Market Overview 10/26/07

5:00 PM EDT :

Treasuries took losses today but they were relatively mild considering the extent of gains made by the stock indices. In late trading, the 10-Year Treasury Note was down by 5/32, raising its yield to 4.40%; the Dow was up by 134.78 points to 13,806.70; and the Nasdaq was up by 53.33 points to 2,804.19.

The catalysts for today's stock rally were a strong earnings report from Microsoft and positive guidance from Countrywide (despite a miserable third quarter). These were enough to eclipse the negatives facing the market. The economic release of the day was not stock-friendly. The final Consumer Sentiment Index for the month indicated that consumers were generally more pessimistic than they have been in almost a year-and-a-half.

And oil prices continue to climb. The price of a barrel of light, sweet crude oil for December delivery rose by $1.40 on the New York Mercantile Exchange to settle at a new record high of $91.86. Yet, the Dow rose by 0.99% on the day; the S&P 500, 1.38%; and the Nasdaq, 1.94%. All three indices made solid progress for the week as well. The Dow gained 2.11%; the S&P 500, 2.31%; and the Nasdaq, 2.90.

Despite the gains in stocks this week, Treasuries held their ground. For the week, the yield of the benchmark, 10-Year Note was up by only 1 basis point after falling last week by 29 basis points (yield moves inversely to price).

Next week's events calendar is brimming with potential market-movers but starts out slowly. There are no major economic releases slated for Monday and the only one on Tuesday is the Consumer Confidence Index for the month from the Conference Board, an independent research firm. September's index came in at 99.8, a sharp drop from August's 105.6, which in turn was a sharp drop from July's 111.9.

The situation was summarized in the news release by Lynn Franco, Director of the Board's Research Center: "The Consumer Confidence Index is now at its lowest level in nearly two years (Nov. 2005, 98.3). Weaker business conditions combined with a less favorable job market continue to cast a cloud over consumers and heighten their sense of uncertainty and concern. Looking ahead, little economic improvement is expected and with the holiday season around the corner this is not welcome news."

Little change is expected in October's reading with the consensus forecast being 100.0. Yet recent economic data has generally been bearish and another drop in the confidence indicator would not be too surprising.

The Federal Reserves monetary policy committee, the Federal Open Market Committee (FOMC), will begin a two-day meeting on Tuesday. Since the results of the meeting will undoubtedly catch some market participants in the wrong position, many traders take defensive actions prior to the publication of the meeting statement. This includes reeling in long positions and covering shorts. Some traders take to the sidelines. But others will attempt to get ahead of the market by taking positions based on their opinion of what the Fed will do.

On Wednesday morning, key economic data will be released which might affect expectations for the outcome of the Fed meeting. The Commerce Department will be releasing its first estimate of gross domestic product (GDP) for the third 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 first, or advance, report for last quarter will be followed next month by a preliminary report, and a final report will be issued in December.

The final report on the second quarter showed that the economy grew in the April through June period by 3.8%. This was an improvement from the first quarter increase of 0.6%. In fact, it was the strongest reading in five quarters.

For the third quarter (July through September), analysts predict that GDP rose by about 3.1%. If the reading is notably weaker, many observers will assume that another Fed rate cut is assured.

Also out on Wednesday morning is the Employment Cost Index (ECI) for the third quarter. The ECI, a measure of the seasonally adjusted level of compensation costs for all civilian workers, rose in the second quarter by 0.9% following a 0.8% increase in the first quarter. The index is a more comprehensive gauge of labor costs than the wage data contained in the monthly employment reports because it also incorporates salaries and employer costs for non-cash employee benefits. For the third quarter, another 0.9% increase is anticipated.

The report on construction spending for September will be released a little later on Wednesday morning. In the last report, the Commerce Department said that the seasonally adjusted, annualized pace of spending rose in August by 0.2%. Although this was stronger than the decline of 0.1% that had been predicted, revisions pushed July's originally reported decline of 0.4% down to 0.5% and June's previously reported gain of 0.1% was revised to a decline of 0.1%.

As expected, the residential category continued to deteriorate. The spending rate there was down by 1.4% in August following a 1.7% decline in July and a 1.0% decline in June. August's decline was an eighteenth consecutive monthly contraction and the spending rate was the lowest since December of 2003. Another decline is expected for September, pulling the overall spending level down by a predicted 0.1%.

And the Chicago Purchasing Managers Index, a gauge of manufacturing activity for the heavily-industrialized region, will be released Wednesday morning. Last month, the index came in at 54.2, up from 53.8 in August. Any reading over 50.0 indicates a general expansion of activity relative to the preceding month and September's represented a seventh consecutive month of growth following modest contractions in January and February.

But, of course, the main event of the day will be the conclusion of the Fed's policy meeting. Between January of 2001 and June of 2003, the Fed reduced the short-term lending rate between banks (fed funds rate) from 6.50% to a decades-low 1.00% in order to reduce general borrowing costs and stimulate the economy. Then, between June of 2004 and June of last year, the FOMC raised rates fourteen times to 5.25% in order to prevent the economy from overheating and thereby fueling inflation.

Between June of last year through early August of this year, the Fed took no rate action but maintained a slightly hawkish (that is, tightening) bias, citing elevated core inflation and concerns that it might not abate as expected. But the troubled housing and mortgage industries began to obstruct credit flows since investors backed away from risky mortgage debt, thereby eroding its value. Consequently, lenders in general tightened loan standards, making it harder to borrow money. In the meantime, holders of mortgage loan products have suffered losses since buyers are scarce. This bottleneck reduces the amount of money flowing through the monetary system and drives up the cost of borrowing.

With the complex network of risk-sharing in the world markets, the credit troubles spread. In August, France's largest bank froze three of its hedge funds because of mortgage-related losses. The incident prompted central banks in numerous countries to make short-term loans to banks in order to keep money flowing and ease investor anxiety.

The Federal Reserve was one of the central banks pumping additional reserves into the monetary system. It even made a temporary 0.50% cut to the discount rate, the rate banks must pay for loans directly from the Fed. This brought the rate down from 6.25% to 5.75%. In addition, the committee extended the length of time reserves could be borrowed and it made a public relations push to diminish the negative connotations attached to such borrowing (loans from the Fed were typically considered last resort measures).

Nevertheless, short-term commercial debt offerings dried up and investors flocked to the safety of government backed securities. In order to ease the credit situation, the Fed decided in its September meeting to cut the fed funds rate by 0.50%, from 5.25% to 4.75%. This was the first rate cut since June of 2003 and the largest since November of 2002. The policy committee also cut the discount rate again by 0.50% from 5.75% to 5.25%.

Late last month, many Fed watchers felt that another cut would be made this month, but doubts were raised when the employment report for September revealed revisions to past data that indicated a respectable gain in nonfarm payrolls in August instead of the first decline in four years as had originally been reported. Moreover, comments by Fed officials earlier this month did not seem to signal that another cut in rates was imminently forthcoming.

