unlike yesterday’s calm in the March core wholesale price report, consumer prices for March excluding food and energy jumped by 0.4%, the highest in nearly two years.
Why is the bond market so nonchalant in the wake of bad news on inflation? Perhaps yesterday’s sharp drop in housing starts has something to do with the recent incarnation of confidence among debt investors. Indeed, the government reported that housing starts hit a brick wall in March, falling 17.6% from February. That’s the biggest drop since 1991.
Yes, Virginia, housing starts surged to an all-time high in February. As a result, even after the March decline, housing starts are still at a level that prior to 2004 was thought to be nosebleed terrain.
Yet the housing industry saw fit to put on the breaks. Is this the start of the much-discussed popping of the real estate bubble? If so, maybe the bond bulls aren’t so crazy after all. A serious, sustained decline in the housing market has the potential to take the wind out of the economy’s sails, and in the process making everyone but a bond trader miserable.
But more than a few analysts aren’t ready to throw in the towel on the real estate boom just yet. “It’s too early to get excited about this. You are coming off huge numbers in January and February,” David Wyss, chief economist for Standard & Poor’s, tells Knight-Ridder. Mark Zandi, chief economist at Economy.com, is similarly skeptical that this is the end, explaining to the Washington Post that the drop in housing starts is a “head fake. The [real estate] market isn’t slowing at all.”
If true, that implies that the Fed will continue tightening the monetary screws. Or so the futures markets for Fed funds predicts. The June ’05 contract for Fed funds is priced for a 3.0% rate. That, of course, is speculation. Truth at the moment is 2.75%, although that rate will be officially reassessed when the Federal Open Market Committee gathers for its next regularly scheduled meeting on May 3.
If gold prices and the U.S. Dollar Index have any influence on May 3 confab, another rate hike is coming. The precious metal inched up in Wednesday trading, holding fast to the 1.6% gain logged yesterday. Meanwhile, the U.S. Dollar Index slipped to its lowest in nearly a month.
Getting the buck back into an ascending mode will take some convincing from the Fed, and 25 basis points may not be enough to do the trick. John Rothfield, a currency strategist at Bank of America, sees pressure building for another rate hike of some degree. “Market expectations for the pace of Fed tightening are still down fairly aggressively over the past month,” he tells Bloomberg News. “We expect the dollar to keep drifting lower.”
Rothfield’s not alone. Whether that has any impact on the Fed remains to be seen. But as we go into the next FOMC with a CPI report that’s raising warning flags, it’s only a question of time before the bond market catches on that the risk in fixed-income may be higher than suggested in the 10-year’s yield trend of late.