Forces Driving Interest Rates

Treasuries posted a second month of substantial losses in May as prospects for further interest rate cuts by the Federal Reserve dimmed. Several of the major economic releases of the month were stronger than anticipated and statements from the Fed policy committee were the principal influences on the market.

The yield of the benchmark 10-Year Note gained 33 basis points in the course of the month (yield moves inversely to price) and this followed a 32 basis point rise in April.

The bond market began the month with four straight losses. The first was basically a technical reaction following three previous gains. The end-of-month support was gone and Treasuries lost ground to profit-taking despite generally bearish economic news including a slight decline in April's manufacturing activity and a drop in the level of construction spending in March. A rise in the dollar and a decline in oil futures helped support the stock market, which also weighed against bonds.

The second decline of the month was sharper. The employment report for April indicated just a 20,000 decline in the seasonally adjusted level of nonfarm payrolls, though forecasters had been calling for a drop of around 80,000. Moreover, the report said that the unemployment rate, the percentage of the active workforce without jobs, slipped to 5.0% from March's rate of 5.1%. Analysts had expected an increase to 5.2%.

Stronger than expected economic data hurts bonds since it argues against interest rate cuts from the Federal Reserve.

More strong data came the following Monday when the Institute for Supply Management released its index on the non-manufacturing or services sector. It indicated an expansion of activity in the sector in April. This was the first growth reading of the year and it surprised analysts who had predicted another contraction reading.

On the sixth of the month, bonds fell again as stocks rose despite negative corporate news and a rise in oil prices. But Treasuries were finally able to post a win the next day as oil surged once again and stocks buckled under the pressure.

The news of the day also lent support for bonds. Productivity growth in the first quarter was stronger than anticipated and strong productivity helps keep inflation from labor costs down. Though also normally a plus for stocks, traders theorized that some of the productivity gain was tied to payroll cuts.

The sharp decline in stocks (the Dow down over 200 points) was augmented by profit-taking as the indices had been at or near multi-month highs in the previous session.

Treasuries got another boost on the 8th on relief when the week's 10-Year Note and 30-Year Bond auctions were over. Further weakness in stocks lent support for bonds on the 9th. Stocks were being hit by reports of more losses in the financial sector, an on-going development that had undermined credit flows and kept the Federal Reserve in an accommodative posture. The credit concerns even trumped the report of a smaller trade deficit than predicted in March. The deficit figure meant that -- all other things being equal -- the initial estimate of gross domestic product growth for the first quarter would be revised higher.

Stocks recovered somewhat on the following Monday (the 12th) and Treasuries lost ground. A portion of the stock move was technical following the previous week's losses. Stock traders also found encouragement from the first decline in oil futures following six consecutive session advances and five consecutive record closing highs.

Bond losses accelerated the following day as the report on retail sales for April showed a strong ex-auto increase. March's ex-auto gain was also revised up. Sales were also respectable even if both auto sales and gasoline sales were factored out, suggesting that consumer spending was fundamentally solid.

Besides the core strength in retail sales, inflation concerns were stoked by news that import prices rose more than expected in April due to rising oil costs.

But inflation concerns were eased on the 14th when the Consumer Price Index, a gauge of price changes at the retail level, was released. It showed a tamer increase than had been forecast and the core index, which excludes the volatile categories of food and energy, showed only a nominal rise.

More bond-friendly news came out the next day. The Federal Reserve reported that industrial production -- a gauge of output from the nation's factories, mines, and utilities -- contracted in April. The report also said that capacity utilization, the ratio of output to potential output fell to its lowest level since September of 2005. This was a welcome inflation indicator since it meant there was more slack in the production process and less of a chance that bottlenecks would occur, preventing demand from being met and driving up prices.

Further signs of weakness in the manufacturing sector were provided by the New York and Philadelphia branches of the Federal Reserve. They both reported contractions in the manufacturing sectors of their regions in May.

Bonds backed up a little the next day but continued to make progress on the 19th and 20th as stocks showed some weakness. But both markets were disrupted on the 21st when the minutes of the Federal Reserve's last policy meeting (April 29 and 30). They indicated that the Fed might be reluctant to make further rate cuts:

"The Committee agreed that that the statement to be released after the meeting should take note of the substantial policy easing to date and the ongoing measures to foster market liquidity. In light of these significant policy actions, the risks to growth were now thought to be more closely balanced by the risks to inflation. Accordingly, the Committee felt that it was no longer appropriate for the statement to emphasize the downside risks to growth. Given these circumstances, future policy adjustments would depend on the extent to which economic and financial developments affected the medium-term outlook for growth and inflation. In that regard, several members noted that it was unlikely to be appropriate to ease policy in response to information suggesting that the economy was slowing further or even contracting slightly in the near term, unless economic and financial developments indicated a significant weakening of the economic outlook."

Treasuries continued to decline the next day at an accelerated rate. The market experienced a technical bounce on Friday of that week. Some of the lift was provided by safe-haven buying before the three-day Memorial Day weekend but the downward trend in prices continued in the last week of the month.

Housing :

The housing data released in May was mixed, which made it stronger overall than expected since the weakness of the sector was assumed. The construction spending report for March supported the assumption of weakness. It indicated that the seasonally adjusted, annualized rate of spending in the residential construction sector fell to its lowest level in five years. However, the report revised a decline in February to a nominal increase -- the first in two years.

The National Association of Realtors said that its index of pending home sales fell in March. The decline was larger than analysts had predicted and February's decline was revised to an even deeper one.

Yet, the Commerce Department reported a surprising jump in the rate of housing starts in April. The increase was the largest since January of 2006. In addition, the rate of building permit issuance also rose -- the first increase in five months and the largest increase since December of 2006.

Not all of the starts news was as strong as it appeared. New construction was strongest in multi-family structures. The rate of starts on single family units fell to its lowest level since January of 1991.

The sales data was mixed. The National Association of Realtors reported that the pace of existing home sales fell in April, matching January's level as the lowest in eight years.

But the Commerce Department said that the rate of new home sales rose in April, though from a downwardly revised level in March. April's rate still exceeded analysts forecasts.