Market Overview 08/31/07

5:00 PM EDT :

Treasuries took moderate losses today as stocks finished the month with a rally. In late trading, the 10-Year Treasury Note was down by 6/32, raising its yield to 4.53%; the Dow was up by 119.01 points to 13,357.74; and the Nasdaq was up by 31.06 points to 2,596.36.

News that the administration is addressing the problems of rising mortgage delinquencies and foreclosures with a new FHA refinancing program helped ease credit and liquidity concerns and blocked some of the safe haven flow toward Treasuries. This theme was underscored when Fed chief Ben Bernanke said "The Federal Reserve stands ready to take additional actions [besides recent short-term injections of cash into the monetary system and the cut to the discount rate] as needed to provide liquidity and promote the orderly functioning of markets."

Much of the economic data released today also favored stocks. Personal income and spending rose more than expected last month. Factory orders were also up more than predicted in July. The Chicago PMI indicated a stronger expansion of manufacturing activity in the region than observers were expecting. And the Consumer Sentiment Index edged up slightly in the latter part of August, though it was still much more pessimistic than July's final index reading.

Aside from the economic data and credit situation, the markets were reacting to end-of-month, pre-Labor Day position squaring. The progress in the stock market came despite a rise in oil futures. High energy prices often dampen stock trader sentiment since they act as a brake on the economy. A barrel of light, sweet crude oil for October delivery rose by $0.68 on the New York Mercantile Exchange to settle at $74.04. This was the highest close for a front-month contract since August 3. But for the month, the price fell by $4.17 from the record high close of $78.21 on July 31.

By the end of stock trading, the Dow was up by 0.90%, the S&P 500 by 1.12%, and the Nasdaq by 1.21%. For the week, the Dow edged down by 0.16% and the S&P 500 by 0.36%. The Nasdaq gained 0.76% since last Friday's close. For the month, all three indices made progress with the Dow gaining 1.10%; the S&P 500, 1.29%; and the Nasdaq, 1.97%. And despite today's losses in the bond market, the benchmark 10-Year Treasury Note yield fell by 9 basis points this week (yield moves inversely to price). For the month, the yield fell by 21 basis points. It fell by 29 basis points in July.

Next week's economic calendar contains the two, early-month heavyweights: the national manufacturing index and the employment report. Following the three-day weekend, traders will be facing the manufacturing release on Tuesday. In last month's release, the Institute for Supply Management (ISM) reported that its index came in at 53.8 in July. This was down from June's reading of 56.0. Any reading over 50.0 indicates a general expansion of activity relative to the preceding month and July's represented a sixth consecutive monthly expansion.

The index trended down from late October of 2005 to the beginning of this year, posting slight contraction readings last November and then again in January -- the first since May of 2003. But the sector has been recovering and June's reading was the strongest in fourteen months. But July's was the weakest in four months and for August, the index is predicted to have slipped once again to about 53.0.

Another important item in the manufacturing data is the price index, a measure of inflation in the sector. July's price index of 65.0 was welcomed by observers. Though it still indicated a solid increase in prices, it was the weakest expansion indicator in five months.

Also out on Tuesday is the report on construction spending for July. In the last report, the Commerce Department said the seasonally adjusted, annualized pace of spending fell by 0.3% in June following four consecutive increases. But spending in the residential sector continued to slide. The rate fell by 0.7% in June, a thirteenth consecutive contraction. Given the state of new home construction, permit issuance, and sales, the weakness in the residential spending pace came as no surprise. Another decline in the residential sector is forecast for July. The overall construction spending rate is expected to have been flat (0.0%).

On Wednesday afternoon, the Federal Reserve will release its latest edition of its Beige Book. The Beige Book, so named for the color of the hard copy cover) is an anecdotal summary of economic conditions in the twelve Fed regions and the monetary policy committee uses it as one of its background resources during its policy deliberations. The next committee meeting is September 18.

Though the summary is often overlooked because other reports have already sketched out the economic situation, Wednesday's release will get added attention for what it says about the recent changes in the credit market. Though the last regular policy meeting on the 7th ended with no change in interest rates or policy position, a liquidity crunch caused by a nosedive in demand for certain mortgage-backed securities forced the Fed to inject additional short-term reserves into the monetary system and cut the discount rate (the rate changed to banks for loans directly from the Fed).

(Note: the ISM Services Index, originally reported here that it would be released on Wednesday, will actually be released on Thursday.)

On Thursday, the jobless claims report may also get additional attention because it heralds the approach of Friday's employment report. The data collection periods for the two reports do not coincide (the employment information for the month was collected before this week's jobless claims were made). But the trend in claims can provide insight on the state of the labor market and the latest trend has been bearish. In yesterday's report, the Labor Department said that the seasonally adjusted level of initial claims for state unemployment benefits rose last week by 9,000 to 334,000. The unexpected increase was the largest since the week ending June 16 and the level was the highest since the week ending April 14. The four-week moving average, which smoothes out some of the short-term volatility, rose by 6,250 to 324,500, the highest reading since the week ending April 28. The average weekly reading for the year to date is 318,118.

Continuing claims for the week ending August 18 (continuing claims must be at least a week old) rose by 13,000 to 2.579 million, the highest level since the week ending April 14. The four-week average rose by 11,250 to 2.561 million, its highest level since the week ending January 14. The average weekly reading for the year so far is 2,525,545.

While the claims data still indicate that hiring continues to exceed layoffs, the rising claims levels point to a diminishing gap between the two processes.

The revised report on productivity for the second quarter also comes out on Thursday. The preliminary report, released on the 7th, said the seasonally adjusted, annualized rate of nonfarm business productivity (output per hour) rose in the second quarter by 1.8% following a 0.7% rise in the first quarter. The average cost per hourly unit of output -- or unit labor costs (ULC) -- rose by 2.1% in the second quarter according to the preliminary report. This was a deceleration from a 3.0% rise in the first quarter.

The upward revision to gross domestic product growth in the second quarter from 3.4% to 4.0% suggests that the initial productivity estimate will also be revised higher. Analysts are looking for a 2.3% gain in Thursday's release. Strong productivity usually eases labor costs, reducing inflation pressures and giving the Fed more leeway to cut interest rates. This is good for both stocks and bonds. High productivity is additionally beneficial for stocks since it reflects greater efficiency and suggests improved corporate earnings. The preliminary ULC number is expected to have been trimmed in the final report to about 1.7%.

Also on Thursday, the ISM will release its index data on the non-manufacturing, or services, sector of the economy. Though the services sector is much larger than the manufacturing sector, the data series does not carry the same clout as the manufacturing data. One reason is the very size of the services sector. It is so large that extremes offset one-another and broad-based changes are necessary to make a significant impact on the overall index. Another reason the services data is less market moving than the manufacturing information is that the services data series is relatively young (begun in 1997 vs. 1948 for the manufacturing series).

July's index came in at 55.8. As is the case with the manufacturing index, any reading over 50.0 indicates general growth and July's reading represented a fifty-second consecutive monthly expansion. However, this was down from June's fourteen-month high of 60.7. The drop was the largest since September of 2005. The index for August is expected to show another slip to about 54.5.

The main event on Friday is the release of the employment report for August. Forecast misses are frequent and have been known to roil the markets so traders have learned to exercise caution ahead of the monthly releases. July's report was weaker than expected. The Labor Department said that the seasonally adjusted level of nonfarm payrolls rose by just 92,000, the smallest increase in five months and the second smallest increase since November of 2004. Moreover, June's originally reported rise of 132,000 was revised down by 6,000 to 126,000.

The report said that the unemployment rate, the portion of the active workforce without jobs, edged up to 4.6% in July from June's rate of 4.5%. The increase was the first since April and the rate was the highest since January. Nevertheless, it is still considered low by historical standards.

For August, forecasters are predicting a payroll increase of about 120,000. The unemployment rate is expected to have remained at 4.6% or to have edged up to 4.7%. A 4.7% reading would be the highest in the last twelve months.

