The Next Test for Markets: Retail Sales

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If February retail sales are soft, blame the tax man.

February retail sales data could be a test for markets Wednesday since it could show just how much the U.S. consumer was impacted by a hike in payroll taxes, and a delay in tax returns in January and February.

The markets have made important assumptions about the strength of the U.S. consumer, and the stronger-than-expected February jobs report added to that view.

The outcome could also determine whether the government's auction of $21 billion in 10-year notes goes well or not. It could be one of just three auctions in the last year to come in with a yield above 2 percent.

Economists expect to see a 0.5 percent increase in retail sales, compared to a smaller 0.1 percent rise in January. Economists also forecast that sales, when excluding autos and gasoline, rose 0.5 percent, according to Thomson Reuters.

"For the headline number, gasoline prices have gone up. That could boost it a little. On the other hand, income tax refunds were delayed due to the fiscal cliff, and that seems to have delayed refunds that could have lined consumers' pockets," said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi. Consumers have also been hit by a 2 percent increase in the payroll tax.

"Everything would suggest that the payroll tax holiday's gone away, and a spending spree has gone away," he said. But he noted a positive sign is that retailers added more than 50,000 workers in January and February.

"Retail sales should be important," said Art Cashin, director of floor operations at UBS. "Everybody is still trying to resolve the early concern about the payroll tax that popped up with the leaked Wal-Mart email and the somewhat confusing results we're seeing at other places." Cashin was referring to reports that a Wal-Mart executive's emails said early February sales were a "total disaster," blaming the payroll tax increase.

Wal-Mart Tuesday added some grist to the debate about the consumer Tuesday. The retailer's CFO Charles Holley was quoted as saying at an investor conference that customers are still seeing delays in getting their tax refunds. He said Wal-Mart has cashed $2.7 billion tax refund checks at its U.S. stores so far this year, down from $4 billion by the same time last year. But he also was quoted as saying that the payroll tax increase, however, does not seem to be hurting consumers.

(Read More: Wal-Mart Tops Estimates, but Guidance Is Weak)

"Retail sales are supposed to be 30 percent of real consumer spending, that comes out in the GDP report," said Rupkey. "So it's an important report tomorrow, but there's no guarantees."

Besides retail sales at 8:30 a.m. ET, there is also import prices data. Business inventories are reported at 10 a.m., and the Treasury auctions $21 billion 10-year notes at 1 p.m. "The when-issued market is trading in a way that suggests that the 10-year auction will yield, next to February's auction, the second highest since April of last year," said Ian Lyngen, senior Treasury strategist at CRT Capital. "Yields have backed up so far that sidelined investors might find these levels enticing," he said.

Treasurys broke a losing streak Tuesday, with yields moving lower for the first time in six sessions, ahead of Wednesday's 10-year auction and Thursday's auction of $13 billion 30-year bonds. The 10-year was yielding 2.02 percent late in the day. Lyngen said the when-issued yield was 2.02 percent, while last month's auction of $24 billion 10-year notes was at a yield of 2.046 percent, and the yield last April was 2.043 percent.

"We do have retail sales and that may give us a little bit of a shock or surprise," he said, noting of all the auctions the 10-year is the most difficult. "That is the one that has typically been more prone to tails and required more of a concession to take down."

The Dow, meanwhile, rose 2 points Tuesday to 14,450, enough to give it an eighth day of gains and another record close. The S&P 500 slipped 3 points to 1552. Apple fell 2.2 percent to $428, failing to follow through on what traders were hoping was signs of a reversal Tuesday.

What Else to Watch

Traders are watching the dollar which has been weighing on oil prices as it moves higher. On Tuesday, the green back moved higher, then lower, temporarily sending oil about a percent higher. But the dollar recovered, and oil futures closed at a two-week high of $92.54, on a gain of just 48 cents per barrel.

As the dollar recovered ground, "that kind of limited the advance in the market. The underlying supply and demand fundamentals really don't point toward rising prices," said Gene McGillian, analyst at Tradition Energy. "We have more ample supplies, and we have yet to see any significant increase in product demand." McGillian said one move that's been interesting is the narrowing gap between U.S. West Texas Intermediate, and more expensive Brent, the international benchmark.

That gap closed by about a dollar on Tuesday, to about $17 per barrel, as traders bid up WTI ahead of U.S. government oil inventory data Wednesday at 10:30 a.m. McGililan expects the weekly numbers to show a 3 million barrel build of crude and a 1 million barrel draw of gasoline.

Traders are keeping one eye on Europe and the other on Washington. President Obama meets with House Republicans on Capitol Hill Wednesday. House Speaker John Boehner holds a presser following the meeting, at 1:30 p.m. Senate Democrats are expected to release their version of the federal budget in the afternoon.

Earnings are expected from retailers Men's Wearhouse and Express.