Weekly Report 9/24/07

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 24, 2007)
Day Release Period Survey Actual Prior Revised
Monday No Releases
Tuesday S&P/CS Composite-20 YoY JUL -4.0% -- -3.5% --
S&P/CS Home Price Index JUL -- -- 199.2 --
Consumer Confidence SEP 104.0 -- 105.0 --
Richmond Fed Manufacturing Index SEP 5 -- 2.3% --
Existing Home Sales AUG 5.49M -- 5.75M --
Existing Home Sales MoM AUG -4.6% -- -0.2% --
ABC Consumer Confidence SEP 23 -- -- -- --
Wednesday MBA Mortgage Applications SEP 21 -- -- -- --
Durable Goods Orders AUG -3.5% -- 5.9% --
Durable Goods Ex Transportation AUG -0.8% -- 3.7% --
Initial Jobless Claims SEP 22 317K -- 311K --
Continuing Claims SEP 15 2555K -- 2544K --
GDP Annualized 2Q F 3.9% -- 4.0% --
Personal Consumption 2Q F 1.4% -- 1.4% --
GDP Price Index 2Q F 2.7% -- 2.7% --
Core PCE QoQ 2Q F 1.3% -- 1.3% --
Thursday New Home Sales AUG 828K -- 870K --
New Home Sales MoM AUG -4.9% -- 2.8% --
Friday Help Wanted Index AUG 24 -- 25 --
Personal Income AUG 0.4% -- 0.5% --
Personal Spending AUG 0.4% -- 0.4% --
PCE Deflator YoY AUG -- -- 2.1% --
PCE Core MoM AUG 0.1% -- 0.1% --
PCE Core YoY AUG 1.8% -- 1.9% --
Chicago Purchasing Manager SEP 53.0 -- 53.8 --
Construction Spending MoM AUG -0.2% -- -0.4% --
U. of Michigan Confidence SEP F 84.0 -- 83.8 --

Market Preview
Next week’s scheduled economic releases are expected to focus on many different fronts including housing, manufacturing, inflation and the consumer. Likely to be most closely watched will be those numbers related to the consumer’s health, given the market’s recent concerns over the economy and its roughly 70% control over the economy. As such, consumer-focused releases will come from Tuesday’s Consumer Confidence for September, expected to carry a 104.0 reading, the weekly ABC Consumer Confidence readings, Wednesday’s Personal Consumption figures for the 2nd Quarter and finally, from Friday’s triple reports of Personal Income, Personal Spending and September Final for the University of Michigan Consumer Confidence Index.

Housing-related data will carry near-equal weight where releases come from Tuesday’s S&P/CS Home Price Index and Existing Home Sales, expected to be down 4.6% from July. Thursday’s release of New Home Sales completes the housing picture for the week. Manufacturing data is reflected in reports from the Richmond Fed, Durable Goods Orders, and GDP for the 2Q07 and the Chicago Purchasing Manager’s Index. Lastly, any inflationary pricing pressures will be covered in the GDP’s Personal Consumption Index and the GDP Price Index, both expected to show contained prices.

In keeping with last week’s start of the quarterly earnings season, expect new and industry-leading companies’ releases to shape performance in the week’s equity markets. Expect bond markets to be primarily impacted by updated views about the likelihood of an economic recession.

ECONOMIC CALENDAR REVIEW (week of September 17, 2007)
Day Release Period Survey Actual Prior Revised
Monday Empire Manufacturing SEP 18.0 14.7 25.1 --
Tuesday Producer Price Index MoM AUG -0.3% -1.4% 0.6% --
PPI Ex Food & Energy MoM AUG 0.1% 0.2% 0.1% --
Producer Price Index YoY AUG 3.2% 2.2% 4.0% --
PPI Ex Food & Energy YoY AUG 2.2% 2.2% 2.3% --
Net Long-Term TIC Flows JUL $85.0B $19.2B $120.9B $97.3B
Total Net TIC Flows JUL $60.0B $103.8B $58.8B $34.4B
NAHB Housing Market Index SEP 20 20 22 --
FOMC Rate Decision Expected SEP 18 5.00% 4.75% 5.25% --
ABC Consumer Confidence SEP 16 -- -15 -17 --
Wednesday MBA Mortgage Applications SEP 14 -- 2.4% 5.5% --
Consumer Price Index MoM AUG 0.0% -0.1% 0.1% --
CPI Ex Food & Energy MoM AUG 0.2% 0.2% 0.2% --
Consumer Price Index YoY AUG 2.1% 2.0% 2.4% --
CPI Ex Food & Energy YoY AUG 2.2% 2.1% 2.2% --
CPI Core Index SA AUG -- 211.250 210.933 --
Consumer Price Index NSA AUG 208.000 207.917 208.299 --
Housing Starts AUG 1350K 1331K 1381K 1367K
Building Permits AUG 1348K 1307K 1373K 1389K
Thursday Initial Jobless Claims SEP 15 321K 311K 319K 320K
Continuing Claims SEP 8 2575K 2544K 2585K 2597K
Leading Indicators AUG -0.4% -0.6% 0.4% 0.7%
Philadelphia Fed. SEP 2.6 10.9 0.0 --
Friday No Releases