Since then, however, prospects for a rate cut have picked up again. On Monday evening, October 15, Fed Chairman Ben Bernanke delivered a speech before the Economic Club of New York. In it, he gave an overview of the interrelated mortgage and credit market problems and summarized the central bank's responses to the recent market turmoil.

Of particular interest to market participants were his warnings that the economy might experience more challenges ahead. He noted that, "Since the September meeting, the incoming data have borne out the Committee's expectations of further weakening in the housing market, as sales have fallen further and new residential construction has continued to decline rapidly. The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year."

He also said, "Conditions in financial markets have shown some improvement since the worst of the storm in mid-August, but a full recovery of market functioning is likely to take time, and we may well see some setbacks."

Moreover, economic data released in the last couple of weeks has been bearish. The report on housing starts said the pace in September was the lowest in over fourteen years. The report on existing home sales for last month revealed the lowest rate in at least eight years. The rate of new home sales rose in September but the latest data showed that this was from a revised level on August that was sharply lower than previously reported.

And concerns about the mortgage / credit situation have recently been revived by a huge earnings miss reported earlier this week by Merrill Lynch. The earnings news principally reflected deep losses associated with mortgage-backed investments.

For these reasons, many traders feel that next week's FOMC meeting will end with further rate cuts. Most predict that the committee will cut the fed funds and discount rates by 0.25%. A few are looking for another aggressive cut to the rates of 0.50%. Others think the committee will decide to make no rate changes. The policy statement will be released at about 2:15 PM Eastern Time.

Compounding the problems facing bond traders is that Wednesday is the last trading day of the month and affords portfolio managers with their last opportunity to make adjustments for the period. This is the process whereby holdings are rebalanced on the basis of such characteristics as yield, risk, and return horizon. This usually entails the purchase of Treasuries even in mixed portfolios since the securities have a fixed lifespan and carry no credit risk.

On Thursday, the markets are likely to be still reacting to the results of the Fed meeting. But they will also have to contend with more economic data. As usual, the jobless claims report will address the employment situation and it may get more attention than usual since it heralds the approach of the Friday's employment report. The data collection periods for the two reports do not coincide so the claims numbers will not have a direct relationship with the employment figures, but traders will be closely scrutinizing the claims report, nonetheless.

In yesterday's report, the Labor Department said the seasonally adjusted level of initial claims for state unemployment benefits fell by 8,000 last week to 331,000. The previous week's originally reported 337,000 figure was revised up to 339,000, which was a 30,000 increase from the week before.

The reports over the past month have generally exhibited larger than expected swings in the initial claims number and following the big increase in the week of October 13, a decline in last week's number had been anticipated. The four-week moving average, which smoothes out some of this week-to-week volatility, rose by 7,750 to 324,750. This is up slightly from the year-to-date weekly average of 318,238.

Yesterday's report indicated that the level of continuing claims for the week ending October 13 (continuing claims must be at least a week old) rose by 7,000 to 2.530 million but the previous week week's originally reported 2.534 million was revised down by 11,000 to 2.523 million. The four-week moving average slipped by 3,750 to 2.526 million. The weekly average for the year-to-date is about 2.530 million.

Because of the recent pattern of moves in the data, the initial claims level for this week is expected to have increased slightly.

The other early release on Thursday is the report on personal income and spending for last month. In August, the seasonally adjusted, annualized level of personal income, the fuel for spending, rose by 0.3%, the smallest increase since a flat reading (0.0%) in April. August's rise followed three consecutive months month's of 0.5% increases. Although income growth had decelerated, the report said personal consumption expenditures (PCE or consumer spending) rose by 0.6%, up from July's 0.4% and the biggest increase in four months.

The inflation measures in the report were tame. The PCE price index fell by 0.1%, the first decline since last October, and the price index minus the volatile categories of food and energy rose by just 0.1%.

For September, both income and spending is expected to show increases of 0.4%. Over the last twelve report months, the average change in income has been 0.5% and the average in spending has been 0.4%.

At 10:00 AM Eastern Time Thursday, the Institute for Supply Management (ISM) will release its index figures on the nation's manufacturing sector for October. In September's release, the overall index came in at 52.0, the lowest reading since March's 50.9. The index was 52.9 in August. Like the Chicago index, any reading over 50.0 reflects growth for the month.

Between June of 2003 and October of last year, the index posted forty-one straight expansion readings. But the extent of growth declined throughout last year until the index indicated slight contractions in November and then last January. The index strengthened after that, hitting a fourteen month high of 56.0 in June. But each three reading since then was weaker than the one before. For October's index, little change from
September's reading is anticipated.

Traders will also be watching the prices index since it measures inflation pressures associated with the sector. September's index came in at 59.0, down from August's 63.0. Though it still indicated an increase in prices manufacturers were paying, the index was the lowest since February.

Another economic release on Thursday is the report on pending home sales for September from the National Association of Realtors. The last report said that the seasonally adjusted index of pending sales fell by 6.5% in August to a record low following a 10.7% drop the month before. The first report was published in 2005 and the NAR has data going back to 2001.

The index is a measure of contract activity and the NAR asserts that 80% of contracts become sales within two months and a large portion of the rest, two months thereafter. The weakness in July and August's reports was reflected in September's existing home sale report.

On Friday, the employment report for October will take center stage. September's report said that the seasonally adjusted level of nonfarm payrolls rose by 110,000. The increase had been predicted but, as noted above, the report was much stronger than expected since August's originally reported decline of 4,000 was revised to a gain of 89,000 and July's previously reported gain of 68,000 was revised to 93,000.

A key category behind the revisions to July and August was government employment. July's previously reported decline of 52,000 was trimmed to 28,000 and August's originally reported decline of 28,000 was revised to an increase of 57,000. In September, government payrolls grew by 37,000.

Despite the increases in payrolls, they were not enough to prevent the unemployment rate from edging up to 4.7% from August's 4.6%. Though still considered low, the rate was the highest since August of last year. The unemployment rate is the portion of the workforce (over 16 years old and actively seeking employment) without jobs. While the number of jobs can increase, so can the workforce. September's report said that it rose by 573,000 individuals after falling by 340,000 in August.

Current predictions for October call for another gain in payrolls of about 90,000. The unemployment rate is expected to have remained at 4.7%. But traders have learned that the reports frequently fail to meet forecasters' estimates. Therefore, because of the uncertainty, the markets are usually subdued the afternoon before the report comes out.

The final release of the week is the report on factory orders for September. In August, the seasonally adjusted level of new orders reportedly fell by 3.3% after an increase in July of 3.4%.

Since September's report for durable goods items (which make up slightly more than half of factory orders) has already been released and indicated a surprising 1.7% decline in that category, recent predictions of a rise in factory orders of about 1.0% have been revised sharply lower. Nondurable goods have averaged a modest 0.2% increase so far this year and if that figure is plugged into prediction calculations, this would result in an overall decline in the orders level of 0.8%. This would be the first back-to-back decline since July and August of last year.