The final economic news scheduled for next week is the report on wholesale inventories and it is likely to be overshadowed by the jobs report. For one thing, the wholesale sector is only one component of the inventory picture. A report on business inventories -- which includes data from the manufacturing, wholesale, and retail sectors -- will be released on the 14th. For another thing, the information is somewhat dated as Friday's report is for the month of July.

Wholesale inventory growth has been relatively steady this year so far. The average monthly change has been an increase of 0.4%. Inventories were up by 0.5% in both May and June and an increase of 0.4% or 0.5% is predicted for July. Sales have been strong, averaging 0.9% increases in the first six months of the year. They were up by 0.6% in June following a 1.3% rise in May.

The combination of inventory and sales changes has kept inventories at extremely lean levels. The inventory-to-sales (I/S) ratio was a record low 1.11 in both May and June. The I/S ratio is the value of remaining inventory divided by the value of sales for the month. The result indicates how many months it would take to entirely deplete stocks on hand. A low ratio indicates strong pressure to replenish supplies. Even if sales were soft in July, the I/S ratio would only be marginally affected.

10:30 AM EDT :

Treasuries are down this morning and stocks are up as the flight to the government backed sector is waning on talk of bailing out mortgagors caught between rising payments and falling home values. News reports this morning say President Bush will be recommending a set of initiatives today aimed at addressing the mortgage situation. The development lends some support to securities backed by mortgages and the complex structure of financial relationships into which such securities are intermixed.

This news was followed up by a speech this morning by Federal Reserve Board Chairman, Ben Bernanke. In his keynote address at a central bank symposium at Jackson Hole, Wyoming, he spoke on "Housing, Housing Finance and Monetary Policy." His discourse outlined the development of the U.S. housing industry and its impact on the economy. Of particular note are his comments on the Fed's recent actions and their relationship to the current housing / mortgage situation.

Some critics have said that the Fed has no business bailing out financial market participants. Mr. Bernanke responded in his address this way, "It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy."

With regard to upcoming Fed decisions on monetary policy, Mr. Bernanke said, "economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as
needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets."
(BERNANKE ADDRESS)

The economic data released today was also unfavorable to bonds; that is, it was more bullish than anticipated, which lessens pressure on the Fed to cut interest rates. In the first release of the day, the Commerce Department said that personal income, the fuel for consumer spending, rose in July by 0.5%, the largest increase since March. Personal consumption expenditures (PCE or consumer spending) rose by 0.4%, up from a 0.2% increase in June (originally reported as 0.1%). While the gains were a bit higher than analysts had predicted, both readings were right in line with the monthly averages of the previous twelve months.

Later, in a separate report, the Commerce Department said that the seasonally adjusted level of factory orders rose in July by 3.7%. The rise was the largest in four months and June's originally reported increase of 0.6% was revised up to 1.0%. Analysts had predicted an increase of between 3.0% and 3.5% due to last week's reported increase of 5.9% in durable goods orders. In today's report, the increase in the durables category was revised up to 6.0%. Nondurable goods orders rose by 1.3%.

The volatile transportation sector was a large contributor to the overall gain. Orders there were up by 11.0%. But even excluding the category, orders rose last month by 2.4% following a 0.4% ex-transportation decline in June. Another significant category orders excluding those in the defense sector because defense needs are not governed by standard market forces. While defense orders soared by 31.5% in July, the biggest jump since last November, orders outside the category still increased by 3.2%. And even if commercial aircraft orders are further excluded from the ex-defense category, orders were still up by 2.7%.

Interested observers also look at the category of ex-defense capital goods minus aircraft since it provides a gauge of core business demand on the manufacturing process. Orders there rose by 1.7% last month following a 0.2% decline in June and a 1.5% decline in May.

In other news, the Chicago branch of the National Association of Purchasing Management (now known nationally as the Institute for Supply Management) released its index figures on the highly-industrialized region's manufacturing activity for August. The overall index came in at 53.8, up from July's reading of 53.4. Any reading over 50.0 reflects a general increase of activity relative to the preceding month and August's index indicated a stronger expansion than the 53.0 that analysts had predicted. The national index for August will be released next Tuesday.

The last economic release of the day was somewhat anticlimactic. According to news sources, the final Consumer Sentiment Index reading for the month from the University of Michigan came in at 83.4, up slightly from the preliminary reading of 83.3. Despite the nominal increase, the index was still down sharply from July's final reading of 90.4. In fact, it was the lowest reading since the final reading in August of 2006. The expectations index slipped in the last half of the month to 73.7 from the preliminary 74.1 and July's final reading of 81.5. But the index of present conditions edged up to 98.7 from 97.7. This was still well
below July's final reading of 104.5.

There are a lot of market influences at play this morning so price movements are likely to be erratic. It is the last day of August so any remaining close-out activity for the month has to happen today. Trading volumes will be light as a number of market participants are already on the sidelines and many who are not will be attempting to get there as soon as possible in order to extend the last holiday weekend of the summer. Most bond trading will close at 2:00 PM Eastern Time instead of 3:00 on the recommendation of the Securities Industry and Financial Markets Association.

Market Overview August 24, 2007

5:00 PM EDT :

The 10- and 30-year Treasury securities made gains today as the shorter end of the maturity spectrum took losses. Stock rallied. In late trading, the 10-Year Treasury Note was up by 6/32, lowering its yield to 4.62%; the Dow was up by 142.99 points to 13,378.87; and the Nasdaq was up by 34.99 points to 2,576.69.

Today's economic news was surprisingly bullish. The level of durable goods orders jumped in July by the largest percentage amount in ten months and the key subcategories indicated that the gains were broad-based. And the report on new home sales for last month revealed a modest bounce in July though analysts had been looking for another decline to a new seven-year low.

The news helped lift stocks. Market sentiment has improved this week on generally easing concerns regarding the credit / liquidity issue. The Federal Reserve made no further cash injections into the monetary system today and this was seen as a positive sign; that is, reserve levels apparently seemed adequate to the Fed. Today's stock gains came even though oil prices moved up for a second day. The price of a barrel of light, sweet crude rose by $1.26 on the New York Mercantile Exchange to settle at $71.09. This was the largest one-day jump since July 31.

But by the end of stock trading, the Dow was up by 1.08%, the S&P 500 by 1.15%, and the Nasdaq by 1.38%. All three made solid gains on the week as well with the Dow gaining 2.29%; the S&P 500, 2.31%; and the Nasdaq, 2.86%.

The action in the bond market was at least partly attributable to position-squaring following the recent run-up in the yield curve. In the first two days of the week, investors made a massive shift out of short-term corporate debt and into Treasuries, sending short maturity Treasury yield sharply lower. On Tuesday, the closing spread between the 2-Year and 10-Year Treasury Note was 57 basis points, the largest gap since May 5, 2005. With losses at the short end of the market since then, today's gap is just 33 basis points. Nevertheless, yields at the short end are still sharply lower than they were in the beginning of the month.

Longer termed Treasuries made progress on the week with the yield of the 10-Year Note falling by 6 basis points. This follows a 13 basis point decline last week (yield moves inversely to price). And with the exception of last Tuesday's closing yield of 4.59%, today's was the lowest since March 28.

Next week’s economic calendar is much heavier than this week’s. Moreover, supply is an issue as there will be two Treasury auctions bringing an estimated $31 billion in new notes to market. The week is also the last of the month and is the time when portfolio managers rebalance their holdings on the basis of such characteristics as risk, yield, and return horizon. The process often entails the purchase of Treasuries though recent heavy buying may dampen the need for more purchases. And the week precedes a three-day weekend (Labor Day). Historically, trading volumes are thin in the last week of August as it is traditionally seen as the tail end of vacation season.

The first economic news comes on Monday in the report on existing home sales for last month. In June’s report, the National Association of Realtors said the seasonally adjusted, annualized rate of existing home sales fell by 3.8% from 5.98 million to 5.75 million. This was a fourth consecutive monthly decline and the pace was the lowest pace since March of 2003.

The report said that inventories of homes on the market fell by 4.2% in June, the first decline since December. But due to the slowdown in sales pace, the inventory represented 8.8 months of sales, matching May’s turnover rate.

