Weekly Report - 9/10/07

DE KONING & COMPANY, LLC
W E E K L Y E C O N O M I C & I N T E R E S T R A T E M O N I T O R

ECONOMIC CALENDAR PREVIEW (week of September 10, 2007)
Day Release Period Survey Actual Prior Revised
Monday Consumer Credit JUL $8.0B -- $13.2B --
Tuesday Trade Balance JUL -$59.0B -- -$58.1B --
IBD/TIPP Economic Optimism SEP -- -- 49.5 --
Wednesday ABC Consumer Confidence SEP 9 -- -- -17 --
MBA Mortgage Applications SEP 7 -- -- 1.3% --
Thursday Initial Jobless Claims SEP 8 325K -- 318K --
Continuing Claims SEP 1 2570K -- 2598K --
Monthly Budget Statement AUG -$81.3B -- -$64.7B --
Current Account Balance 2Q -$190.0B -- -$192.6B --
Friday Import Price Index (MoM) AUG 0.2% -- 1.5% --
Import Price Index (YoY) AUG -- -- 2.8% --
Advance Retail Sales AUG 0.5% -- 0.3% --
Retail Sales Less Autos AUG 0.2% -- 0.4% --
Industrial Production AUG 0.3% -- 0.3% --
Capacity Utilization AUG 82.0% -- 81.9% --
U. of Michigan Confidence SEP P 83.5 -- 83.4 --
Business Inventories JUL 0.3% -- 0.4% --

Market Preview
Next week’s scheduled economic releases will offer investors a closer look at consumer’s health and the manufacturing sector. Consumer data starts with Monday’s release of Consumer Credit, expected to rise $9.1B, down from June’s surprisingly high $13.2B reading. This will then be followed by the IBD/TIPP Economic Optimism report, the weekly ABC Consumer Confidence numbers and the weekly MBA Mortgage Applications reading, which has been up the last 2 weeks in a row, in spite of higher mortgage rates, falling house prices and talk of a credit crunch. Jobless Claims, both initial and continuing, will be closely monitored for any confirmation of last week’s surprisingly weak NonFarm Payrolls number. Consumer data will then conclude with Friday’s release of Retail Sales, expected to be up 0.5%, and finish with the preliminary September report on Univ. of Michigan Confidence reading, expected at an 84.0 reading. Tuesday’s release of the nation’s Trade Balance is expected at a $59.0 billion deficit. The Trade Balance deficit has stabilized over the past 1-2 years, as the effect of a lower US $ has made US goods more competitive overseas. The US still imports more than it exports, however that trend seems to be stalling somewhat. The nation’s Current Account Balance, expected at a $190.0B deficit, will be announced Thursday. Finally, Friday brings the Import Price Index, Industrial Production, Capacity Utilization and Business Inventories. All are expected to show a manufacturing sector exhibiting steady growth, contrary to the conventional wisdom of a looming recession.

Look for investors to regain some focus on economic numbers as they primarily watch the Fed for signs of an intra-meeting cut in the Fed Funds rate. Particularly, look for markets to focus on Thursday’s Retail Sales numbers. If they’re weaker than expected, markets will use this data to increase calls for a Fed rate cut on the view that an economy primarily based on the consumer will be witnessing a consumer retrenchment, requiring Fed action to stave off potential further declines.



ECONOMIC CALENDAR REVIEW (week of September 3, 2007)
Day Release Period Survey Actual Prior Revised
Monday Labor Day Holiday – No Releases
Tuesday ISM Manufacturing AUG 53.0 52.9 53.8 --
ISM Prices Paid AUG 63.0 63.0 65.0 --
Construction Spending MoM JUL 0.0% -0.4% -0.3% 0.1%
Total Vehicle Sales AUG 15.6M 16.3M 15.5M --
Domestic Vehicle Sales AUG 11.9M 12.7M 11.7M --
Wednesday ABC Consumer Confidence SEP 2 -20 -17 -19 --
MBA Mortgage Applications AUG 31 -- 1.3% -4.0% --
Challenger Job Cuts YoY AUG -- 21.7% 15.4% --
ADP Employment Change AUG 80K 38K 48K --
Pending Home Sales MoM JUL -2.2% -12.2% 5.0%
Fed’s Beige Book
Thursday NonFarm Productivity 2Q F 2.4% 2.6% 1.8%
Unit Labor Costs 2Q F 1.5% 1.4% 2.1%
Initial Jobless Claims SEP 1 328K 318K 334K 337K
Continuing Claims AUG 25 2575K 2598K 2579K 2573K
ISM Non-Manufacturing AUG 54.5 55.8 55.8 --
ICSC Chair Store Sales YoY AUG 2.5% 2.9% 2.6% --
Friday Change in NonFarm Payrolls AUG 108K -4K 92K 68K
Unemployment Rate AUG 4.6% 4.6% 4.6% --
Change in Manufacturing Payrolls AUG -12K -46K -2K -1K
Average Hourly Earnings MoM AUG 0.3% 0.3% 0.3% --
Average Hourly Earnings YoY AUG 3.9% 3.9% 3.9% --
Average Weekly Hours AUG 33.8 33.8 33.8 --
Wholesale Inventories AUG 0.4% -- 0.5% --