But the durable goods report showed that the decline was due primarily to a sharp drop in defense aircraft orders. Excluding the transportation category, orders were up slightly and they were also up if the defense sector was factored out. Moreover, the category of ex-defense capital goods minus aircraft -- seen as a proxy for core business demand -- also saw an increase in orders (0.4%). These categories will also be closely watched in the factory orders report. In any case, however, the employment news is likely to overshadow the orders data.

10:30 AM EDT :

As feared, mortgage lending giant Countrywide reported an even larger loss last quarter than analysts had predicted due to falling loan volumes, poorly performing loans, and set-asides the company made for future
loan losses.

But stock traders were encouraged by the company's estimation that it would post a profit in the current quarter. In addition, the tech sector is being buoyed by strong earnings reported by Microsoft after the bell yesterday.

In the only major economic news of the day, news sources report that the final Consumer Sentiment Index for the month from the University of Michigan came in at a seventeen month low of 80.0, down from the preliminary reading of 82.0 and from September's final reading of 83.4.

The expectations index fell to 70.1 from the preliminary 71.6 and September's 74.1. The index of current conditions fell to 97.6 from the preliminary 98.2 and September's 97.9. The expectations index was the lowest in fourteen months and the current conditions index was the lowest in thirteen.

Though the sentiment data was weaker than analysts had predicted, the erosion of optimism is not too surprising in light of generally bearish economic reports released recently (housing starts, existing home sales, industrial production, durable goods orders).

Rising oil prices are also a growing concern for consumers and oil futures continue to break new ground. In overnight trading, the price of a barrel of crude oil for December delivery topped $92.00. The price has since backed down but in recent trading it was still higher than the record close of yesterday's regular NYMEX session.

In the bond market this morning, traders are still in the process of absorbing this week's new supply ($6 billion 5-Year TIPS, $20 billion 2-Year Notes, and $13 billion 5-Year Notes). And with the major events of the week over, traders in both markets are now looking ahead to next week's heavy set of influences.

These include the first official look at gross domestic product for the third quarter, the Federal Reserve's latest meeting on monetary policy, the release of a key manufacturing indicator, and the employment report for October. In addition to positioning for these market-movers, traders are also considering how best to close out their books for the month.

Given the nature of these variables, stock and bond price movements may be erratic for a while.

Market Overview 10/19/07

5:00 PM EDT :

Stocks took a beating today as credit concerns intensified. Treasuries were the beneficiary of the retreat from risk and prices were up sharply across the maturity spectrum. In late trading, the 10-Year Treasury Note was up by 26/32, lowering its yield to 4.39%; the Dow was down by 366.94 points to 13,522.02; and the Nasdaq was down by 74.15 points to 2,725.16.

Though stocks had taken losses earlier in the week, they seemed to be holding up relatively well against technical pressures from recent gains (the Dow posted its record closing high of 14,164.53 on October 9), against soft economic data (bearish reports on industrial production, housing starts, initial jobless claims), and against signs that the housing / subprime mortgage / credit market problems were still threatening the economy.

On Monday night, Fed Chairman Ben Bernanke addressed the situation, saying, "Since the September meeting, the incoming data have borne out the Committee's expectations of further weakening in the housing market, as sales have fallen further and new residential construction has continued to decline rapidly. The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year." With regard to the markets he said, "Conditions in financial markets have shown some improvement since the worst of the storm in mid-August, but a full recovery of market functioning is likely to take time, and we may well see some setbacks."

On Wednesday, the Fed's Beige Book also noted that many of the central bank's industry contacts were uncertain about the outlook for the economy and that the housing sector is likely to remain weak. On top of these negative signals, several large banking companies' earnings numbers for last quarter were lower than analyst projections. More bad news today concerning the credit situation was a downgrade by Standard and Poors on a broad array of mortgage-backed securities.

And though oil futures ultimately fell today, yesterday's close was a record high and a break above the $90 per barrel level in overnight trading has some market watchers pondering the possibility of a $100 per barrel price before too long. But today, profit-taking finally pulled futures lower. The price of a barrel of light, sweet crude oil for November delivery fell by $0.87 on the New York Mercantile Exchange, settling at $88.60. The November contract expires on Monday.

The accumulated pressure was finally too much for stocks and all three major indices nosedived today. By the end of stock trading, the Dow had fallen by 2.64%, the S&P 500 by 2.56%, and the Nasdaq by 2.65%. The declines were the steepest for the Dow and S&P 500 since August 9 and the steepest for the Nasdaq since February 27. For the week, the Dow was the biggest loser with a decline of 4.05%. The S&P 500 lost 3.92% on the week and the Nasdaq lost 2.87%.

In contrast, the yield of the benchmark 10-Year Treasury Note fell by an incredible 29 basis points this week (yield moves inversely to price).

Next week, the economic release calendar is light but it includes the reports on home sales (existing and new) for last month. Bonds will also be pressured by a heavy influx of new supply to compete for investor
dollars.

There are no major economic releases slated for Monday or Tuesday. But the first of three Treasury note offerings will be conducted on Tuesday. The Treasury will be auctioning an additional portion of last April's issue of 5-Year Treasury Inflation Protected Securities (TIPS) so the maturity will actually be 4-1/2 years. TIPS have a fixed coupon (interest) rate, but their face value is regularly adjusted according to the Consumer Price Index, so the interest payout amounts fluctuate according to the changes in inflation. At maturity, the greater of the inflation-adjusted or original redemption value is paid out.

The face value of the offering in April's auction was $8 billion, the lowest for an initial issue in the current issue schedule begun in 2004. Consequently, the face value of next week's offering is expected to be $6 billion, down from the $7 billion in each of the last two reopening sales.

In the last reopening in October of last year, the offering met with strong demand. Bids exceeded the offer amount by 2.89 to 1, the highest bid-to-cover ratio in all of the auctions (initial or reopening) in the current issue cycle including last April's. Individual investor demand was a little disappointing, however. Noncompetitive bids totaled just $67 million, down slightly from $68 million in the previous October's auction and well below the $111 million in the initial offering.

But foreign demand for was strong. Indirect competitive bids, which include those from foreign central banks, received 51.4% of all accepted competitive bids and 50.9% of the entire issue. The total award portion in the previous reopening (October 2005) was 23.2% and it was 26.1% in the initial sale of the issue (April 2006).

On Wednesday, the only major economic release is the report on existing home sales for September. In August's report, the National Association of Realtors said that the seasonally adjusted, annualized pace of sales fell by 4.3% to 5.50 million from July's 5.57 million. Though the decline was in line with predictions, it was the sixth in as many months and the pace was the lowest in five years. The report said that inventories of homes on the market rose to 4.581 million, a ten-month's supply at August's sales pace. Average prices fell by $6,700 and median prices by $4,200.

Current projections for September call for another decline in the sales rate of about 3.6% to 5.30 million. If the prediction is accurate, it would be the lowest sales pace since December of 2001.

More supply hits the market on Wednesday as the Treasury conducts 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 auction was generally successful. The bid-to-cover ratio was 3.29, down slightly from August's 3.97 but well above the 2.91 average for the twelve, 2-year offerings prior to September's. Noncompetitive bids were soft, however. They totaled $663 million, down from $856 million in August and down from the twelve-month average of $821 million. In fact, noncompetitive bids represented 3.7% of the issue amount, the lowest portion of a 2-year offering since April of 2005. But foreign demand was solid. Indirect competitive bids garnered 34.2% of the entire issue, the highest award portion since last April and slightly higher than the twelve-month average of 33.6%.

