Market Post: Munis Plummet, Following Treasuries, Reacting to QE3

The tax-exempt market weakened Friday morning, following Treasuries lower, as reaction to the Fed's launch of additional quantitative easing continued to weigh on markets.

Treasury yields soared on the QE3 news Thursday afternoon, and muni yields followed in Friday morning trading.

"The muni market is down pretty good," a New York trader said, adding though that there is increased trading volume.

On Thursday, the 10-year Municipal Market Data yield finished steady at 1.84% while the 30-year yield closed flat at 2.98%. The two-year closed at 0.29% for the 35th consecutive session.

Treasuries were much weaker. The benchmark 10-year yield and the 30-year yield soared 12 basis points to 1.86% and 3.07%, respectively. The two-year increased one basis point to 0.26%.

In the primary next week, the municipal market can expect $8.64 billion in bonds, up from this week's revised $4.04 billion. On the negotiated calendar, $7.64 billion is expected to come to market, up from this week's revised $2.7 billion. On the competitive side, $998.7 million is expected, up from this week's revised $1.34 billion.

In economic news, consumer prices rose 0.6% in August, coming in line with expectations, while core prices rose less than expected with a 0.1% increase. A surge in energy prices was the key factor in the overall increase.

"The sharp rise in headline inflation predates any monetary impulse from QE3 and gasoline price data for the first two weeks of September points to more of the same this month," wrote economists at RDQ Economics. "This is a poor inflation backdrop for the consumer to absorb the punch of QE3. The experience of QE2 was that it weakened the dollar and boosted commodity and energy prices, which in turn pushed up CPI inflation and squeezed household real incomes. We worry, therefore, that QE3 will boost inflation and hurt the real economy and, with headline inflation in the last four months of 2011 reported at only 1%, we expect to see a significant move up in CPI inflation as we head to the end of the year."
In other economic news, retail sales jumped 0.9% to $406.7 billion in August, following a revised 0.6% increase in July. It was the largest advance since a 1% increase in February. The retail sales beat analyst expectations of 0.7% increase.

"This is a weaker-than-expected retail sales report despite the large gasoline-price driven rise in headline retail sales in August," wrote RDQ economists. "Excluding price-related gains in gasoline sales, intermediate spending on construction goods, and auto sales, it appears that real consumer spending is growing less strongly than we previously thought in the third quarter. When commodity prices are rising, retail sales can give a misleading impression of the strength of the consumer as people spend more to buy less. This was a theme after QE2 and we expect it to be a theme going forward after the Fed's announcement yesterday."

Also, industrial production fell 1.2% in August while capacity use decreased to 78.2%. Economists had expected production to rise 0.1% and a 79.2% capacity use rate.

"Even after special factors, this is still a weak report" wrote RDQ economists. "To strip out potential special factors, we focus this month on manufacturing excluding autos, which saw a 0.4% drop in output in the month. After the ISM report for August we warned that modestly contracting orders and rising inventories is a more negative mix for the outlook for manufacturing and today's report from the Fed provides some confirmation of these concerns. Even though an unwinding of these special factors will likely buoy industrial production in September, we do not look for much improvement in underlying manufacturing production trends at this point. As an aside, since this is Fed generated data, the Chairman would have been aware of these weak data at yesterday's policy meeting."

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