Despite the decline in sales, home prices rose. The average price jumped by 6.1% to $276,700 and the median price by 7.4% to $230,100. This was the fifth consecutive monthly increase in both categories and the largest in two years. The average was a record high and the median the highest in eleven months. On a year-over-year basis, both categories were up by 0.3%, the first Y/Y gains since July of 2006.

Forecasts for July’s report call for another decline in the sales pace to about 5.70 million. This would be the lowest reading since November of 2002. But as today’s report on new home sales illustrated, monthly housing data can be relatively volatile since it can be affected by such variables as regional weather, economic, and demographic changes.

On Tuesday, the Conference Board, an independent research firm, will release its Consumer Confidence Index for the month. July’s index was 112.6, up from June’s 105.3 and the strongest indicator of consumer optimism since August of 2001. The healthy job market, falling gasoline prices, and high stock prices are presumed to be factors contributing to the jump in confidence. The expectations index rose to a seven-month high of 94.8 from 88.8 and the index of current conditions rose to 139.2 from 129.9. The current conditions index, like the overall reading, was the highest since August 2001.

For August, the index is expected to have fallen back to between 105.0 and 105.5.

On Tuesday afternoon, the Federal Reserve will release the minutes of its August 7th meeting of the Federal Open Market Committee (FOMC), the Fed’s monetary policy arm. While the meeting ended with no rate or policy position change, the meeting statement did acknowledge tighter credit conditions and the volatile financial markets. In addition, recent comments by board chairman, Ben Bernanke, have underscored the Fed’s concern with the health of the housing market and its influence on the general economy along with the problems with subprime mortgage products and their effect on the financial markets.

While the minutes of the last meeting might provide some clarification of these issues, they will probably not have a deep impact on observers since the credit situation has subsequently deteriorated.

Two weeks ago, Parabis, the largest bank in France, froze three of its hedge funds because they could not be adequately valued due to their U.S. mortgage-backed components. The incident roused liquidity concerns that spurred the European Central Bank to inject huge amounts of cash into its monetary system. Other central banks, including the Federal Reserve, followed suit and continue to stand ready to make additional, short-term monetary infusions.

Last Friday, in another measure to address the situation, the FOMC cut the discount rate—the interest rate charged to banks for loans directly from the Fed. Now, most Fed watchers feel that the FOMC will lower the fed funds rate at the next policy meeting slated for September 18. Some even feel that a cut may be made before then. The fed funds rate is the rate banks charge each other for overnight loans necessitated by daily reserve requirements. While the rate is determined by the borrowing activity, the Federal Reserve sets a target level and adjusts reserves to keep the actual borrowing rate near the target rate. The adjustment is made by injecting funds into or withdrawing funds from the monetary system by selling or buying securities (usually Treasuries or agency debt).

There are no major economic releases scheduled for Wednesday but there are a couple of minor weekly releases that could have an effect on the markets. These are the Mortgage Bankers Association of America’s report on mortgage application activity for this week and the weekly report from the Energy Department on oil inventories.

The bond market may feel some pressure from new supply on Wednesday as the Treasury will be conducting its monthly auction of 2-Year Notes. The arrival of new supply usually keeps bond prices down until the market has a chance to begin digesting the inventory. Traders who will be making bids refrain from pushing prices up prior to an auction in order to keep yields up (bids are for yield—the higher, the better for the auction participants). Other traders also avoid purchasing the soon-to-be off-the-run issue since the new one will have greater liquidity. They also assume a wait-and-see posture until the results of the sale are known.

Last month’s 2-Year Note auction drew lukewarm participation. Bids exceeded the $18 billion offer amount by 2.59 to 1, down from the 2.80 bid-to-cover ratio in June’s auction and from the average of 2.72 for the twelve auctions preceding July’s. Non-competitive bids, a gauge of individual investor demand, totaled $698 million, the lowest amount for a 2-Year issue since November of 2003. This represented 3.9% of the issue, matching April’s, but the twelve-month average was 4.5%.

Foreign demand was unimpressive. Indirect competitive bids, which include those from foreign central banks, garnered 27.4% of the issue. This was the same award percentage as in June’s auction but it was below the twelve-month average of 33.2%.

Wednesday’s issue is expected to have a face value of $18 billion, the same as in the last six offerings. The deadline for competitive bids is 1:00 Eastern Time.

On Thursday, the initial jobless claims report will focus attention on the employment situation once again. Yesterday’s report did not provide much insight. It said the seasonally adjusted level of initial claims for state unemployment benefits fell by 2,000 last week to 322,000. But the previous week’s originally reported figure of 322,000 was revised up to 324,000. The four-week moving average, which smoothes out some of the short-term volatility, rose by 4,750 to 317,750. The weekly average for the year to date is 317,576.

The initial claims data continue to suggest that hiring is outpacing layoffs, resulting in growing payrolls. But the level of continuing claims is continuing to creep higher. The report said that the level of continuing claims for the week ending August 11 (continuing claims must be at least a week old) rose by 16,000 to 2.572 million, the highest reading in four months. The four-week average was up by 7,750 to 2.553 million, the second highest reading in five months. The weekly average for the year to date is 2.524 million.

Also out on Thursday is the preliminary report on gross domestic product (GDP) for the second quarter. GDP is the market value of all final goods and services produced by labor or property in the country in a year’s time. Quarterly data is adjusted and annualized and changes from quarter to quarter indicate the strength and direction of the economy.

The advance report, released on August 30, said that GDP grew in the second quarter by 3.4%, the largest increase since the first quarter of 2006. But revisions going back to the beginning of 2004 resulted in eleven of the thirteen quarters being revised down. The average quarterly revision to the growth figures over that time span was a reduction of 0.3%. The originally reported final reading for the first quarter of 2007 was trimmed from 0.7% to 0.6%, the smallest increase since the fourth quarter of 2002.

The inflation signals in the advance report were mixed but a key indicator was particularly encouraging. The overall price index rose by 2.7% following a 4.2% increase in the first quarter but the price index for personal consumption expenditures (consumer spending) was up by 4.3% following a 3.5% rise. However, the chief contributor to the PCE price index growth was a jump in energy prices. Excluding the volatile categories of food and energy, prices were up by just 1.4% following a 2.4% increase in the first quarter. This was the smallest increase since the second quarter of 2003.

Earlier this month, the Commerce Department reported a much smaller trade deficit in June than had been predicted. In addition, May’s originally reported deficit was also revised down. The lower deficit numbers constitute a positive contribution to GDP. The latest retail sales report also indicated revisions in previously reported data that brightens the second quarter growth picture. Projections for Thursday’s report now call for a growth reading of about 4.0%.

More supply comes to market on Thursday in the monthly 5-Year Note auction. Last month’s was less than successful. The bid-to-cover ratio for the $13 billion offer was 2.15, down from June’s 2.73 and the twelve-month average of 2.45. Non-competitive bids totaled $122 million, down from $187 million in June’s auction and below the twelve-month average of $157 million. And foreign demand was weak. Indirect competitive bids garnered 19.7% of the issue, down from June’s award portion of 32.3% and below the twelve-month average of 30.5%. Thursday’s offer size is expected to be $13 billion, matching the last eight issues.

On Friday, the first release is the report on personal income and spending for last month. In June’s report, the Commerce Department said that personal income, the fuel for consumer spending, rose by 0.4%, matching the increase in May. Personal consumption expenditures (PCE or consumer spending) rose by just 0.1%. This was the smallest increase since a 0.1% decline last September, though May’s originally reported rise of 0.5% was revised to a gain of 0.6%.

The retail sales report for July indicated an increase of 0.3% following a decline the month before of 0.7%. This suggests that the PCE figure in next week’s report will show a stronger gain. Forecasts are calling for a 0.4% increase. Personal income is expected to have risen by 0.3%.