The last eight, 2-Year issues had a face value of $18 billion and that is the projected size of next week's. The deadline for competitive bids is 1:00 PM Eastern Time.

On Thursday, the jobless claims report once again highlights the employment situation. Yesterday's report said that the seasonally adjusted level of initial claims for state unemployment benefits jumped last week by 28,000 to 337,000 from the previous week's 309,000 (originally 308,000). The spike was the largest in eight months and the level was the highest in seven weeks.

The data series has been more volatile than expected in the last few weeks, moving back and forth in larger than expected swings. Analysts note that the latest spike could have been exaggerated by an additional adjustment made to offset the closure of labor offices on Columbus Day. The four-week moving average, which smoothes out some of this short-term volatility rose by 6,000 to 316,500. The average weekly initial claims level for the year-to-date is 317,878. For this week's claims figure, a decline of between 10,000 and 15,000 is anticipated.

The other early release on Thursday is the report on durable goods orders for September. 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 August's report, the Commerce Department said the seasonally adjusted level of durable goods orders fell by 4.9% and this was later confirmed in the factory orders report for the month. The information to follow uses whatever revisions the factory report may have made to August's report on orders for durables.

The decline was the largest in seven months but it followed a 5.9% jump the month before which was the largest increase in ten months. A large contributor to August's decline was the transportation category, which saw a contraction of 11.1%, and within the category, commercial aircraft orders were down by 39.9%. But even excluding transportation, orders were down by 1.8% -- also the biggest drop in seven months.

Orders outside the defense sector are often isolated by analysts since defense orders are not governed by standard market forces. The level of ex-defense orders declined by 5.9% in August following a 4.6% rise the month before. If commercial aircraft orders are further excluded from the ex-defense figures, orders were down by 2.0% in August following a 3.7% increase in July.

And ex-defense orders for capital goods minus aircraft -- seen as a proxy for core business demand on the production process -- fell by 0.5% in August and July's originally reported increase of 1.7% was revised down to a gain of just 0.9%.

For September, forecasters are looking for a bounce in durable goods orders of about 1.5%. The final economic release on Thursday is the report on new home sales. In August's report, the Commerce Department said that the seasonally adjusted, annualized sales pace fell by 8.3% month from 867,000 to 795,000. The decline was the largest since January and the sales rate was the lowest since June of 2000. Another decline in the sales pace of about 1.9% is predicted for September, bringing it down to 780,000. This would be the lowest pace since May of 1997.

Observers will also be watching for inventory levels and price changes. August's report said the number of homes on the market declined for a fifth straight month, falling by 1.5% to 529,000. The drop was the largest since last November and the inventory level was the lowest since January of last year. Yet, given the weak sales pace, the inventory represented 8.2 months worth of sales, up from July's turnover pace of 7.5 months.

The average new home price fell in August by $14,200 to $292,000 and the median price fell by $20,500 to $225,700. The average price was the lowest since last November and the median price was the lowest since November of 2004. On a year-over-year basis, the average price was down by 8.0% and the median price by 7.5%.

The last Treasury auction of the week comes on Thursday with the monthly issuance of 5-Year Notes. September's offering was met with strong demand. The bid-to-cover ratio was 2.86, the highest since August of 2006. But individual investor demand was soft. Noncompetitive bids totaled $119 million, the lowest amount for a 5-year offering since last April. But foreign demand was strong. Indirect competitive bids received 44.8% of the issue, the highest award portion since last December. The last ten issues of the 5-Year Note had a face value of $13 billion and that is the anticipated size of next week's.

On Friday, the only economic news is the final read on consumer sentiment from the twice monthly surveys conducted by the University of Michigan. The preliminary index, released last Friday, came in at 82.0, down from September's final reading of 83.4 and the weakest sentiment indicator since August of last year. Forecasters had predicted a more optimistic reading of about 84.0. Some improvement was seen in the index of current conditions. It came in at 98.2 for the early part of October, up from September's final reading of 97.9. But the expectations index slipped to 71.6 from 74.1.

Recent projections for October's final index number were for little change or a slight rise to 82.5. But recent economic data has been bearish and the sentiment indicator could be lower than expected. If the index has held steady or increased slightly, the news is likely to be discounted unless there are some bullish surprises in upcoming economic data.


10:30 AM EDT :

After solid gains this week, Treasuries are up once again this morning despite a lack of any new economic data. The stock indices are down sharply, spooked in part by further increases in oil futures in overnight and early U.S. trading. But, after the front-month contract price broke through the $90.00 per barrel level last night, it has retreated on a round of profit-taking and in recent trading was at $88.76, $0.71 below yesterday's NYMEX closing level of $89.47.

The fear that tight credit conditions still pose a threat to the economy were stoked by additional poor earnings news in the financial sector. Today's report came from Wachovia and it indicated earnings well below street projections. It joins other misses in the sector reported this week including those from SunTrust, First Horizon, Bank of America, and Wells Fargo.

With attention refocused on the situation, even the better than expected earnings report from Google, released after the bell yesterday, has failed to give the stock market any footing.

The drop in stocks is providing a flow into Treasuries but technical pressure may cap gains today. Although there are no major economic reports today and next week's calendar is light, a heavy load of new supply is heading to market next week as the Treasury will be auctioning a 5-Year Treasury Inflation Protected Securities issue (actually a reopening of last April's TIPS issue), a new 2-Year Note, and a new 5-Year Note. This competition for investor dollars will keep a lid on the bond market until the results of the auctions are known.

The existing and new home sales reports for last month will be released next week. Though they are expected to show further declines -- a plus for bonds in that this would further bolster the case for a Fed rate cut -- they could surprise on the high side so this gives traders another reason to be defensive. And, of course, traders may be inclined to cash in on some of their recent gains.

But for now, the bond market is being driven by the losses in stocks. Recent economic data has been bearish and the indices have been at historically high levels despite the swelling parade of quarterly earnings report releases. Yesterday's flat finish for the market may have been a last stand against the combination of negative influences as all three indices have given up a lot of ground in early trading today.

Market Overview October 12, 2007

5:00 PM EDT :

Treasuries began the day in negative territory, and though they pared most of the losses by midday, they fell back again this afternoon and finished deep in the red. The stock indices had a choppy session but the action was all in positive territory and they finished with gains for the day. In late trading, the 10-Year Treasury Note was down by 12/32, raising its yield to 4.68%; the Dow was up by 77.96 points to 14,093.08; and the Nasdaq was up by 33.48 points to 2,805.68.

The centerpiece of today's news was a larger than predicted increase in retail sales last month. The other releases had less of an impact on the markets. The PPI was up sharply last month but this followed a sharp plunge the month before. Moreover, the core index, which excludes the volatile food and energy components, was only up slightly in September.

