Margin Squeeze Hits Headlines. False Start Baked into Bonds

President Obama was on CBS this morning discussing the state of the U.S. economy.  In the Q&A session Obama cited a weak housing market and high gasoline prices as the biggest "headwinds" to economic growth. Main Street is already aware of the unfriendly pressures exerted on consumer walles when food and energy costs rise, Wall Street on the other hand is just beginning to accept that observation as a legitimate  threat aka "headwind". 

Further evidence of Main Street's margin squeeze was presented this morning when scheduled data was released. Here is a quick recap....

(Reuters) - Sales at U.S. retailers posted their smallest gain in nine months in April as high food and gasoline prices drew spending away from other areas, but upward revisions to March's data suggested consumer spending in the first quarter might have been stronger than initially thought. Total retail sales increased 0.5 percent for a 10th straight month of gains, the Commerce Department said on Thursday. March sales were revised up to a 0.9 percent increase from a previously 0.4 percent rise. Economists polled by Reuters had expected retail sales to increase 0.6 percent last month. The data implied consumer spending, which accounts for 70 percent of U.S. economic activity, got off to slow start in the second quarter as household budgets remained stretched by high food and energy prices. Receipts at gasoline stations, which accounted for about 10.5 percent of overall retail sales in April, rose 2.7 percent after rising 4.1 percent the prior month.  Gasoline prices rose 24 cents or 6.6 percent to $3.85 a gallon in April from March, according to the Energy Information Administration. Excluding gasoline, retail sales were up 0.2 percent after rising 0.5 percent in March. Sales at food and beverage stores rose 1.2 percent after gaining 0.2 percent in March.  Auto sales rose 0.2 percent after declining 0.7 percent in March. Clothing store receipts rose 0.3 percent last month, while sales at building materials and garden equipment suppliers edged up 0.1 percent. So-called core retail sales -- which exclude autos, gasoline and building materials - rose 0.2 percent after a 0.6 percent rise in March.

(Reuters) - U.S. claims for unemployment aid fell sharply last week after a surprisingly big rise the prior week, a government report showed on Thursday. Initial claims for state unemployment benefits fell 44,000 to a seasonally adjusted 434,000 in the week ended May 7, the Labor Department said. Analysts had expected the claims to drop to 430,000. Revised data for the week ended April 30 showed a rise of 47,000 in jobless claims to 478,000, fueled largely by about 25,000 spring break layoffs in New York. Many states in the Northeast allow for non-teaching staff to file for unemployment benefits when schools close for spring and summer breaks. To some degree, last week's drop was a reaction to the prior week's surge, which was not anticipated by the factors the department uses to seasonally adjust the claims number, a Labor Department official said. New York's spring break occurred at an unusual time this year.

(Bloomberg) -  Wholesale costs in the U.S. rose more than forecast in April, led by higher prices for food and fuel. The 0.8 percent increase in the producer-price index compares with the 0.6 percent median estimate of economists surveyed by Bloomberg News, Labor Department figures showed today in Washington. The core measure, which excludes volatile food and energy costs, climbed 0.3 percent, more than projected.Rising costs may lead businesses such as Whole Foods Market Inc. to increase prices, boosting the cost of living for American consumers. “Inflation really shouldn’t be much of a concern beyond food and energy prices, and that’s going to be more of a near- term phenomenon,” said Sean Incremona, a senior economist at 4Cast Inc. in New York who accurately forecast the gains. “The core is very gradually moving higher, but it doesn’t look to be running away anytime soon.”

Wall Street's new found concerns over the "margin squeeze"  have financial markets feeling quite nervous about missing 3-4% economic growth expectations for 2011.  Those worries are now showing up in commodities prices, which are adjusting to reflect a potential contraction in demand (remember 2008?). Since Cinco de Mayo, oil has fallen from $108/barrel to $96.  A sustained retracement in energy costs would go a long way in relaxing consumer sentiment and correcting (distorted) inflation expectations.

The Fed says the effects of high food and energy costs will be "transitory"...whether or not this cost-push inflation (without the necessary wage growth) is "transitory" or not will dictate how "transitory" the economic slowdown will be....which will in turn dictate whether or not bonds rally through current barriers.  3.14% is the biggest hurdle blocking a continued shift "down in coupon". See teal line in the chart below....

MUST READ: MBS Ledge: Shift in Production Coupon Potentially in Progress

Plain and Simple: The prospects for one last run lower in rates are back on the table, but we remain defensive. Breaking out of the 1st quarter range would not only imply a shift in economic outlooks and technical trading tactics ...but a shift in duration bias...a shift in the MBS production coupon...a shift in hedge ratios.  This requires a great deal of commitment from the bond market. It requires portfolio rearranging. It requires rebooted hedging strategies. It requires position squaring and an accumulation of longer dated debt.   We're seeing the preliminary signs of this process already being in progress...but no sustained commitment as been confirmed.

Based on the month-long rally seen in the chart above, the bond market seems to be on the ball when it comes to pricing in expectations for below-forecast economic growth. From that perspective, if oil prices continue to move lower and the cost of living cheapens up, this bond rally might reverse course. If oil prices rise without a corresponding uptick in wages and faster job creation, we could be looking at QEIII (not priced into yields).  Keep your eye on the ball, oil prices are playing a big role in the directional drift of interest rates.

OUR POINT:  The Fed says the effects of high food and energy costs will be "transitory"...whether or not this cost-push inflation (without the necessary wage growth) is "transitory" or not will dictate how "transitory" the economic slowdown will be....which will in turn dictate whether or not bonds rally through current barriers.  Our opinion is the Fed has underestimated the sensitivity of Main Streeters to an increased cost of living. We expected economic growth to disappoint even the Fed's recently downgraded estimates. Our thesis is based on a lack of wage growth, high productivity levels, subpar job creation (need at least 200k jobs created per month to see growth top 3.00%YoY), and a housing market that continues to stagnate in a pool of its own filth.  The  "margin squeeze", as we call it,  has been the primary motivation behind our 2011 economic outlook. The recovery process will be long, choppy, and highly-sensitive to unanticipated shocks. It is very important to differentiate between false starts and "transitory" effects.

January 12, 2011: Beige Book: Housing is Weakest Link. Wage Growth Missing. Margin Squeeze Looms

February 1, 2011: Margin Squeeze Concerns Deepen as Manufacturing Sector Expands

February 3, 2011: Productivity Gains Darken Hiring Outlook. How Might that Impact Housing?

February 16, 2011: FOMC Minutes: Harping on High Productivity & Margin Pressures

March 3, 2011: Inflation Expectations Distorted by Bullish Perspectives of Reality

March 17, 2011: Inflation Update: Cost of Living Rising as Wage Growth Lags

April 29, 2011: Economic Slowdown: Transitory Effects vs. False Starts