Last Week’s Market in Review
Markets last week were startled by news of the Fed’s larger-than-expected rate cuts, causing markets to square up to the new operating environment. 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
Most economic numbers released last week were near or below their expectations, helping to solidify the Fed’s need to take more aggressive action, however some data clearly didn’t support the Fed’s moves, leading some market participants to question whether the Fed may have gone too far, bailing out risky investor behavior and violating the principle of moral hazard. In general, most inflationary numbers did give the all-clear sign for the Fed to lower rates, although with commodity prices hitting near-daily record highs, it’s a challenging debate to square up market activity with such benign inflationary readings, particularly the PPI numbers. Data not supporting the Fed’s moves were centered on manufacturing and employment. The Empire Manufacturing and Philly Fed reports showed manufacturing continuing to hum right along, perhaps benefiting from a lower US$ in world markets, while most troubling was the weekly Jobless Claims numbers, both Initial and Continuing. These numbers clearly threw a wrench into the market’s expectations of a recession, as both releases showed jobless claims contracting significantly. With last month’s weak Employment Report acting as the harbinger of swinging sentiment towards a declining economy and the need for a Fed rescue of sorts, this past week’s Jobless Claims figures bring into serious question last month’s Employment numbers, which may have an upward revision in its future. You may recall that August’s NonFarm Payroll numbers that showed a contraction of 4,000 jobs was mostly the result of a precipitous decline in government jobs. Some analysts suggested that a seasonal distortion in government jobs caused by teachers returning to classes may have been the primary reason for the decline, making the likelihood of later revisions possible.

Bond Markets
Commercial Paper – Asset-Backed Commercial Paper (ABCP) saw significant improvement last week, benefiting both from Fed action and lower perceived credit risks in the market, mostly the result of the ejection of defunct issuers in this market. Despite the market stabilization for the week, difficult markets prevailed as concerns over the market value of the assets collateralizing the ABCP continued to make it challenging environment to attract buyers. CP yields fell 44bp to end the week at 5.19% while outstanding CP balances continued to fall, ending the week at $1.87T, where an additional $48.1 billion in CP fell from the market. The CP market has now declined in each of the last 6 weeks, bringing it to the lowest outstanding CP market in the last 7 years. Declines in ABCP outstanding contributed $15.6 billion of the overall decline.

In improvements in the CP market in European markets, the Bank of England announced last week that they would copy the Fed’s move from a few weeks ago and will now accept 3-Month Commercial Paper as collateral for 3-Month borrowings from the central bank. This has significantly improved the standing of CP markets overseas.

Treasury Bills – Demand for 1, 3, & 6-month US Treasury bills increased again for the 4th straight week, causing yields to fall in response. Yields fell 53, 22 & 12 basis points to yields of 3.31%, 3.77% and 4.09%, respectively. Actions by the Fed and concerns over the potential rise of inflationary pressures from these actions steepened the short-end yield curve.

Treasury Notes - 2-10 year maturity US Treasury notes fell on the week, steepening the yield curve in the process. The closely-watched 2-10-year maturity spread rose 16bp over the week to a spread of 58bp. Yields for 2-Yr notes rose 1bp to end the week at 4.05% while the benchmark 10-Yr U.S. Treasury note also fell on the week, sending its yield up 17bp to a 4.63% level.

TIPS – Treasury Inflation-Protected Securities experienced a highly eventful week leading the benchmark 10-year security to see its yield rise 10bp to a 4.70% level. This yield increase was the result of a combination 20bp rise in the security’s real yield to 3.30% on investor’s revised views of higher future inflation and an updated CPI rate released last week that showed a lower year-over-year price rise. On the year, TIPS have generated the highest return of any investment-grade class of securities in the fixed income markets. Sporting a 6.54% return year-to-date, vs. a US Government Credit Index that has generated a return of 3.82% over the same period. In an era of higher expected inflation rates, TIPS would be expected to benefit more than nominal securities, due to this security’s unique capability of protecting investors from the negative effects of inflation.