Last Week’s Market in Review
Markets last week returned to shaky ground, particularly after Friday’s release of the August Employment Report. As such, the following set of commentary is an attempt to report on changes in particular market segments while adding some perspective in the process.

Economic Statistics
Several upbeat economic numbers were released last week, but any progress was quickly smothered by Friday’s release of the August Employment Report. This report showed that August net job creation actually contracted by 4,000 jobs, the first contraction since August 2003. The Unemployment Rate stayed even at 4.6%. Adding to the injury, July’s figure was reduced from 92,000 jobs to 68,000 jobs. Economists had expected 100,000 jobs to have been created in August. On top of even that, Manufacturing jobs fell by 46,000 from the projection of a contraction of 10,000 jobs. This was viewed with alarm as previous reports had suggested the Manufacturing sector had been benefiting from a lower US dollar. Notably, the decline was led by a sharp drop in Government jobs, which some suggest is a seasonal anomaly associated with teachers and the new school year, while other analysts pointed out that the service industry, which drives approximately 70% of the total economy, actually boosted payrolls by 60,000 jobs in August, after adding 78,000 jobs in July. This suggested that the consumer may not be as affected by the market’s recent turmoil as the headline numbers might suggest.

It is believed that both job and wage growth is needed to help sustain consumer spending. This report kicks the legs out of the job growth side of the equation, but a 3.9% year-over-year gain in wages continues to support the wage side. Month-over-month, wages rose 0.3%, which typically wouldn’t occur in a time when jobs are actually contracting, bringing the question over the so-called seasonal effect from teachers on the headline numbers into a higher level of debate.

On the Employment Report’s release, markets sang with a chorus of calls for the Fed to lower the targeted Fed Funds rate, with many calling for an immediate intra-meeting decrease and others calling for a larger 50 basis point drop to occur. Even others said the Fed is emphatically behind the curve and isn’t in step with the impact of the markets recent problems.

Bond Markets
Commercial Paper – Asset-Backed Commercial Paper (ABCP) saw another week of difficult markets as concerns over the market value of the assets collateralizing the ABCP continued to make it difficult to attract buyers. As a result, CP market yields rose to another 6-year high of 6.30%. Outstanding CP levels fell an additional $54 billion on the week to a $1.93T level. Outstanding CP levels have dropped 13% over the past month, or roughly $300 billion, of which $216.2 billion are direct obligations of ABCP issuers. CP investors are being even more selective in recent days, focusing on avoiding issues from Structured Investment Vehicles, also known as SIV’s. SIV issuers are even more exposed to their ability to roll maturing paper than so-called conduits, due to their lower reliance on bank liquidity agreements to ensure investors will be paid at maturity. SIV’s are also required to hold assets and credit facilities equal to as much as 3 weeks of net outflows of maturing paper. These rollover issues have prompted SIV’s to be forced to liquidate assets to repay CP investors, furthering the downward market spiral. Increasing the ABCP market uncertainty, Moody’s last week downgraded or placed on review $14 billion of CP sold by SIV’s.

Market participants are beginning to realize that while increased foreclosures on subprime loans ignited the market’s flame, the extensive use of leverage by investors in these markets has built the flame into a firestorm. In past markets, this would have likely been a much more manageable problem, but in today’s markets where investors are leveraged through the issuance of CP many times over, any so-called run on the markets can have a devastating impact, even enveloping the financial health of non-leveraged investors.

Money-center and investment banks alike continue to have significant exposures to CP markets, namely from letters of credit they have issued to provide liquidity to these issuers in the event they cannot refund maturing paper. The reason these liabilities aren’t broadly reported is due to their structure as conduits where the 1st-loss exposure has been previously sold to equity driven investors. Because the 1st-loss exposure is held by others, accounting rules allow banks to treat their stop-gap exposures as off-balance sheet liabilities. Market participants are pressing these banks for more transparency regarding these exposures. The last time the shaky use off balance sheet accounting was a market issue, the collapse of Enron and other energy companies occurred.

