Mon, Sep 03, 2001 page19

• Increase in spending challenges market's reaction

  Economic indicators showing an increase in consumer spending have elicited a need to validate consumer confidence levels

  • By Caroline Baum / BLOOMBERG
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  The bond market has always had its set of pet indicators, some of which have legs (the monthly employment report and National Association of Purchasing Manage-ment's Index, for example), others of which are fleeting.

  In recent weeks, Treasuries had a significant rally in response to economic numbers that at best confirmed what we already knew.

  I'm talking about the Federal Reserve's anecdotal assessment of the economy, known as the beige book, and consumer confidence.

  Treasuries had their biggest rally in three months on Aug. 8, after the beige book delivered a dour assessment of the economy.

  The report noted that the weakness evident in manufacturing for almost a year was spreading to other sectors of the economy.

  The 30-year bond rallied 1.25 points, with yields falling nine to 14 basis points across the curve.

  To some students of the Fed's colorized books, the reaction to the beige one seemed unusual. It's the least revealing of the three briefing books, colored blue, green and beige, that are prepared in advance of each of the eight meetings a year.

  The blue book examines financial developments and variables.

  The green book contains a thorough review of recent economic developments and the staff forecast. The beige book is a compendium of anecdotal information from the Federal Reserve banks, gleaned from business contacts in each district.

  During the early 1980s, Congress was clamoring for more timely information from the secretive central bank.

  "Twenty percent interest rates captured a lot of attention," says Neal Soss, chief economist at Credit Suisse First Boston, who was a special assistant to then Fed chairman Paul Volcker.

  A decision was made to make the beige book, as bland as its cover, a public document.

  The beige book contains a summary of business conditions, encompassing manufacturing, retailing, real estate, the labor market and banking. Each of the 12 Federal Reserve banks contributes a section on conditions in its particular district.

  Much of the information contained in the beige book is a reiteration of old news. For example, July manufacturing conditions as summarized in the Aug. 8 beige book were previewed in the NAPM Index released on Aug. 1. Two weekly readings on chain store sales are widely publicized. Comprehensive bank loan data are released every Friday by the Fed.

  In general, then, it's not so much the news content of the beige book but how the Fed spins it. Traders think they can get a leg up if they know which of the Fed banks is preparing the beige book, the tone of which presumably will be dictated by the bias of that particular bank president.

  "The reaction tells you something about the market," says Jim Glassman, senior economist at J.P. Morgan Chase.

  CSFB's Soss took issue with that thesis. "In general the beige book may not be interesting or informative, but the last one was," Soss says. "It was the first opportunity to see the reaction from the business leadership to the tax rebate. What we learned was that retailers were not stocking up for back-to-school and Christmas sales "even though the tax cuts are creating cash flow for customers," he says.

  The fact that we're sending customers US$3.5 billion in cash for 11 weeks running -- the equivalent of 5 percent of weekly retail sales -- did not seem to resonate with business leaders, Soss says. "The [expected] sales were not worth adding inventory for but instead would be used for inventory liquidation." So much for my theory about no informational content in the beige book. At least Soss agreed that the consumer confidence report for August was not new news. The Conference Board's measure of consumer sentiment fell two points to 114.3, the lowest level since April. Looking at a chart, it's hard to make a case for a true deterioration in consumer attitudes. Instead, after a plunge from September to February, confidence has been stable in the 110 to 120 range for six months.

  The yield on the two-year note fell to its lowest level since 1992 following Tuesday's confidence report. At 3.58 percent currently, the yield is the lowest since the Treasury started selling the notes in 1972.

  To send yields plunging to all-time lows, investors must be convinced that confidence leads economic activity.

  Hardly. Asha Bangalore, an economist at Northern Trust Corp, looked at the correlation between the Index of Coincident Indicators, a gauge of current activity, and consumer confidence.

  "The highest correlation between the two variables -- 71 percent -- occurs with the consumer-confidence index leading the Coincident Index by three months," Bangalore says.

  "I never remember seeing something in the confidence numbers that we didn't understand," says J.P. Morgan's Glassman. "There aren't any mysterious drifts. Consumers react to income, job security and the stock market. The markets are looking at jobless claims every week." Consumer confidence is often a feedback loop, Glassman says, with consumers reflecting the spin in the news, which, in turn, reflects things like consumer behavior.

  The same thing may be happening with the yield levels. In order to justify them, traders and investors need validation in each new piece of questionably relevant information.

  The 2.5 percent increase in real consumer spending in an otherwise anemic second quarter challenges the bond market's reaction to consumer confidence this week. It may just be that the yield levels need justification -- and anything will suffice.
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