Business inventories were only slightly higher in August but they remained at historically lean levels. Lastly, the first of two Consumer Sentiment Index readings for the month was weaker than anticipated, though survey results are not always reliable indicators of forthcoming consumer behavior.

The retail sales news, last week's sharp upward revision to August's payroll number, and yesterday's report of a smaller than expected trade deficit in August all point to a firmer economic picture than previously thought and reduces the chances of a rate cut by the Federal Reserve at the next monetary policy meeting. The shifting perspective undercut the bond market and although further rate cuts would be good for stocks as well, the economic implications of the recent data have been good enough so far to sustain progress in the stock market.

Besides the retail sales news, stocks got a boost from better than expected earnings reported by McDonalds and positive analyst guidance on Eastman Kodak and Safeway. Mergers and acquisitions activity also brightened trader sentiment. Software maker, Oracle, has made a bid for BEA Systems and video game maker, Electronic Arts, announced that it was buying BioWare and Pandemic Studios. Such aggressive actions are considered bullish since they seem to reflect confidence in the economy on the part of corporate decision makers.

A negative influence on stocks was another rise in oil prices. The price of a barrel of light, sweet crude for next month delivery rose by $0.61 on the New York Mercantile Exchange to settle at $83.69, a new record high for a front-month contract. High energy prices support the energy sector of the stock market but they are generally bearish since they divert business and consumer spending from other areas of the economy.

Nevertheless, by the end of stock trading, the Dow had gained 0.56% on the day; the S&P 500, 0.48%; and the Nasdaq, 1.21%. The Dow's close was the second highest on record and the S&P's was the third. The Nasdaq's close was the second highest in six-and-a-half years. The price of the 10-Year Treasury Note lost ground on the week, pushing its yield up by 5 basis points. Yield moves inversely to price.

Next week's economic calendar is relatively light but it contains a key inflation indicator, an important report on industrial production, a couple of regional manufacturing indices, a look at housing construction, and the
Federal Reserve's latest summary of the economy.

On Monday, the only major release is the New York Fed's report on the region's manufacturing activity for the month. Last month, the index of general business conditions came in at a four-month low of 14.7. This was down from August's reading of 25.1 and was slightly below the lower end of forecasts between 15.0 and 20.0. Any reading over 0.0 indicates a general increase in activity relative to the preceding month and September's was a twenty-eighth consecutive growth indicator. For October, the index is expected to have edged down to about 14.0.

The New York region is comparatively small. The importance of the NY Fed Index comes from the fact that it provides the first glimpse of manufacturing activity for the month. The index is also seen as a predictor of the more influential index from its regional neighbor, Philadelphia. But the correlation between the two indicators is not actually all that good. In the last four years, the two have moved in the same direction about 60% of the time. The Philadelphia index will be released on Thursday.

On Tuesday, the Federal Reserve will release its report on industrial production; a gauge of output from the nation's factories, mines, and utilities. According to the last report, industrial production rose in August by 0.2%, a little less than the 0.3% that analysts had predicted but July's originally reported gain of 0.3% was revised up to 0.5%. However, two of the components saw contractions in output in August. Manufacturing output fell by 0.3%, the first decline in six months and the largest decline in seven months. Mining output declined by 0.6%, also the largest drop since January. It was only in the volatile category of utilities that output increased. It rose by 5.3%, the biggest jump since last February.

There was a somewhat worrisome inflation indicator in the report. Capacity utilization, the ratio of output to potential output, was 82.2% in August. Not only was this higher than the 82.0% that analysts expected, but July's originally reported 81.9% was also revised up to 82.2%. The last two readings were the highest since August of last year. High utilization means less slack in the production process which can lead to bottlenecks. When demand cannot be met, prices rise.

But a closer look at the utilization data revealed a less dire picture. Once again, the utilities category was the central reason for the high reading. Utilization there rose from 83.6% to 87.9% while the largest category, manufacturing, saw a decline to 80.7% from 81.0% and mining saw a decline to 90.2% from 90.8%.

For September, overall industrial output is expected to have risen by about 0.1%. Capacity utilization is expected to have remained at 82.2%.

Wednesday brings the Consumer Price Index, a gauge of inflation at the retail level. It fell in August by 0.1%, the first contraction since last October. Energy prices constituted the largest component contributing to August's decline with its index falling by 3.2%. Excluding the volatile categories of food and energy, the so-called core index was up by an in-trend and anticipated 0.2%. Food was an upward pressure on the headline number with an index increase of 0.4%.

For September, following two months of virtually no change (01% and -0.1%) a rebound of about 0.2% is anticipated for the overall index. The core index is expected to have risen by 0.2% for a fourth consecutive month.

The report on housing starts is also slated for Wednesday. In August's release, the Commerce Department said that the seasonally adjusted, annualized pace of starts fell by 2.6% to 1.331 million, the lowest rate since June of 1995. Furthermore, July's originally reported rate of 1.381 million was trimmed by 1.0% to 1.367%. The report also said that the rate of building permit issuance, a gauge of near-term starts, also declined, losing 5.9% to 1.307 million. Though this has subsequently been revised to a 4.8% decline to 1.322 million, the pace was still the lowest since June of 1995.

For September, the starts pace is predicted to have fallen another 3.5% to 1.285 million and the rate of permit issuance is expected to have declined once again.

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 policy deliberations. The next committee meeting is slated for the 30th and 31st of the month.

The summary is often overlooked because other reports have already revealed the economic situation, but observers will be closely scrutinizing Wednesday's release for any specific emphasis it might place on economic, inflation, and financial market issues. In August, the Fed cut the interest rate it charges to banks for loans (the discount rate). Then, in September it cut the rate again and also the Fed's target rate for short-term loans between banks (the fed funds rate).

These actions were made in an effort to prevent tightening credit conditions from choking off the economy. But they have raised some inflation concerns since prior to the cuts, the Fed had maintained a slightly hawkish stance on rates because of concerns that inflation might not subside in coming quarters as anticipated. Fed watchers are currently not sure if the policy committee will ease rates again at the end of the month.

On Thursday, the jobless claims report will highlight the employment situation. In yesterday's report, the Labor Department said the seasonally adjusted level of initial claims for state unemployment benefits fell by 12,000 last week to 308,000. A decline of some magnitude had been anticipated due to a larger than expected increase the week before (originally reported as a gain of 16,000 but revised to an increase of 20,000 in yesterday's report). The four-week moving average, which smoothes out some of the week-to-week volatility, declined by just 3,000 to 310,250. The average weekly claims level for the year to date is 317,375. As a rule of thumb, any reading below 400,000 is considered an indication that hiring is outpacing layoffs.

The report said that the level of continuing claims for the week ending September 29 (continuing claims must be at least a week old) fell by 15,000 to 2.521 million, the lowest reading in fifteen weeks. The four-week average fell by 19,000 to 2,535,500. The average weekly level of continuing claims for the year-to-date is 2,529,949.

The latest decline in initial claims was somewhat larger than expected so analysts are looking for a slight increase in last week's level as the recent volatility continues to settle out.