The next major release on Friday is the report on factory orders for July. In the last report, the Commerce Department said the seasonally adjusted value of new orders rose by 0.6% in June following a 0.5% decline in May. The increase was the largest since March though observers were expecting a stronger gain. The report said that durable goods orders rose by 1.3% (revised in today’s report to 1.9%) and that nondurable goods orders fell by 0.1%. Excluding transportation, orders were down by 0.5%. Excluding those in the defense sector, orders were up by 0.9% but if commercial aircraft orders were further excluded, orders were down by 0.9%. Ex-defense orders for capital goods minus commercial aircraft, a proxy for core business demand, were flat (0.0%) in June after a 1.5% decline in May.

Recent forecasts were calling for a 0.9% increase in factory orders in July but the much stronger than expected durables report suggests that the gain will be significantly stronger. A better estimate would be between 3.0% and 3.5%.

Also on Friday, the Chicago branch of the National Association of Purchasing Management (now known nationally as the Institute for Supply Management) will release its index figures on the region's manufacturing activity for August. July's release said the organization's Purchasing Managers Index came in at 53.4, down from June's 60.2. Any reading over 50.0 reflects a general increase of activity relative to the preceding month but July’s index was much lower than the 59.0 forecasters had predicted. Little change is anticipated in August's index reading.

The final release of the week is the final read on consumer sentiment according to the survey data compiled by the University of Michigan. In the preliminary reading, released last Friday, the overall index was 83.3, down from July's final reading of 90.4 and the lowest reading since last August. Analysts are predicting a slight improvement in the final reading to about 84.0 but this would still be the lowest final reading in twelve months.

10:30 AM EDT :

Despite stronger than expected economic data released this morning, Treasuries are holding up relatively well with the long end of the market in positive territory. Bullish data often hurts bonds since it diminishes the case for a Fed rate cut. The stock market has also failed to get a significant boost from the news and the indices are currently narrowly mixed.

In the first release of the day, the Commerce Department said that the seasonally adjusted level of durable goods rose by 5.9% in July, a much stronger jump than the 1.0% that analysts had predicted. It was the largest gain since last September. Moreover, June's last reported increase of 1.5% was revised to a gain of 1.9%.

Durable goods are defined as items meant to last three years or more. They are usually labor-intensive to produce, expensive, and therefore often financed. Because of this, the trend in orders provides some insight regarding upcoming production activity and the effect interest rates may be having on the process.

A volatile category is transportation and it saw a gain of 10.8% in July. Within the category, motor vehicle orders were up by 9.8% and orders for commercial aircraft were up by 12.6%. But even excluding transportation, orders were up by 3.7%, the largest gain since August of 2005.

Another category that can skew the overall picture is defense since orders there are not governed by standard market forces. Defense orders were up by 30.3% but excluding the category, orders were still up by 4.9%. Further excluding commercial aircraft from the ex-defense figures showed a gain in orders of 4.1% last month, the biggest jump since March of 2004.

And another closely watched category is ex-defense capital goods minus commercial aircraft. This category is seen as a proxy for core business demand on the production process. It saw an increase of 2.2% in July, the first increase in three months and the largest increase in four.

Later, in a separate report, the Commerce Department said that the seasonally adjusted, annualized pace of new home sales rose last month by 2.8% to 870,000, up from an upwardly revised 846,000 pace in June (originally reported as 834,000. The increases came as a surprise to analysts, who were predicting a decline in July to 820,000.

The increase was not geographically broad-based as the pace fell in the Northeast by 24.3% and in the Midwest by 0.9%. But in the larger contributing regions, the rate increased. The South saw a rise of just 0.6% but the West saw a spike of 22.4%, its largest increase since March of last year.

The report said that the inventory of homes on the market fell by 0.9% to 533,000. This was the fourth consecutive monthly decrease and the lowest level since January of last year. Combined with the increased sales pace, this inventory represented 7.5 months worth of sales, down from 7.7 months worth of inventory at the end of June.

The report said the average new home price fell to $300,800 from June's $304,900 but the median price rose to $239,500 from $230,600. The average price was down by 3.4% on a year-over-year basis and the median price was up by 0.6%.

This morning's data may still provide some traction for stocks and bond traders may begin to exercise some caution ahead of next week's heavier news calendar and new supply headed to market.

A Hopeful Housing Market Sign

Source: U.S. Census Bureau

Initial Jobless Claims in Sideward Trend But Continuing Claims Creeping Higher

Source: U.S. Department of Labor

Market Overview August 17, 2007

The Fed cut to the discount rate spurred a rally in stocks today, which put some pressure on the bond market. But short-term maturities also found some support from the Fed news while the long end of the market pared earlier losses for a mixed close. In late trading, the 10-Year Treasury Note was down by 6/32, raising its yield to 4.68%; the Dow was up by 233.30 points to 13,079.08; and the Nasdaq was up by 53.96 points to 2,505.03.

The Fed action eased jitters that liquidity problems stemming from the effects of declining values of certain types of debt securities would cripple the economy and financial markets. It also raised expectations that more-enduring fed funds rate cuts may be forthcoming. But the news caught the markets off-guard and stocks soared in early trading as investors who were betting on further losses had to liquidate their short positions.

The stock indices eased back somewhat following the morning scramble then basically maintained a holding pattern until a late session bump higher. The economic news of the day was largely overlooked. The first of two consumer sentiment indices to be released this month indicated a larger erosion of optimism since the end of last month than had been forecast, but the recent turmoil in the stock market suggested that this might be the case.

Stocks were also not hindered by a rise in oil futures today. A barrel of light, sweet crude oil for next month delivery rose by $0.98 on the New York Mercantile Exchange to settle at $71.98. By the end of stock trading, the Dow had gained 1.82% on the day; the Nasdaq, 2.20%; and the S&P 500, 2.46%. All three were lower for the week, however, with the Dow losing 1.21% and the Nasdaq, 1.57%. The S&P 500 fared better with a loss for the week of only 0.53%. The Dow is down by 6.6% from its record closing high of 14,000.41 posted on July 19. The S&P 500 is down by 6.9% from its record high of July 19. And the Nasdaq is down by 7.9% from its six-and-a-half year closing high, also set on July 19.

The yield of the benchmark 10-Year Treasury Note closed only 1 basis point higher than yesterday for its second lowest close since May 10 (yield moves inversely to price). On the week, the yield fell by 14 basis points after a 13 bp rise last week.

Next week, the economic calendar is extremely light so volatility is apt to remain high as the markets may be buffeted by additional news items regarding the credit situation. On Monday, the only scheduled release is the Index of Leading Economic Indicators for last month. In the last release, the Conference Board, an independent research firm, said the index fell in June by 0.3%, the fourth decline of the year to date and the largest since February.

The decline surprised analyst who were expecting a slight increase. Moreover, the originally reported 0.3% rise in May was revised to 0.2%. The heaviest pressures on the index in June came from a decline in building permit issuance, an increase in jobless claims, and a decline in consumer expectations (the Consumer Confidence Index is compiled by the Conference Board).

Although the rate of building permit issuance continued to decline in July, the average level of initial jobless claims declined, and the consumer expectations index rose to its highest level in seven months. The sharp drop in stocks constitutes a negative influence on the index, but analyst still believe that it will show a rebound of about 0.3% from June's reading.

There are no major economic indicators scheduled until Thursday so Wednesday's minor releases may get more than their usual share of attention. These are the Mortgage Bankers Association of America's report on mortgage application activity for this week and the weekly report from the Energy Department on oil inventories.

The only release on Thursday is the jobless claims report. Yesterday's said that the seasonally adjusted level of initial claims for state unemployment benefits rose by 6,000 last week to 322,000, the highest reading since the week ending June 16. This is slightly above the weekly average for the year to date of 317,375. The report said continuing claims for the week ending August 4 (continuing claims must be at least a week old) rose by 17,000 to 2.567 million. The four-week average rose by 1,000 to 2.548 million, in-line with the weekly average for the year so far of 2.523 million.

Despite the recent elevations, the data still suggest that hiring is outpacing layoffs and adding to nonfarm payrolls. In addition, following three weeks of increases, a slight decline in this week's initial claims level would not be too much of a surprise in next Thursday's release.