The Federal Reserve has recognized the problems in this market and 3 weeks ago allowed banks to borrow from the Fed discount window and use ABCP securities as collateral for those borrowings – a significant expansion of the Fed’s willingness to contain the market’s recent problems. Other analysts see the exposures as too great for even the largest money-center and investment banks and have issued profit and sell warnings. Also, analysts insist that the requirements to lend money to CP issuers, per their letter of credit guarantees, is so great that it has created its own virtual credit crunch, where these bank’s lending capacity has been captured by their CP obligations, effectively shutting other legitimate borrowers out of the market. [See related discussion under Fed below]

Treasury Bills – Demand for 1, 3, & 6-month US Treasury bills increased somewhat for the 2nd straight week, causing yields to fall in response. Yields fell 13, 5 & 2 basis points to yields of 4.04%, 4.07% and 4.19%, respectively. Yields had risen throughout the week until Friday’s release of the August Employment Report increased calls for Fed rate cuts to combat what some are calling a likely recession.

Treasury Notes - 2-10 year maturity US Treasury notes rallied as well on the week where both maturities fell in yield. The closely-watched 2-10-year maturity spread widened for the 2nd week in a row by 9bp to a spread of 48bp. Yields for 2-Yr notes fell 23bp to end the week at 3.91%, in line with the rally in shorter bills. The benchmark 10-Yr U.S. Treasury note also rallied on the week, pushing its yield down 14bp to a 4.39% level.

Treasury Bonds – the 30-year long bond also rallied, moving down 12bp on the week to a yield of 4.70%. Treasury market activity on the week continued to flatten the yield curve, even though it’s still positive. Friday’s Employment Report significantly increased the market’s view of a looming recession, causing longer-dated yields to rally.

TIPS – Treasury Inflation-Protected Securities couldn’t stay out of the fray last week, falling in yield to 2.19% for the benchmark 10-year security. This is the lowest real yield since early 2007 and is down from the last 12 month high of 2.82%, recorded on 6/12/07. Many investors view falling real yields as tacit approval for the Fed to lower the targeted Fed Funds rate without igniting the threat of inflation, currently standing at 2.4%.

Interest Rate Markets
Fed Funds – The options market suggests a 42% chance of a cut in the target Fed Funds rate to a level of 4.75%. However, there’s a slightly lower 37% chance of a rate cut to only 5.00%. The previous week’s predictions forecast a 21% probability of a decrease to 4.75% and a 46% chance of a drop to 5.00%. [See FOMC Fed Funds Target Implied Probability Chart below]

TED Spread – the “TED” spread, defined as the difference in Treasury vs. Euro-Dollar (or more precisely LIBOR) rates widened further on the week to a spread of 166bp. This was after ending the prior week at 155bp. A rallying 3 Mo T-Bill and a rising 3 Mo LIBOR rate accounted for the changes.

Discount Rate – There was no significant news to report on Discount Rate activity over the past week.

Stock Markets
Stock market volatility picked back up last week, as equity prices fell around 2% from the previous Friday. The weak Employment Report pushed talk of an economic recession, sending prices lower, particularly those of consumer luxury items. Banks and financial companies continued to lag behind the broader market, now showing a year-to-date decline of 12.1% vs. a gain of 2.5% for the S&P 500. The CBOE’s VIX index, which measures volatility in the S&P 500, rose to a week-ending level of 26.23, though still down from recent highs above 30. Its 1-year average stands at 14.16.

Currency Markets
US$ - The US$ lost ground last week, closing Friday at its lowest level over the past year against other leading currencies. The greenback ended the week at a 79.96 level, suggesting that investment opportunities are contracting in the US markets.

Commodity Markets
Commodities - as represented by the Continuous Commodity Index, or CCI, rose another 1.2% from the prior week as commodities returned to reacting to their normal indicators. Overall, price advances in crude oil led the move higher, where crude ended the week at $76.70 per barrel, up $2.66 on the week.

Fed and Global Central Banks
The Federal Reserve stayed out of the spotlight last week although a significant amount of investor energy was focused debating what they should do. Clearly with last week’s weaker Employment Report, sentiment has shifted to calls in favor of the Fed lowering the targeted Fed Funds rate, possibly by 50bp, and also before the next scheduled FOMC meeting on September 18th.

Interest Rate Chart















Source: C15 Bloomberg

The chart above details the current US Treasury yield curve, along with the same yield curve 1 and 12 months ago.

FOMC Fed Funds Target Implied Probability Chart
The following chart details the market’s views of the probability of changes in the Fed Funds Target rates. Chart 1 shows the option market’s probabilities (of a change in the Fed Funds target level) over a timeframe covering each of the FOMC meetings held over the next several months.

CHART 1
Expected Future Outcomes and Most Likely Path(s)