A little later on Thursday morning, the Conference Board, an independent research firm, will release its Index of Leading Economic Indicators for September. The data series has been mildly bearish throughout the year with five contraction readings in the first eight months. But the last report said that within the previous six months (March to August), the index was up by 0.5%. It fell by 0.6% in August following a 0.7% increase in July. Indicators such as a decline in initial jobless claims and a rise in stocks point to a positive index reading for September. Analysts are predicting an increase of about 0.4%.

The final economic release of the week comes at noon on Thursday when the Philadelphia branch of the Federal Reserve publishes its index data on the region's manufacturing activity for this month. In September's release the index came in at 10.9, up from a flat reading (0.0) in August and the second best reading (after an 18.0 last June) since August of last year. Forecasters had predicted a reading of only about 2.0. As is the case with the New York Fed index, any reading over 0.0 indicates a general expansion of activity relative to the preceding month. A slightly weaker growth reading of about 8.0 is predicted for October.

10:30 AM EDT :

The economic news of the day was mixed but the report on retail sales has been the focus of attention, bearing down on Treasuries and giving stocks a modest boost.

The Commerce Department reported that the seasonally adjusted level of retail sales rose in September by 0.6% after a 0.3% increase in August. The gain was larger than the consensus estimate of 0.2% but some forecasts were calling for an increase of about 0.5%. Auto sales, a volatile category that makes up about a quarter of all sales, were up by 1.2% after a 3.3% increase in August. Excluding the category, sales were up by 0.4% following a 0.4% decline.

For obvious reasons, another volatile category is sales at gasoline stations. Sales there were up by 2.0% in September following a 2.6% decline the month before. Excluding both the auto and gas station categories, sales were up by 0.2% following a 0.1% decline in August.

Other large gaining categories were nonstore retailers (up by 1.1%), health and personal care stores (up by 1.0%), electronics and appliance stores (up by 0.9%), and food and beverage stores (up by 0.8%). Building material and garden supply stores saw a nominal gain of 0.1%. Declines were posted in the categories of miscellaneous store retailers (down by 1.3%); sporting goods, hobby, book, and music stores (down by 0.7%), furniture and home furnishings stores (down by 0.6%); clothing and clothing accessories stores (down by 0.4%). General merchandise stores saw a decline of 0.1%).

The major inflation news of the day was mixed but the headline surprise is weighing against both stocks and bonds. The Labor Department reported that its Producer Price Index, a gauge of inflation at the wholesale level, rose in September by 1.1%, the largest increase since February. Though a bounce was expected after August's 1.4% oil-related plunge (the largest since October of last year), last month's increase was larger than the 0.5% that analysts had predicted. On a year-over-year basis, the index was up by 4.4%, the largest Y/Y margin since June of 2006.

But energy was again a major factor in the overall move. The energy index rose by 4.1% in September, the biggest increase since last November. This followed a 6.6% decline in August, the largest drop since April of 2003. Foods, another volatile category, also jumped more than expected last month. The index for that category, after four months of declines, rose by 1.5%, the largest increase since March.

The inflation news was not all bad. Excluding foods and energy, the so-called core index rose by just 0.1% in September. On a year-over-year basis, the core index was up by 2.0%. This is still somewhat elevated but an improvement from August's Y/Y margin of 2.2% and July's 2.3%. Price pressures further down the production pipeline were also relatively tame. The index for prices at the intermediate stage of production rose by 0.4% last month following a 1.2% decline in August. At the initial, or crude, stage of production, the price index rose by 0.1% following a 3.0% decline.

The report on business inventories was also released this morning and though it was a little softer than anticipated, the news was not all that surprising. The Commerce Department said the seasonally adjusted level of business inventories rose by 0.1% in August, the weakest gain since a flat (0.0%) reading in March. Sales fell by 0.4% due to a 1.6% decline in the manufacturing sector.

This combination raised the inventory-to-sales (I/S) ratio up to 1.27 from July's 1.26. The I/S ratio is the value of inventories divided by the values of sales for the month. The result shows how many months it would take to entirely deplete the stocks on hand at the prevailing sales pace. A low ratio means pressure is high on the production process to replenish supplies. Though August's ratio was up from July's, it was
still not far from the record low of 1.25.

In the final economic release of the week, news sources report that the preliminary index on consumer sentiment for the month from the University of Michigan came in at 82.0, down from September's final reading of 83.4 and the weakest sentiment indicator since August of last year. Forecasters had predicted a more optimistic reading of about 84.0. Some improvement was seen in the index of current conditions. It came in at 98.2 for the early part of October, up from September's final reading of 97.9. But the expectations index slipped to 71.6 from 74.1.

5:00 PM EDT :

Treasuries got slammed today by the employment report for last month while stocks made respectable gains. In late trading, the 10-Year Treasury Note was down by 31/32, lowering its yield to 4.4.63%; the Dow was up by 91.70 points to 14,066.01; and the Nasdaq was up by 46.75 points to 2,780.32.

Last month's employment figures were within predicted levels but upward revisions to the nonfarm payroll numbers in the preceding two months dimmed prospects of another Fed rate cut at the end of the month. Though lower borrowing rates would also benefit stocks, the stronger than expected labor situation means businesses are still expanding and more wage earners mean more consumer spending.

The employment report trumped all other influences and by the end of stock trading, the Dow had gained 0.66% on the day; the S&P 500, 0.96%; and the Nasdaq, 1.71%. All three made solid gains for the week, a fourth consecutive advance. The Dow rose by 1.23%, the S&P 500 by 2.02%, and the Nasdaq by 2.92%. The S&P 500's close today was a record high and the Dow's was its second highest on record. The Nasdaq's close was the highest since February 1, 2001. In the bond market, the yield of the benchmark 10-Year Note, despite rising by 12 basis points today, was up by only 4 basis points for the week. This follows a decline of 3 basis points last week. Yields move inversely to price.

Next week, the economic calendar is back-weighted. There are no economic releases slated for Monday and the bond market will be closed in observance of Columbus Day. There are no economic reports on Tuesday either but in the afternoon, the Federal Reserve will release the minutes of its last monetary policy meeting, held on September 18.

Between January of 2001 and June of 2003, the Federal Open Market Committee (FOMC, the monetary policy arm of the Fed) reduced the short-term lending rate between banks (fed funds rate) from 6.50% to a decades-low 1.00% in order to reduce general borrowing costs and stimulate the economy. But between June of 2004 and June of 2006, the FOMC raised rates fourteen times to 5.25%. The rate remained there until last month when the committee cut the rate by 0.50% to 4.75%.

In the meetings between the last rate increase and September's rate cut, the FOMC had said that its primary concern was with the threat of inflation. In the meetings just prior to last month's, the committee said that though it expected elevated inflation levels to abate over time, the possibility that they might not abate as expected was keeping the Fed in a wait-and-see stance regarding rates.

But the troubled housing and mortgage industries jolted the credit market since it caused investors to back away from risky mortgage debt. Consequently, lenders in general have tightened loan standards, making it
harder to borrow money. In the meantime, holders of mortgage loan products are in a bind since buyers are scarce. This bottleneck reduces the amount of money flowing through the monetary system and drives up the cost of borrowing.