The heaviest news day next week is Friday with two releases. The first is the report on durable goods orders for July. Durable goods are defined as items meant to last three years or more. They are usually labor-intensive to produce, expensive, and therefore often financed. Because of this, the trend in orders provides some insight regarding upcoming production activity and the effect interest rates may be having on the process.

In the report for June, the Commerce Department said the seasonally adjusted value of new orders for durable goods rose by 1.4% June following a 2.3% decline in May. June's increase was revised to 1.3% and May's decline was revised to 2.4% in the subsequent release of the factory orders report. The gain came from a strong jump in the volatile category of transportation, and specifically in the category of orders for commercial aircraft. Excluding transportation, orders were down by 1.0% following a 0.3% decline in May (these and the figures cited below are from the revised data which came out after the last durables report).

Another category that is closely watched is orders excluding those from the defense sector since defense orders are not governed by standard market forces. Defense orders fell by 6.8%, leaving ex-defense orders with a gain of 1.8%. But further excluding the commercial aircraft component, orders were down by 0.3% in June.

The category of ex-defense capital goods minus aircraft is also highly-regarded since it provides some insight on core business demand. Orders were flat (0.0%) in June following a 1.5% decline in May.

For July, durable goods orders are expected to have increased again by about 1.0%.

The last major economic release of the week is the report on new home sales for last month. In June, the seasonally adjusted, annualized pace of new home sales fell by 6.6% to 834,000, the second lowest reading since December of 1997 (March's pace was 830,000). The decline was the fifth in the first six months of the year and the largest since January. Moreover, May's originally reported pace of 915,000 was revised down to 893,000 and April's 930,000 was revised down to 913,000.

Inventory of new homes on the market edged up by 0.2% to 537,000. At sales pace prevailing in June, this represented 7.8 months worth of supply, up from May's 7.4 month turnover rate. The average home price rose by $5,400 to $316,200 but the median price fell by $3,100 to $237,900. On a year-over-year basis, the average price was up by 3.7% but the median price was down by 2.2%.

Most forecasts call for little change in the overall rate of home sales in July but another decline is a clear possibility.

Fed Makes Temporary Cut to Discount Rate

The Federal Reserve temporarily cut the discount rate by 0.50% today from 6.25% to 5.75%. The discount rate is the interest rate banks must pay for loans directly from the Fed. The central bank's target for the fed funds rate, the rate charged between banks for overnight loans, was left unchanged at 5.25%.

The fed funds rate is actually determined by the needs of the banks which are required to maintain a certain level of reserves on a daily basis. But the Federal Reserve adjusts the level to keep it near the target rate by injecting or withdrawing funds in the monetary system by selling or buying securities (usually Treasuries or agency debt).
(Federal Open Market Operations)

It should be noted that recent short-term injections of cash by the Fed into the banking system have reduced the cost of borrowing money for the time being. Yesterday's effective fed funds rate was 4.90%. In addition to the cut in the discount rate, the Fed made another short-term cash injection of $6 billion this morning.
(DISCOUNT RATE STATEMENT)

Continuing Weakness in Housing Starts

Source: U.S. Census Bureau

Credit Tightening Weighing On Builder Confidence In August

Encouraging Inflation News

The year-over-year trend in the core Consumer Price Index, which excludes the volatile categories of food and energy, has moderated since hitting a ten-and-a-half year high of 2.9% last September.

Source: Bureau of Labor Statistics

Sign of Underlying Inflation Pressures

The seasonally adjusted core (ex-food and energy) Producer Price Index rose by just 0.1% from June to July. But on a year over year basis, the unseasoned core index was up by 2.3%, the largest Y/Y margin since September of 2005.

Source: U.S. Department of Labor

Year-Over-Year Trend in Retail Sales

Year over year comparison (unseasoned data) still positive but rate of increase is trending lower.

Source: U.S. Census Bureau

Market Overview August 10, 2007

5:00 PM EDT :

Earlier today, Treasuries looked as if they were headed to another winning session but stocks finished in much better shape than one would have thought by their performance this morning. When the dust settled, Treasuries were in negative territory and the stock indices were mixed. In late trading, the 10-Year Treasury Note was down by 6/32, raising its yield to 4.80%; the Dow was down by 31.14 points to 13,239.54; and the Nasdaq was down by 11.60 points to 2,544.89.

Liquidity panic sent stocks sharply lower this morning after a huge sell-off yesterday. But the Federal Reserve pumped cash into the U.S. banking system three times today, bringing the amount total for the last two days to $62 billion. In that time the European Central Bank has injected the euro equivalent of $187.5 billion into its system. Other central banks, including those in Japan, Canada, and Australia also made monetary infusions to help maintain liquidity in their markets and the global financial network.

Stocks rebounded with all three major indices poking into positive territory at about 1:30 Eastern Time. Though they slipped back again, they were on the upswing at the end of the session and the S&P 500 even managed to eke out a nominal gain on the day.

Most of this week's economic releases have taken a back seat to the liquidity concerns and today's were no exception. The report on import and export prices revealed a strong rise in import prices last month but little change excluding the oil component. Export prices saw a modest rise but none if the agricultural sector is factored out.

The Treasury budget report may have provided some drag on bonds this afternoon. It indicated that outlays exceeded receipts last month by $36.3 billion. The deficit figure was higher than the $33.2 billion posted in July of last year and was higher than the $32.5 billion than had been predicted. Nevertheless, the running total for the fiscal year to date (begun last October) is a deficit of $157.3 billion, still the lowest for the same time periods in the last five fiscal years.

But the principal snag for bonds was the recovery is stocks. The Dow had been down by 212.82 points or 1.60% at its low of the day but finished the session with only a loss of 0.23%. The Nasdaq had been down by 2.09% but closed with a 0.45% loss. The S&P 500 had been down by 1.63% but closed with a gain of 0.04%. With all the attention on the losses in the last couple of days, it may surprise some that
all of the major indices made gains on the week. The Dow moved ahead by 57.63 points or 0.44%. The other indices did even better with the Nasdaq up by 1.34% and the S&P 500 up by 1.44%. Treasuries lost ground on the week with the yield of the benchmark 10-Year Note rising by 12 basis points (yield moves inversely to price). This was the first increase in five weeks.

Though it was probably not a major contributor to the move in stocks, oil futures declined today. A barrel of light, sweet crude oil for next month delivery fell by $0.12 on the New York Mercantile Exchange to settle at $71.47. This displaced yesterday's close as the lowest since July 3.

Next week's economic calendar is relatively heavy and the first item on Monday is a major release. The Commerce Department will be issuing its report on retail sales for last month. June's report said that the seasonally adjusted level of sales fell by 0.9%, the largest contraction since August of 2005. A large contributor was the auto sector where sales declined by 2.9%, the largest drop in sixteen months. But even excluding the sector, sales were down by 0.4%, the largest decline since last September.

Another volatile category for obvious reasons is sales at gasoline stations. The category saw a decline of 1.1% in June, the first drop since last October. Yet, excluding the auto and gas station components, sales fell by 0.3% in June -- the largest drop since April of 2004.

Other sectors showing the largest weakness were home-related. Sales at furniture and home furnishings stores fell by 3.0% and sales at building material and garden equipment and supplies dealers fell by 2.3%. Both declines were the largest since February of 2003.

A rebound is anticipated for July's sales. The overall increase is expected to be around 0.5% and the ex-auto increase, around 0.4%.

Also on Monday is the report on business inventories for June. May's report indicated a 0.5% rise, the largest since last August. A rise in inventories is often a positive economic indicator since it can reflect preparation for increased demand. This was confirmed in May's report by the fact that the level of inventory outflows rose more than the rise in inventories. Overall sales were up by 1.3%, leaving the inventory-to-sales (I/S) ratio at 1.26, down from April's 1.27 and only slightly higher than the record low of 1.25. The I/S ratio is the value of remaining inventory divided by the value of sales for the month. The result indicates how many months it would take to entirely deplete the stocks on hand at the prevailing sales pace. A low ratio means that inventories are lean and pressure is high on the production process.