Interest Rate Markets
Fed Funds – After last week’s surprise rate cut of 50bp by the FOMC to 4.75%, the options market is currently forecasting another rate cut by the October meeting to 4.50%. Options for the Fed Funds target rate forecast a 48% chance of a 25bp cut in the target Fed Funds rate, equivalent to the forecast of a 25bp rate cut held the prior week. The market holds a 37% chance of no change in the rate. [See FOMC Fed Funds Target Implied Probability Chart below]

LIBOR – Last week, actions by the Bank of England and the Fed served to reduce risks in most European markets, allowing LIBOR to fall. On the week, 3-Month LOBOR fell about 50bp, both on lower perceived risks to credit markets and the Fed’s rate cuts.

TED Spread – the “TED” spread, defined as the difference in Treasury vs. Euro-Dollar (or more precisely LIBOR) rates contracted by 23bp to end the week at a spread of 143bp. The TED spread has averaged a level of 50bp over the past 12 months 3-Month LIBOR rates fell to a 5.20% level, down about 44bp, while 3-Month Treasury bill yields fell a smaller amount of 22bp, ending the week at a yield of 3.77%. A significant improvement in the European financial markets and a reduction in short-term T-Bill rates on the view the Fed may be on the verge of a series of rate reductions designed to revive economic growth rates..

Discount Rate – The FOMC chose to reduce the discount rate at last week’s scheduled meeting by an equivalent amount as the targeted Fed funds rate, moving the lending rate to a 5.25% level.

Stock Markets
Stock market volatility fell significantly last week after the Fed’s move brought order to markets by reducing both the Fed Funds and Discount Rate. With a lower discount rate to apply to earnings models, stock markets rallied on the Fed’s news, ending up around 3% on the week from the previous week’s close. This was the largest one-week gain since March of this year. Year-to-date, the Dow Jones Industrial Average has risen 10.9%, while the S&P 500’s rise has been less robust at 7.6%. Large-cap stocks have led the markets this year primarily on their larger overseas exposures, which have benefited from a lower US$. The NASDAQ has risen 10.6% over the same time period as technology stocks have benefited from a strong level of business capital spending. While these returns are strong, they pale in comparison to the Chinese stock market’s impressive rise of 167.9%, also year-to-date.

The CBOE’s VIX index, which measures volatility in the S&P 500, fell significantly to a week-ending level of 19.00 from the previous week’s close of 24.92, and down from recent highs above 30, but still above its 1-year average of 14.60.

Currency Markets
US$ - On news of the Fed’s move with the Fed Funds and Discount Rates, the US$ lost even more ground last week, closing Friday at a 78.59 level against other major currencies, after hitting an intra-week low of 78.40. Only against the Japanese Yen did the dollar show any strength. Against the Canadian dollar, popularly referred to as the Loonie, value parity was reached, making both currencies’ value equal for the first time since 1976. Traders expect the dollar’s value to fall further, particularly if the Fed continues to reduce its targeted Fed Funds rate.

Commodity Markets
Commodities - as represented by the Continuous Commodity Index, or CCI, rose an additional 3.4% from the prior week as commodity prices reacted to supply constraints. This index has rallied over 10% higher over the last month. Crude oil continued to lead the index higher, closing the week at $81.620 per barrel, up $2.52, and after closing at an intra-week high of $83.90. Tensions with Iran resurfaced on the week, pushing traders to rally the commodity on views of possible supply disruptions. Other markets, such as corn and wheat continued to rally as well, with wheat continuing to hit another all-time high, closing the week at $874 per contract of 50,000 bushels, up $36 from the previous week’s close.

Fed and Global Central Banks
The U.S. Federal Reserve and the Bank of England garnered the spotlight last week, as the markets essentially forced both central banks’ hands to abandon the argument of moral hazard and move to restore market calm. The Bank of England’s moves were the most debated as their stronger views on moral hazard had caused them to avoid the prospects of bailing out its own markets, which saw the debate focus on the troubles of Northern Rock, Plc, a British building society (Britain’s equivalent of a U.S. thrift). Northern Rock had seen the value of its balance sheet deteriorate rapidly from recent market turmoil. At first, the BoE essentially ignored the troubles on the view of moral hazard, which implies that coming to its rescue would have effectively bailed out risky market behavior. When the BoE did act, they did so by copying the U.S. Fed’s recent allowance of accepting mortgage loans as collateral to any central bank borrowing. This news had the unintended effect of creating a run on the institution’s deposits. Arguing that their new plan would be focused on rescuing depositors, not shareholders, the BoE then took the drastic step of guaranteeing all or Northern Rock’s depositors regardless of their balances. On this news, the run was halted and European markets reacted favorably, sending LIBOR down to end the week at a 5.20% level.