With the complex network of risk-sharing in the world markets, the situation has become wide-spread. In August, France's largest bank froze three of its hedge funds, not allowing investors to add to or liquidate their holdings. The incident prompted central banks in numerous countries to make short-term loans to banks in order to keep money flowing and ease investor anxiety.

The Federal Reserve was one of the banks pumping additional reserves into the monetary system. It even made a 0.50% cut to the discount rate in August. The discount rate is the rate banks must pay for loans directly from the Fed. In addition, the committee extended the length of time reserves could be borrowed and it made a public relations push to diminish the negative connotations attached to such borrowing (loans from the Fed were typically considered last resort measures).

Nevertheless, short-term commercial debt offerings dried up and investors flocked to the safety of government backed securities (Treasuries). In order to ease the credit situation, the Fed made another 0.50% cut to the discount rate and cut the fed funds rate last month.

The bond market, which normally benefits from rate cuts, took a hit after the Fed action. For one thing, it eased the flight-to-safety flow that had been generated by the credit situation. For another thing, the aggressive actions were seen as potentially inflationary. But, after the initial reaction played itself out, prices of Treasuries trended higher once again -- until today's meltdown.

Fed watchers will be very eager to see if the minutes of the September meeting shed any light on the committee's assessment of the inflation threat and the effect on it that the cuts might make. They will also be interested to see if August's employment report was mentioned as a contributing factor in the committee's decision to cut rates.

The only major economic release on Wednesday is the report on wholesale inventories for August. The release is considered second-tier since the wholesale category is only one part of the inventory picture and the data is somewhat dated. In July's report the Commerce Department said that the seasonally adjusted level of wholesale inventories rose by 0.2%. This was lower than forecasters were calling for and June's previously reported gain of 0.5% was revised down to 0.3%. Moreover, July's gain was the weakest inventory reading since a 0.3% decline was posted last December.

Sales also slowed in July, growing by just 0.1% after a 0.4% increase in June. Yet, inventories remained lean. The inventory-to-sales (I/S) ratio came in at a record low 1.11 for a third consecutive month. 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.

Inventory gains are expected to have been sluggish again in August with a projected increase of 0.2% or 0.3%. The I/S ratio is still expected to indicate lean supply levels, however.

Besides the inventories report, traders will also have a couple of minor, weekly reports to consider. These are the oil inventory report from the Energy Department and the application index data from the Mortgage
Bankers Association.

The release schedule heats up on Thursday. The jobless claims report will highlight the employment situation once again. In yesterday's report, the Labor Department said the seasonally adjusted level of initial claims for state unemployment benefits rose by 16,000 last week to 317,000. The increase was a little stronger than analysts had anticipated but they were looking for a move higher after a net decline of 36,000 over the previous four weeks. The four-week moving average, which smoothes out some of the short-term volatility, was up by just 500 to 312,750. For the year to date, the average weekly level has been 317,564.

The report said that continuing claims for the week ending September 22 (continuing claims must be at least a week old) declined by 10,000 to 2.541 million. The four-week moving average fell by 12,750 to 2,557,250. This was still up from the weekly average for the year to date of 2,530,474.

Little change is expected in this week's claims level but given the larger than expected rise in the last report, a slight pull-back would not be too surprising.

Two trade-related reports are also slated to be released on Thursday morning. These are the report on international trade for August and the report on import / export prices for September. In the last report on the balance of trade, the Commerce Department said that the seasonally adjusted value of imports exceeded that of exports in by $59.2 billion in July. This was a slightly narrower monthly deficit than June's $59.4 billion gap but June's figure was sharply revised from its originally reported $58.1 billion. In fact, data revisions going back to the beginning of the year resulted in larger deficit readings in every month except April.

The report indicated that the value of exports surged by 2.7% in July to a record high $137.9 billion. This was the largest jump since March. But the larger category of imports rose by 1.8% to a record high $196.9
billion.

August's trade gap is expected to be slightly narrower than July's. The consensus prediction is for a deficit of $59.0 billion but some analysts have predicted a gap as small as $58.5 billion. Since net exports constitute a component of gross domestic product, a larger gap figure would translate into a larger deduction from GDP and a smaller deficit would translate into a smaller deduction from GDP.

The report on import and export prices gives some indication of inflation pressures stemming from the trade situation so observers usually focus on the import sector. In the last report the Labor Department said its index of import prices fell in August by 0.3%, the first decline since January. While oil played a part (the price index for petroleum products fell by 1.3%), the decline was broad-based. Even excluding oil, import prices were down by 0.1%. Moreover, July's originally reported overall gain of 1.5% was revised down to 1.3% and the originally reported ex-oil increase of 0.2% was revised to a rise of just 0.1%.

On the export side, prices were up by a 0.2%. The large but volatile category of agricultural products rose by 1.0% but excluding the category, export prices were up by 0.1%. July's originally reported overall gain of 0.2% was revised to a decline of 0.1% and a flat reading (0.0%) excluding agriculture was revised to a decline of 0.2%.

According to the Energy Department, average spot oil prices moved sharply higher last month. Consequently, a rise in the import price index is anticipated. Forecasts are between 0.5% and 1.0%.

Supply may generate some resistance for the bond market on Thursday morning as traders position for the Treasury's auction of 10-Year Treasury Inflation Protected Securities (TIPS). TIPS have a fixed coupon (interest) rate, but their face value is regularly adjusted according to the Consumer Price Index, so the interest payout amounts fluctuate according to the changes in inflation. At maturity, the greater of the inflation-adjusted or original redemption value is paid out.

In the current auction schedule (begun in July of 2003) a new 10-Year TIPS issue is offered twice a year but three months after each initial offering, an additional amount of the issue is sold so there are two initial and two reopening auctions each year. Next week's offering is a reopened of July's issue and the last such auction had a face value of just $6 billion, the lowest offer size for a 10-Year TIPS reopening in the current issue schedule.

The last reopening auction in April was weak. Bids exceeded the $6 billion offer amount by 1.88 to 1, the lowest bid-to-cover ratio for a reopening of the security in three years. Noncompetitive bids, a gauge of individual investor demand, totaled $27 million, the lowest amount for any 10-Year TIPS offering since October of 1998. Foreign demand was extremely light. Indirect competitive bids, which include those from foreign central banks, received just 18.6% of the issue. The average award in this bid category in the previous six reopenings was 47.1%.

But July's initial offering was well-received. The bid-to-cover ratio was 1.97, the highest for an initial offering of the security since January of 2004. Noncompetitive bids totaled $71 million, the largest amount in an initial offering since last July. And indirect competitive bids garnered 43.4% of the issue, the largest portion of an initial sale since January of 2006.

