Oil:                        Tops$103 per barrel
Stocks:                  Friday slide sets up for weak Monday
Bonds:                  10-yr Treasury yield hits 3.5%
PPI                        Core ok; overall zooms
Consumer Conf.    Weakens further
GDP                       0.6% – remains weak

Economics This Week: Inflation and GDP highlight

Date      Item                          Est.                 Comment
3/7        Employment Data      30k/5%           Uptick in unemployment expected

Stocks Under the Gun

Last week’s equity market again saw significant pressure, with the Dow off over 300 points on Friday. The reasons for the sell-off are many, including rising oil prices and a fear of both inflation and recession. One of the biggest drivers appears to be Fed Chairman Ben Bernanke’s testimony to Congress last week. Bernanke’s comments clearly highlight the Fed’s concern about a more serious economic slowdown than they had anticipated last summer. As we head into the trading week today, negative market reaction may have a way to go. For example, Japan's benchmark Nikkei 225 index plunged 4.5% in overnight trading and the preopen on Monday showed the Dow down another 500 points.

If it’s any consolation, Bernanke indicated the Fed would continue to provide an accommodative monetary policy to help soften the economic slow down. Translated, this means further Fed cuts and additional liquidity by the FOMC to the banking system. The Fed’s FOMC is scheduled to meet March 18, and the expected result is another 50 bps rate cut. The criticism that’s being leveled against the Fed is that all this free cash in the market will ultimately lead to inflation – imagine that – inflation with oil above $100 – why is anyone surprised?

Municipal Market Implosion

Last week saw one of the most devastating price declines in municipal market history. What is so remarkable about this price decline is that it has nothing to do with the quality of the bonds and everything to do with market liquidity.

As of Monday last week, the municipal bond market was on its way to a very good month, with a return of buying and a reduction in concern about the monoline insurers. However, in a matter of just days, municipal yields rocketed to levels not seen in many, many years. This caused concentrated and massive selling in longer-dated municipal high quality bonds as well as municipal high yield bonds. The sell-off also impacted shorter dated municipals but to a lesser extent.

There were at least several factors contributing to the sell off.

The first factor was the selling pressure in the auction rate market. The turmoil in this “cash” like market caused yields to rise significantly. This, in turn, had many buying that sector to the exclusion of longer maturity paper. This nearly eliminated the buying in the longer maturities as yields started to rise.

The second key event key last week was a wave of selling by the alternative municipal hedge funds to meet collateral calls on their leveraged high quality portfolios. This same condition occurred last August, but buying support was quickly found. This time around, potential buyers are not in place, especially those institutions that remain on the sideline trying to shore up their own liquidity. This forced the alternative funds to sell into an already weak and damaged market.

Third, the supply of municipals is starting to build. Lots of this supply is coming from refinanced deals by those issuers who had short-term auction securities that needed to be called. The concern of more supply in an already “squeezed” market made participants that much more weary about buying anything in the near-term.

Lastly, according to Citigroup, “Because the repricing happened so rapidly, in most cases the
investment community was unable to identify new pockets of demand that might find the
new values attractive. To be sure, a handful of trades did occur. Some of the most distended situations include the case of a taxable bond fund that picked up tax-exempt pre-refunded bonds, backed by Treasuries, at yield levels above those available on taxable Treasury securities.”

Resolution?

The end result is that, as we start this week, municipal yields are at an unprecedented 120% of Treasury yields and over 110% of LIBOR. On a taxable equivalent basis, “AA” municipal bonds are near 6%, which equals 9.23% taxable – junk bond levels! If there is any good news, it’s that some of these relative yield levels are very attractive and ultimately will find buying demand from mutual funds and traditional long only buyers that have focused on the intermediate part of the yield curve.

The big question, of course, will be how quickly that demand arrives and from what groups of
buyers? These yields levels are bringing in buyers not normally seen in municipal land, including foreign investors, hedge funds, and taxable institutional buyers.

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