Current forecasts call for an inventory increase of about 0.4% in June but retail sales were soft that month and the last wholesale trade report indicated the smallest gain in sales in five months. Consequently, the I/S ratio may edge higher but still remain low by historical standards.

A key inflation indicator, the Producer Price Index (PPI) is slated for release on Tuesday morning. In June's release, the Labor Department reported that the PPI, a gauge of inflation at the wholesale level, fell by 0.2% following a rise in May of 0.9%. The decline was the first since January and surprised forecasters who had predicted a slight increase of 0.1% or 0.2%.

But the effect of the news was offset by a larger than predicted increase of 0.3% in the so-called core index, which factors out the volatile categories of food and energy. This was the largest rise in four months. Moreover, May's originally reported increase of 0.1% was revised slightly higher to 0.2%.

The report indicated that the price index for foods fell by 0.8% after a 0.2% decline in May. The energy index declined by 1.1% in June after a 4.1% rise. An encouraging sign was a weakening in price pressure further down the production pipeline. At the intermediate stage of production, the price index rose by 0.5%, the smallest rise since a decline in January. At the initial or crude stage of production, the price index was up by 0.3% following a 2.0% increase in May.

On a year-over-year basis, the PPI was up by 3.3% following a 4.1% Y/Y increase in May. But at the core level, the index was 1.8% higher than a year earlier, the largest Y/Y increase since a same-sized margin in February.

The index is expected to have increased in July by 0.5%. Although the energy component will likely be a large contributor to the jump, the core index is expected to have risen by 0.4%. This would be the largest core increase since February.

The other major release on Tuesday is the report on international trade for June. In the last report, the Commerce Department said the seasonally adjusted value of imports exceeded that of exports by $60.0 billion in May following a $58.7 billion deficit in April. The report said the value of imports rose by 2.3% to a record $192.1 billion while exports rose by 2.2% to a record $132.0 billion.

The deficit reading was right in line with predictions and while the deficit figures have been trending up since hitting an almost two-year low of $56.8 billion in January, May's figure was still down from last August's record high of $67.61 billion. A deficit of $61.0 billion is predicted for last month -- the price of imported oil playing a large role.

On Wednesday, an even more influential inflation indicator than the PPI will be released. This is the Consumer Price Index (CPI) which tracks changes in prices at the retail level. According to the Labor Department, the CPI rose by 0.2% in June following a spike of 0.7% in May. The gain was the smallest since January. Excluding the volatile categories of food and energy, the so-called core index also rose by 0.2%, as expected. The index for food prices rose by 0.5% while the index for energy fell by 0.5%. The decline in energy prices was reflected in a 0.2% decline in the transportation category. But the largest change came in the price index for apparel. It fell by 0.6%, the fourth consecutive monthly decline.

Unlike the PPI, July's CPI is expected to show no acceleration of growth with overall and core increases of 0.2%.

Another early release on Wednesday is the New York Fed's index on the region's manufacturing activity for the month. In July, the index was 26.46, up from 25.75 in June and the strongest reading in thirteen months. Any reading over 0.0 reflects a general increase in activity relative to the preceding month and July's index represented a twenty-sixth consecutive expansion. A twenty-seventh growth reading is anticipated for this month but the index is expected to be a little less forceful at 19.0.

A little later on Wednesday, the Federal Reserve will release its report on industrial production; a gauge of output from the nation's factories, mines, and utilities. The last report said output rose in June by 0.5% after a decline in May of 0.1%. Manufacturing output increased by 0.6%, the largest expansion in three months. Mining output rose by 0.5%, the largest increase in six months. Output from the highly-volatile utilities category rose by 0.3% following a 1.6% decline in May.

A disturbing feature of June's IP report was the level of capacity utilization, the ratio of output to potential output. It rose to 81.7%, the highest reading since last October. Moreover, the readings for the previous three months were revised higher: March's from 81.2% to 81.4%, April's from 81.5% to 81.6%, and May's from 81.3% to 81.4%. The Fed is concerned with the level of utilization since reduced slack in the production process, indicated by higher CU numbers, increase the possibility of bottlenecks that prevent demand from being met. The result is that the relative scarcity of output drives up prices.

For July, industrial production is expected to have increased by 0.4%. Capacity utilization is expected to have increased to a ten-month high of 81.8%.

On Thursday, the jobless claims report will be scrutinized for insights on the employment situation. In yesterday's report, the Labor Department said the seasonally adjusted level of initial claims for state unemployment benefits rose last week by 7,000 to a five-week high of 316,000 from an upwardly revised reading of 309,000 the week before (originally reported as 307,000). The four-week moving average, which smoothes out some of the short-term volatility, edged up by 1,750 to 307,750. Despite numerous swings, the trend has been steady for some time. The latest reading was in line with the average weekly reading for the year to date of 317,226. The average for all of 2006 was about 313,000. After two weeks of increases, the level of initial claims for this week is expected to have dropped off by about 5,000.

Yesterday's report said that the level of continuing claims for the week ending July 28 (continuing claims must be at least a week old) rose by 39,000 to 2.559 million. The four-week moving average rose by 2,000 to 2,545,750. The trend in continuing claims has been tilted slightly upward. The latest claims figure was up from the average weekly reading for the year to date of 2.521 million and from the average of 2.459 million for all of 2006.

The report on housing starts for last month also comes out on Thursday morning. In June's report the Commerce Department said that the seasonally adjusted, annualized pace of starts rose by 2.3% to 1.467 million. Despite the increase, the pace was still the third lowest in seven years. Moreover, May's rate was revised from 1.474 million to 1.434 million and April's pace from 1.506 million to 1.485 million. Another bearish detail was a 7.5% plunge in the rate of building permit issuance to 1.406 million (seasonally adjusted, annualized). The issuance figure was subsequently revised to a decline of 7.0% to 1.413 million. But the decline was still the second largest since September of 1999 and the rate was the lowest since June of 1997. The issuance rate is seen as an indicator of near-term start activity.

More bad news for the sector is forecast. The latest prediction for July's starts rate calls for a decline of 4.6% to 1.400 million. This would be the lowest pace since August of 1997. Another decline in the permit issuance rate is also predicted.

At noon on Thursday, the Philadelphia branch of the Federal Reserve will release its index on the region's manufacturing activity for the month. July's index reading was 9.2, well below June's 18.0 but, like the New York index, any reading over 0.0 reflects growth and July's Philadelphia reading was a seventh straight expansion indicator. For August, the index is expected to be about the same as July's.

The only other major release comes on Friday. This is the preliminary read on consumer sentiment for the month from the University of Michigan's twice-monthly surveys. The final sentiment index for July was 90.4, the highest reading in five months. Forecasters are calling for a less optimistic reading in next week's release of about 87.0. The ongoing gyrations in the stock market have undermined evaluations of personal wealth. The relatively small increase in nonfarm payrolls and rise in unemployment rate reported for last month may also have eroded comfort levels.

10:30 AM EDT :

The stock market is continuing its free-fall this morning with the Dow lately down by over 200 points following yesterday's nearly 400-point drop. Treasuries are benefiting by comparison but gains are still relatively mild as the Federal Reserve is once again pumping a temporary cash infusion into the monetary system to maintain liquidity.

The cause of the latest developments is increased fear that the decline in value of securities backed by poorly performing subprime mortgages will have a ripple-effect throughout the financial markets due to the complex of relationships among its various components. As each new instance of a subprime mortgage-related problem has arisen (for example, the losses sustained by Bear Stearns) the concern has intensified. Yesterday's news that the situation had affected France's largest bank was the latest and largest jolt to the markets so far.

In order to offset the reduction of liquidity caused by the reduced value of mortgage securities, the Fed has stepped up its open market operations, making short-term loans to banks. Today's loans (actually sale and repurchases through primary securities dealers) were made using mortgage backed securities as the sale (or collateral) component. The dealers will buy them back in a few days but in the meantime, the money that goes into the bank will increase their available reserves, thus reducing the effective overnight borrowing rate between banks (fed funds rate). It should be noted that the current effective fed funds rate is still higher than the 5.25% target rate set by the monetary policy committee.