Later Thursday afternoon, the Treasury is scheduled to release its budget figures for September. But, since September marks the end of the 2007 fiscal year, the report may be delayed due to auditing activity. In September of 2006, receipts exceeded government outlays by $56.3 billion. Forecasters predict that last month's bottom line will be a larger surplus of around $100 billion. One of the reasons for the projection is that August's reported deficit of $117.0 billion was much larger than estimates at the time of an $85 billion deficit. Some of the variance may have been due to calendar issues which are expected be compensated for in September's numbers.

If the current prediction is accurate, this would result in a total deficit for the 2007 fiscal year of $174.3 billion. This compares favorably to the $248.1 billion deficit in fiscal year 2006. In fact, it would be the smallest yearly deficit in five years. Lower deficit figures are a plus for bonds since they mean the Treasury will not have to issue as many debt securities (Treasuries) in the future.

Friday's slate of economic releases contains a couple of heavyweights. The report on retail sales will indicate the strength of consumer buying last month. In August's report, the Commerce Department said that the seasonally adjusted level of sales rose by 0.3%. Though this fell short of predictions of a 0.5% gain, July's originally reported increase of 0.3% was revised to a gain of 0.5%.

Auto sales showed strength in August, rising by 2.8%, the largest increase since September of last year. But excluding this sector, sales were down by 0.4%, the largest ex-auto drop since September of 2006. A major contributor to the weakness was the category of sales at gasoline stations. Though lower gas prices were expected to result in lower sales totals, the decline was a larger than anticipated 2.4%, a third consecutive monthly drop and the largest since last October. Excluding both the auto and gas station categories, sales were 0.1% lower in August following an 0.8% increase in July.

For September, overall sales are expected to have risen by 0.2% and ex-auto sales by about 0.3%. Some analysts are looking for stronger sales figures, though.

The other major release on Friday is the Producer Price Index (PPI) data for last month. In the last release, the Labor Department said the PPI, a gauge of inflation at the wholesale level, fell in August by 1.4%, the biggest decline since last October and a much bigger drop than the 0.1% analysts were predicting. As expected, the primary reason for the decline was a drop in energy prices, the index for which fell by 6.6%. This was the largest decline since April of 2003. Another volatile category, foods, also saw a price index contraction of 0.2% -- a fifth consecutive monthly decline.

But excluding these two categories, prices of finished wholesale goods rose by 0.2%. While this was an in-trend core reading and not a major inflation alarm, it came after a 0.1% reading in July and was a little higher than analysts were expecting. On a year-over-year basis, core prices were up by 2.2%, a little less than July's Y/Y increase of 2.3%, but it was still the second highest reading since September of 2005.

Forecasts for September call for an overall increase in the PPI of about 0.5% and an increase at the core level of about 0.2%.

The report on business inventories for August will also be released on Friday. July's report was more bullish than expected. In it, the Commerce Department said that the seasonally adjusted level of inventories rose by 0.5%. Previously released reports on manufacturing and wholesale levels showed 0.2% gains in those categories. The only unknown at the time of the business inventories report was the level of inventories in the retail category. July's report said they rose by 1.0%, the largest jump since May of last year.

Sales were also strong in July, rising by 1.1% following a 0.3% decline in June. The combination of inventory levels and sales pushed the I/S ratio down to 1.26 from June's 1.27. July's reading was only slightly higher than the record low of 1.25.

The latest factory orders report said that manufacturers' inventories were down by 0.1% in August and the forecast for the wholesale sector is for a gain of 0.2% or 0.3%. Despite July's spike in retail inventories, the average monthly change for the year so far is only an increase of 0.3%. If these values are plugged into the weighted calculation of total inventories, it produces a gain of 0.1%. But analysts are apparently looking for another above-trend increase in the retail category since the consensus prediction is for a gain of 0.3%. In any case, the I/S ratio is expected to remain low.

The final economic item on next week's calendar is the initial read on consumer sentiment for the month from the surveys conducted by the University of Michigan. According to news sources, the final index reading for September came in at 83.4, down from the preliminary reading of 83.8 and matching August's final figure as the lowest since August of last year.

The expectations index slipped to 74.1 from the preliminary reading of 74.4 but this was still better than August's final read of 73.7. But the index of current conditions fell to a twelve-month low of 97.9 from the preliminary 98.3 and August's 98.4.

The preliminary September index is expected to reveal an increase in optimism as higher stock prices improve household wealth and lower interest rates increase buying power and brighten the economic outlook.

10:30 AM EDT :

Bond traders did not like this morning's employment report for September and Treasuries are down sharply. Stocks are up but gains there have been relatively mild because of the mixed nature of the news and the fact that price levels are already high.

Although the seasonally adjusted level of nonfarm payrolls rose by 110,000 last month as expected, August's originally reported decline of 4,000 was revised to a gain of 89,000 and July's previously reported gain of 68,000 was revised to 93,000. The stronger numbers are bullish for the economy and argue against the Fed cutting rates.

Another negative for rate cut prospects was a 0.4% increase in average hourly earnings in September following two months of 0.3% increases. The earnings figure is an inflation indicator and aside from the rate implications, high inflation undercuts the present value of bonds since it means interest and principal payouts in the future will be made in less valuable dollars.

In the goods producing sector, construction payrolls fell by 14,000 and manufacturing fell for a fifteenth consecutive month with a decline in September of 18,000. In the services sector, the biggest gainer was education and health, which saw payrolls increase by 44,000. This marked three years of consecutive monthly expansions in that category. The next highest gainer was in leisure and hospitality services where payrolls grew by 35,000, a twenty-third consecutive gain. Payrolls in business and professional services gained 21,000 jobs.

There were weak spots in services, however. Financial activities -- which include finance, insurance, and real estate -- saw a net loss of 14,000 last month, matching August's decline. Retail trade saw a decline of 5,200.

A key category behind the revisions to July and August was government employment. July's previously reported decline of 52,000 was trimmed to 28,000 and August's originally reported decline of 28,000 was revised to an increase of 57,000. In September, government payrolls grew by 37,000.

Despite the increases in payroll, they were not enough to prevent the unemployment rate from edging up to 4.7%. Though still considered low, the rate is the highest since August of last year. The unemployment rate is the portion of the workforce (over 16 years old and actively seeking employment) without jobs. While the number of jobs can increase, so can the workforce. Today's report said that it rose by 573,000 individuals in September after falling by 340,000 in August.

The report is especially significant since August's reported decline was seen as an important influence on the Fed's decision to cut rates at the last policy meeting on September 18. The improved assessment of the labor situation therefore diminishes expectations for another rate cut at the next meeting slated for the 30th and 31st of this month.

The bond market's reaction to the jobs report may be getting an extra nudge due to a reduced trading window today. The Securities Industry and Financial Markets Association (formerly the Bond Market Association) has recommended an early (2:00 PM EDT) close today ahead of the Columbus Day weekend. The bond market will be closed on Monday though the stock market will remain open.

In the stock market, the bullish economic implications of the payroll number are currently the focus of attention. Traders are even discounting negative guidance from Merrill Lynch and Washington Mutual this morning as backward-looking data that will be followed by improvements in the current quarter. Another supportive factor is a decline in oil futures. In recent trading, the price of a barrel of crude oil for November delivery was down by $0.57 to $80.87.