Tuesday Look Ahead: Markets Pricing in Fed—and Some Inflation

A flood of earnings news Tuesday is unlikely to sway a market counting down to next week's Fed meeting, and the promise of a new flood of easy money.

Sandra Baker | Photographer's Choice | Getty Images

Stocks rose Monday on the weaker dollar, but the market finished well off its highs as concerns about the banking sector's exposure to mortgage liabilities continued to drag down financials. The Dow was up 31 to 11,164, and the S&P 500 was up 2 at 1185, an important resistance level. Financials were the worst performers, down 0.4 percent, one of two S&P sectors to decline. The other was defensive utilities, down 0.3 percent.

Commodities, like equities, moved higher Monday as the dollar wilted after the weekend G-20 meeting. Traders said the markets are now looking ahead to the Fed's meeting next week, and its anticipated announcement Wednesday that it will restart quantitative easing, viewed as dollar negative. The Fed has said it may resume purchases of Treasury securities to battle weak economic growth and low inflation.

Clearly, the markets are already betting on the Fed's success in battling low inflation, if you look at the action inMonday's TIPS auction.

Inflation Nation?

Investors swarmed a $10 billion auctionfor 5-year Treasury Inflation Protected Securities Monday, resulting in the first negative yield at a TIPS auction ever. The securities were yielding minus 0.55 percent.

"We're able to issue securities with negative real rates. That 's what they were trading at and when the auction cleared, you had to pay to play," said George Goncalves, Treasury strategist for Nomura Americas. "Demand was very, very good because a lot of people are looking for inflation protection. They're seeing the action of the Fed eventually working and generating inflation."

Goncalves said the action was also exaggerated because it was such a small pool of securities offered.

TIPS investors receive a consideration for the level of inflation and their principal when TIPS mature. In the case of this auction, the anticipated inflation premium would be less because of the negative yield.

"The auction yield is striking, but it reflects a condition in the Treasury market that has been in place for months, chiefly that yields on shorter maturities have moved below the inflation rate. The auction put an exclamation point on the condition," Pimco's senior market strategist Tony Crescenzi wrote in a note.

Inflation talk has also been creeping up in the stock market, as more and more companies discuss rising agriculture and metals prices during their quarterly earnings calls.

Harris Private Bank CIO Jack Ablin put out his own note Monday on the threat of inflation, just ahead of the TIPS auction. "We believe inflation remains an eventuality. Timing remains the wild card," he wrote.

Greenback Flounders

Ablin pointed to the fact that consumers are anticipating a 4.9 percent inflation rate, according to the latest Conference Board survey, and U.S. import prices, a leading inflation indicator, are up 3.5 percent year-over-year. He also said housing has been a drag on the readings, but if you look at gold, it's warning of inflation. Gold rose 1 percent Monday to $1338.90 per troy ounce.

"It tends to lead year-over-year CPI by nearly two years. That (gold) indicator suggests year-over -year CPI could reach 2.7 percent by September, 2012; ex housing, probably higher than that," Ablin wrote.

Some experts are paring their gold exposure. Pacific Investment Management's CEO Mohamed El-Erian said the firm's taken its gold position from 10 percent to 3 percent, because the trade doesn't make as much sense any more and it's crowded. He also said Pimco cut back on its gold position in August. El-Erian was speaking to the Financial Womens Association and was interviewed by CNBC's Michelle Caruso-Cabrera.

Treasury Building
Treasury Building

In the bond market Monday, investors bought the 10-year, pushing its yield lower to 2.554 percent. Ironically, dramatically low-yielding Treasurys are a deflation play, said Goncalves. "Both (Treasurys and TIPS) are doing well. The question is, which one is right?" he said.

Dollar Dilemma

The greenback floundered Monday, after the G-20 finance ministers' weekend meeting ended with a communiqué that spoke to cooperation to keep trade balances at a sustainable level and a promise not to devalue currencies. The market shrugged it off as a weak pledge, and reverted to looking ahead to the Fed's meeting. The dollar touched a new 15-year low against the yen.

U.S. Treasury Secretary Timothy Geithner, in a letter to the G-20 ministers, had recommended using specific targets to help countries adjust current account imbalances, but the G-20 did not agree and adopted the more general language at its weekend meeting instead.

"I think there's a sense that obviously trade targeting got pushed quite far up the agenda, as a way of directing the discussion toward global imbalances," said Alan Ruskin, head of global G-10 foreign exchange strategy at Deutsche Bank.

"Numbers could not be agreed on, but it did generate some strange bedfellows to the extent that Germany is in agreement with China on that it didn't make an awful lot of sense," he said.

German Economy Minister Rainer Bruederle said Saturday that he thought Fed easing is in his view is "indirect manipulation" of the foreign exchange rate.

The dollar has been in decline since the Fed first raised the possibility of more easing in August, and developing countries have been concerned that the U.S. move is fueling a flood of capital into their economies and a rise in exchange rates. At the heart of the G-20 currency struggle is thedisagreement between China and the U.S. on China's currency policies.

The U.S. view is that China's artificially depressed currency gives China an edge in export markets. China complains that the U.S. is doing nothing to reduce its huge deficits.

On that front, there was the appearance of some progress. Geithner said Saturday that he believes China is now committed to allowing the yuan to rise in value, according to reports. The Treasury secretary also made a last minute visit to China Sunday to continue discussions with China's vice premier Wang Qishan.

What to Watch

Ruskin said China may let its currency appreciate 5 percent annually.

Chinese Yuan and US Dollar
STR | AFP | Getty Images
Chinese Yuan and US Dollar

"The minimum it creates a somewhat more tolerant Administration. If unemployment remains this high in this country, China is going to be quite an easy country to beat up on.. for people in Congress, not the administration," he said.

"It looks very piece meal still, and it doesn't necessarily change the dynamic of this very sharp flow of funds from the developed world, particularly into Asia. That dynamic will stay the same until the Fed tightens," he said. Ruskin said the dollar would continue to weaken against the emerging world, but the decline against the euro may be slowing.

"Levels above $1.50 will be tough to achieve because Europe has its own set of problems," he said. The euro traded on both sides of $1.40 Monday.

What to Watch

The Treasury Tuesday offers $35 billion in 2-year notes. "It's a cash surrogate. It will be fine. The big wild card will be the 5- and 7-year auctions" Wednesday and Thursday, Goncalves said. The 2-year slipped Monday ahead of the auction, driving its yield higher to 0.367 percent.

Tuesday's data includes S&P/Case Shiller home price data at 9 a.m. and FHFA home price data at 10 a.m. Consumer confidence is also released at 10 a.m.

Earnings reports are expected from Arcelor Mittal, DuPont, Ford, UBS, Bristol-Myers Squibb, Biogen-Idec, CIT, Kimberly-Clark, Paccar, McGraw-Hill, TD Ameritrade, Valero, U.S. Steel, Celanese, Ashland, Sherwin-Williams, Johnson Controls, First Energy, and Cummins, ahead of the open. Massey Energy, Aflac, Dreamworks and McKesson report after the bell Tuesday.

Goldman Sachs Tuesday is expected to price $250 million or more of a special 50-year bond, aimed at individual investors. Goldman is seen as testing the waters with the small offering, which is expected to yield between 6.125 and 6.25 percent. Goldman has previously served as underwriter on century bonds. Norfolk Southern issued a 100-year bond during the summer.

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