If the measures being taken by the Fed ultimately fail to have the desired results, the next step would be a reduction in the central bank's target for the fed funds rate. Such a move would be the first rate cut since June of 2003.

In today's news, the Labor Department reported that its import price index rose by 1.5% in July. While this was higher than the 0.9% to 1.0% that had been predicted but a hefty increase was really no surprise given the rise in oil prices last month. According to the Energy Information Administration, the average spot price for Brent crude oil last month was a record high $76.93 per barrel, an 8.3% jump from June's $71.05. Today's report indicated that imported petroleum prices rose by 7.0% in July following a 4.4% increase the month before. Excluding this volatile category, prices were up by just 0.2%

The impact of the overall import price increase last month was also mitigated by the fact that June's originally reported increase of 1.0% was revised to 0.9% and May's increase of 1.1% was also trimmed to 0.9%. June's originally reported ex-oil increase of 0.2% was also cut to 0.1%.

Another hopeful sign regarding trade-related inflation is that spot prices of oil are declining (though it is obviously too early to say what the average for August will be). On July 31, the Brent crude spot price was $77.01 per barrel. Last Wednesday, it was $70.42.

Today's report said that the price index for exports rose by 0.2% after a 0.3% rise in June. Excluding the large but volatile category of agricultural products, the price index was flat (0.0%) following a 0.2% increase. The index for agricultural products rose by 1.5% in July following a 2.7% increase in June.

The final market-related new item of the week comes out this afternoon. At 2:00 PM Eastern Time, the Treasury will release its budget figures for last month. In July of last year, the value of government outlays exceeded receipts by $33.2 billion. A slightly smaller deficit of about $32.5 billion is predicted for last month.

This would bring the running total for the fiscal year to date (begun last October) to a deficit of $153.5 billion. While still a sizeable gap, it compares favorably to the $239.6 billion shortfall for the same period in the 2006 fiscal year. In fact, the total to date would be the smallest deficit for the same period since 2002 when it was $145.5 billion. The improved budget picture is a plus for Treasuries since it means fewer debt securities will have to be issued in the future to fund government operations and pay the debt on previously issued securities.

Results of Today's Fed Meeting

As expected, the Federal Reserve's monetary policy committee left interest rates alone today. The fed funds rate (overnight borrowing rate between banks) remains at 5.25% and the discount rate (rate for loans from the Fed) remains at 6.25%. The statement did acknowledge tighter credit conditions and the volatile financial markets but the prevailing view of the policy committee remains that the threat of inflation is the predominant concern. This means that the committee continues to tilt toward a tightening stance on rates or, at least, that the committee is not inclined to lower rates in the near future.
(FOMC STATEMENT)

The Fed is Not Going to Like This

The Labor Department released its report on productivity for the second quarter of 2007. The report included multi-year revisions which indicate a steeper trend in the growth of unit labor costs, the average cost per hour of output from nonfarm business workers.

OLD DATA:


NEW DATA

Source: Bureau of Labor Statistics

Market Overview August 3, 2007

5:00 PM EDT :

Treasuries rose today as developments in the stock market went from bad to worse in afternoon trading action. Late in their sessions, the 10-Year Treasury Note was up by 20/32, lowering its yield to 4.68%; the Dow was down by 281.91 points to 13,181.91; and the Nasdaq was down by 64.73 points to 2,511.25.

Most of the major market influences were aligned to support bonds today. The employment report, typically a powerful market-mover, came in weaker than expected with fewer job gains than predicted in July and the highest unemployment rate in six months.

And the ISM Services Index took a larger than expected fall in July. While still indicating an expansion of activity, the reading was the weakest since March. The news brought the stock market's two day rally to a halt, thereby making Treasuries that much more appealing.

News that American Home Mortgage was slashing its operations and a downgrade of Bear Stearns by Standard and Poor's raised credit concerns -- giving a boost to government debt and placing additional pressure on stocks. Stocks did not even get a lift from a sharp downturn in oil futures. A barrel of light, sweet crude oil for next month delivery fell by $1.76 on the New York Mercantile Exchange to settle at $75.10. The decline was the largest for a front-month contract since June 8. Last Tuesday, the closing price was a record high $78.21.

By the end of stock trading, the Dow had lost 2.09% on the day; the S&P 500, 2.66%; and the Nasdaq, 2.51%. Since July 19, when the Dow closed at its record high of 14,000.41, the index has lost 5.9%. The Dow's close today was the lowest since May 1, the Nasdaq's since April 19, and the S&P 500's since April 2. Thanks to gains on Monday, Wednesday, and yesterday, the Dow only lost 0.63% for the week; the S&P 500, 1.77%; and the Nasdaq, 1.99%.

In contrast, the yield of the benchmark 10-Year Note fell this week by 8 basis points, a fourth consecutive weekly decline totaling 50 basis points (yield moves inversely to price). Today's closing yield was the lowest since May 11.

Next week, the economic release calendar is relatively light, but new Treasury supply will be coming to market and the Federal Reserve's Open Market Committee (FOMC), the monetary policy arm of the central bank, will be holding a policy meeting.

There are no major market influences scheduled for Monday. On Tuesday, the Labor Department will release its preliminary report on productivity for the second quarter. The final report for the first quarter said that productivity (output per nonfarm business worker per hour) rose by 1.0% following a 2.1% increase in the fourth quarter of last year. The deceleration reflects the slowdown in the general economy as indicated by the gross domestic product (GDP) which rose by 0.7% in the first quarter following a 2.5% increase in the fourth quarter.

The initial report on the seasonally adjusted, annualized level of GDP for the second quarter indicated a 3.4% increase from the level in the first quarter. Consequently, analysts are looking for a stronger productivity reading. Current predictions run between 2.0% and 2.4%.

Increased productivity is usually a positive influence on the markets. The increased output per hour is seen by stock traders as a bullish economic development; more efficiency and therefore better earnings. And the efficiency often translates into reduced labor costs per unit of output which has a salutary effect on inflation pressures -- a plus for both stocks and bonds. However, the relationship between output and labor costs is not always so simple. While productivity growth decelerated in the first quarter, unit labor costs rose by only 1.8% following a surge in the fourth quarter of 8.9%. For the second quarter costs are expected to have increased by between 1.5% and 2.0%.

But the main event of the day will be the release of the FOMC's latest statement on monetary policy. Between June of 2004 and June of last year, the FOMC hiked short-term interest rates seventeen times in quarter-percent increments from a forty-six year low of 1.00% to 5.25%. Since then, the committee has made no further rate changes but its position has been that inflation risks remain dominant.

Earlier this year, Fed watchers had expected a rate cut before too long since the economy seemed to be faltering. But the initial report on second quarter gross domestic product indicated a 3.4% growth rate following just a 0.6% increase in the first. Moreover, the Fed has not provided any discernable signal that it intends to change its current policy stance.

In his appearances last month before the House Financial Services Committee and the Senate Banking Committee, Fed chief Ben Bernanke said that although core prices (ex-food and energy) for personal consumption expenditures had moderated somewhat in the previous couple of months, the data could reflect transitory conditions and that increased resource utilization and a spill-over of high energy prices into other areas could lead to higher levels of inflation.

This echoed the last few policy statements, the last of which expressed the sentiment this way, "Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures."

No rate change is anticipated on Tuesday but the policy statement has the potential to move the markets as any perceived shift in position could cause a sharp response. Of particular interest will be the amount of emphasis the statement puts on the weak housing and subprime mortgage finance situations. Mr. Bernanke devoted a great deal of time on the matter in his congressional testimony. But even if there is nothing new in the statement, this could weigh on the markets as it would be interpreted as a confirmation that no change is forthcoming in the months ahead.

The statement is usually issued at around 2:15 PM Eastern Time. The uncertainties associated with the release will keep traders in a defensive posture in the morning and the response to the statement will color market action in the afternoon.

