Speculative-grade credit spreads continued to siden yesterday despite the sharp gain in equities owing to additional weak economic news. Spreads have also widened in response to the sharp drop in Treasury yields, which have resulted partly from the Treasury's decision to eliminate issuance of 30-year bonds. Risk-aversion appears to remain high, as evidenced by the proximity of high-yield spreads to their recent wides. Yesterday, the S&P spec index widened to 1242.3 basis points over Treasuries verus 1238.9 basis points the previous day. Spreads remain relatively close to the 2001 high of 1,263.2 set on October 3rd and much wider than the level seen on September 10th when the spread was +992.4 basis points. The recent widening is largely the result of six factors: weak equities, concerns about the economic outlook, shrinking liquidity in low-grade issues, weakness in emerging markets debt, flight-to-quality buying of U.S. Treasuries, and the Treasury's elmination of the 30-year bond. Current trends are not likely to change until these factors are mitigated. One key positive sign was the strong reception to last week's record issuance of investment-grade debt. The strong demand suggests that risk-aversion is not as deep as seems apparent in the behavior of spreads.
Factory orders fell 5.8% in September, a sharper drop than the 5% decline the market was expecting. The value of new orders fell to $313.1 billion, the lowest since March 1997. August orders were revised down to show a 0.1% decline compared to the initial estimate of no change. The sharp drop in factory orders comes as no surprise given the 8.5% drop in September durable goods orders reported on Oct. 25. Today's report adds data on nondurable goods orders, which fell 2.6% in September. Orders of non-defense capital goods excluding aircraft fell 9.2%.
The weaker-than-expected employment data once again provides an opportunity for investors to measure the extent to which weak economic news is already priced into the market. The bond market's failure to gain and the equity market's resilience in the face of yesterday's reported plunge in the NAPM are evidence that a large degree of weak economic and corporate news has already been discounted. Nevertheless, today's data probably reaches beyond the pessimistic expectations in the markets and is weak enough to suggest GDP will decline at a SAAR of 2% to 3% or more in the current quarter. The report is weak but in some ways does not come as a shock given the plethora of hints foreshadowed in the major labor market indicators. The bond market is now grappling with severe overbought conditions clearly apparent in the RSIs (9-day=84.0), the call/put ratio (2.37: versus 1-year average of 1.39:1; now at highest since at least January 1998), and the skew between call volatility and put volatility (put volatility is usually higher but call volatility has been much higher lately). The overbought conditions have prevented the bond market from continuing its advance. Another obstacle is key resistance at 1998s closing low yields on the 10- and 30-year Treasuries. Both the 10- and 30-year maturities pierced their 1998 low yields of 4.162% and 4.716%, respectively yesterday but failed to close below those yields. As a result, a double-top has now been formed and traders now have a reference point at which to consider selling. Again, it is critical to watch how investors react to this additional news of economic weakness, to gauge the extent of weakness factored into prices.
The yield curve has steepened in the wake of the payroll report as the short-end of the curve outperforms on higher Fed easing expectations. The 2/30 yield spread has widened by 9 basis points to 241 basis points following two days of massive curve flattening that dropped the spread from 276 basis points late Tuesday to 232 basis points late Thursday. For the first time, the market is pricing in a significant possibility that the Fed's rate cut campaign might not stop at 2%. In the long-end, the massive rally in both 10-year notes and 30-year bonds has come under pressure from profit-taking, particularly after the 10-year cash yield failed to hold below the October 1998 low of 4.16% on Thursday.
Fed easing expectations have jumped following the larger-than-expected drop in October payrolls, with the February 2002 Fed Fund futures contract now pricing in more than a 50% chance that the Fed cuts rates down to 1.75% (75 basis points of cumulative easing) over the next three meetings. The November contract is pricing in about a 60% chance that the Fed cuts rates by 50 basis points next week, up from about a 40% chance at Thursday's close.
Nonfarm payrolls plunged 415,000 in October, much more than the 300,000 drop the market was expecting. And the unemployment rate jumped to 5.4%, the highest since July 1996 and well above expectations for an increase to 5.2% from September's 4.9% rate. September payrolls were revised down to show a decline of 213,000 from the initial estimate of -199,000. The BLS noted that "subsequent to the September 11 terrorist attacks, employment declines accelerated markedly in travel- related industries, including hotels (46,000) and auto services (13,000), notably in auto rental agencies and in parking services." The service sector as a whole lost 241,000 jobs in October, the largest since August 1983. Manufacturing employment fell 142,000, the 15th consecutive month of factory job losses. Average weekly hours fell to 34.0 from 34.1, matching the August level, and average hourly earnings rose 0.1% to $14.47 from $14.45. |