The Fed’s spotlight was more timed as the scheduled FOMC meeting was widely expected to force the Fed’s hand through a 25bp cut in the targeted Fed Funds rate. When the Fed announced its move, it shocked most market participants by cutting both the Fed Funds and Discount Rate by 50bp, to 4.75% and 5.25%, respectively. In its closely-watched “statement” the Fed said it made its moves to prevent the downturn in the nation’s housing market from having further negative impact to the economy. Debates surfaced on the news, as several market participants began questioning the move based on arguments such as the potential of the move to raise inflationary expectations, to being non-supportive of the US$, to violating the Fed’s “moral hazard”. Most all analysts deemed this move as the establishment of the “Bernanke Put”. During Greenspan’s tenure as Fed Chairman, his accommodative moves to restore investor calm and promote growth were styled as the “Greenspan Put”, referring to a put as an investment security designed to provide gains in down markets.

Other market participants looked upon the Fed’s moves with even more questions. While most all welcomed the Fed’s moves on the views of it restoring calm and helping markets recover, there is a growing chorus of calls for the Fed to initiate some form of punishment to those viewed as having gotten the economy into this mess. Congress and other politicians have focused on the easy route, criticizing lenders’ actions as “predatory” and the result of “risky lending practices” over the past several years. The result has been a slew of bills and televised hearings. But other more thoughtful analysts have looked beyond that view to a deeper culprit, that of the ultimate buyer of subprime loans. In most cases these buyers are hedge funds. These analysts argue that subprime loans would not have been originated in the manner and depth in which they were, if it weren’t for the fact that willing buyers stood ready to assume the risks. The risk for prime loans is assumed by some market investors, but mostly by Fannie Mae, Freddie Mac and Ginnie Mae. No such governmental entity exists to buy subprime loans, with the exception of some small programs administered by the Federal Housing Authority, or FHA. Even deeper still, these analysts argue the extensive use of leverage by these subprime buyers (mostly hedge funds) has taken a loan type that represents only about 17% of the entire mortgage market and made it into a much larger problem through the extensive use of leverage. As all hedge funds are completely unregulated, these funds engage in behavior that most market investors would never consider, only to have the emergence of the Bernanke Put bail them out, by lowering their cost of funds. Just as leverage is limited in all markets, either by regulation or more conservative business practices, these analysts are using this as a wake-up call to the dangers that unregulated and highly aggressive investors can unleash on markets that are forced to obey the rules.

Economic / Interest Rate Survey
The following table details an August 9th survey of approximately 75 of the nation’s leading economists.
Indicator 3Q07 4Q07 1Q08 2Q08 3Q08 Avg. 2007
GDP 2.4% 2.2% 2.4% 2.5% 2.8% 2.0%
Prev. Survey 2.5% 2.6% 2.7% 2.8% 2.8% 2.0%
Cons. Spend. 2.2% 2.3% 2.5% 2.5% 2.5% 2.8%
Prev. Survey 2.3% 2.7% 2.6% 2.6% 2.6% 2.8%
Unemp. Rate 4.7% 4.7% 4.8% 4.9% 4.9% 4.6%
Prev. Survey 4.6% 4.7% 4.7% 4.7% 4.7% 4.6%
CPI 2.6% 3.3% 2.8% 2.2% 2.3% 2.7%
Prev. Survey 2.6% 3.4% 3.0% 2.3% 2.3% 2.8%
Indicator 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08
Fed Funds 5.00% 4.75% 4.75% 4.75% 4.75% 4.75%
Prev. Survey 5.25% 5.25% 5.25% 5.25% 5.25% 5.25%
10-Yr. Note 4.55% 4.63% 4.75% 4.90% 5.00% 5.00%
Prev. Survey 4.90% 5.00% 5.10% 5.15% 5.20% 5.25%
2-Yr. Note 4.20% 4.30% 4.40% 4.50% 4.60% 4.70%
Prev. Survey 4.80% 4.86% 4.90% 4.90% 5.00% 5.00%
Q07 4Q07 1Q08 2Q08 3Q08 Avg. 2007

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)