On Wednesday, the report on wholesale inventories for June will be released. In the last report, the Commerce Department said the seasonally adjusted level of wholesale inventories rose by 0.5% in May. The increase, the largest in four months, was stronger than the 0.3% or 0.4% that analysts had predicted. But, as expected, sales were also strong -- up by 1.3%. This left the inventory-to-sales (I/S) ratio at a record low 1.11.

The (I/S) ratio is the value of supplies on hand, divided by the value of sales for the month. The result is how many months it would take at the prevailing sales pace to entirely deplete the existing inventory. The low ratio means that pressure to replenish supplies is high -- a bullish economic indicator.

For June, inventories are expected to have risen by about 0.4%, a sixth increase in as many months. The I/S ratio is expected to remain low.

Wednesday also brings a couple of minor releases. The Mortgage Bankers Association will release its report on mortgage application activity for this week and the Energy Department will release its weekly report on oil inventories.

New first new supply (other than the weekly issuance of Treasury Bills -- securities with a maturity smaller than a year) comes on Wednesday as the Treasury will be auctioning a new issue of 10-Year Notes. On the current issuance schedule, there is an initial issue each quarter that is followed a month later with a sale of an additional amount of the initial issue.

The arrival of new supply usually keeps bond prices down until the market has a chance to begin digesting the inventory. Traders who will be making bids refrain from pushing prices up prior to an auction in order to keep yields up (bids are for yield -- the higher, the better for the auction participants). Other traders also avoid purchasing the soon-to-be off-the-run issue since the new one will have greater liquidity. They also assume a wait-and-see posture until the results of the sale are known.

The last initial offering in May produced mixed results. Bids exceeded the $13 billion offer amount by 2.30 to 1, down from February's bid-to-cover ratio of 2.41 and the 2.39 average for the last twelve initial offerings prior to May's. Noncompetitive bids, a gauge of individual investor demand, totaled $61 million, up slightly from February's $57 million but down from the twelve-auction average of $95 million.

But foreign demand was decent. Indirect competitive bids, which include those from foreign central banks, garnered 44.1% of the issue. This award portion was up from the 29.2% in February's auction and the twelve-auction average of 38.5%.

Wednesday's issue will also have a face value of $13 billion, matching the size of the previous eight initial offerings. The deadline for competitive bids is 1:00 Eastern Time.

On Thursday, the jobless claims report comes out. In yesterday's report, the Labor Department said the seasonally adjusted level of initial claims for state unemployment benefits rose last week by 4,000 to 307,000. The previous week's originally reported level of 301,000 was revised up by 2,000 to 303,000. But the four-week moving average, which smoothes out some of the short-term volatility, fell by 3,500 to 305,500, its lowest reading in nine weeks. The average weekly reading for the year to date is 317,200.

The report said that continuing claims for the week ending July 21 (continuing claims must be at least a week old) fell by 16,000 to 2.525 million, the lowest level in five weeks. The four-week average declined by 9,250 to 2.545 million. The average weekly level of continuing claims for the year to date is 2,520,345. Although the latest reading is in line with this year's average so far, it is slightly elevated from the average reading in 2006 of 2,458,519.

Despite last week's increase the initial claims level suggests that hiring continues to outpace layoffs, which translates into net payroll growth.

More supply will be hitting the market on Thursday as the Treasury will be auctioning $9 billion in 30-Year Bonds. The Treasury announcement said the bonds sold on Thursday will actually have a maturity of 29-years and 9-months. The issue does not appear to be a reopening, however, since May's issue was a reopening of February's 30-Year Bond and therefore had at time of sale a 29-year and 9-month maturity. Thursday's issue also does not have the same identification code as May's and February's.

February's auction had mixed results. The bid-to-cover ratio on the $9 billion offering was 2.46, the highest of the three auctions in the current issue cycle (issuance had been discontinued in 2001 and reinstated last year). But non-competitive bids totaled just $9 million, the lowest amount in the current issue cycle up to that time. Indirect competitive bids received a relatively healthy 42.0% of the issue.

Last May's reopening auction was weak. The bid-to-cover ratio for the $5 billion offering was 1.97, non-competitive bids totaled just $2.5 million, and indirect competitive bids garnered only 10.4% of the issue.

On Friday, the report on import and export prices for July will be released. In June, the index of import prices rose by 1.0% following a 1.1% rise in May. A couple of details offset the effect of the inflation concerns roused by the recent increases. For one thing, following a ten-month high jump of 1.6% in March, the increases got progressively smaller in the following three months. Most importantly, excluding the volatile category of petroleum products (imported oil), prices rose by just 0.2% in June -- the smallest increase since February's flat reading (0.0%). Petroleum product prices rose by 4.7% in June.

Export prices showed little movement. Overall prices rose by 0.3% in June after a 0.2% rise in May. Excluding the large but volatile category of agricultural products, prices were up by only 0.1% following a 0.2% rise in May.

The final scheduled new item of the week comes out on Friday afternoon. At 2:00 PM Eastern Time, the Treasury will release its budget figures for last month. In July of last year, the value of government outlays exceeded receipts by $33.2 billion. A slightly smaller deficit of about $32.5 billion is predicted for last month.

This would bring the running total for the fiscal year to date (begun last October) to a deficit of $153.5 billion. While still a sizeable gap, it compares favorably to the $239.6 billion shortfall for the same period in the 2006 fiscal year. In fact, the total to date would be the smallest deficit for the same period since 2002 when it was $145.5 billion. The improved budget picture is a plus for Treasuries since it means less will have to be issued in the future to fund government operations and pay the debt on previously issued securities.

10:30 AM EDT :

The news of the day has been uniformly favorable for Treasuries; that is, more bearish than anticipated. Weak economic news reduces pressure on the Federal Reserve to keep a hawkish stance on interest rates. Currently, Treasuries are firmly ahead while the stock indices have declined sharply.

In the major economic release of the day, the employment report indicated that job growth was weaker than analysts had predicted. The Labor Department said that the seasonally adjusted level of nonfarm payrolls rose by 92,000 last month and June's originally reported rise of 132,000 was revised down by 6,000 to 126,000.

In the goods producing sector, construction payrolls fell by 12,000 and manufacturing payrolls were down by 2,000 (a thirteenth consecutive monthly decline). In the services sector, the category of education and health saw the biggest increase with a gain of 39,000, the thirty-fourth consecutive increase. In the category of financial activities, payrolls gained 27,000 jobs and in the category of professional and business services they were up by 26,000. Payrolls in retail sales fall by 1,200. A surprise was a 28,000 drop in government payrolls, the first decline in eighteen months.

The report said that the unemployment rate, the portion of the active workforce without jobs, edged up to 4.6% in July from June's rate of 4.5%. The increase was the first since April and the rate was the highest since January. Nevertheless, it is still considered low by historical standards. The average monthly reading so far this year has been 4.5%. This compares favorably with last year's average of 4.6% and 2005's average of 5.1%.

An item that was mildly positive for both stocks and bonds was a slight decline in the growth rate of average hourly wages. They grew by about 0.35% in July after two month's of 0.40% growth.

The last major economic release of the week was also bond-friendly. The Institute for Supply Management said today that its index on the services sector came in at 55.8 for July. Any reading over 50.0 indicates a general expansion of activity relative to the preceding month and July's index represented a fifty-second consecutive monthly expansion. As expected, the reading was down from June's fourteen-month high of 60.7. But the drop was the largest since September of 2005 and the reading fell short of the 59.0 to 59.5 that forecasters had predicted.

Though the services index usually does not have the same market influence as the manufacturing (the services data series is relatively young and the sector is so broad that varying categories tend to cancel each other out), the effect of today's report may be getting additional clout from the fact that the manufacturing index forlast month was also weaker than expected.

Another piece of news this morning is also making government-backed debt securities more attractive in comparison with other forms of debt securities. The issue of problems in the housing sector disrupting the financial market was underscored by the announcement from American Home Mortgage Investment Corp. that it was terminating most of its operations and employees. Earlier this week, the lender said it was having trouble repaying bank loans which
had been used to fund mortgage loans.