Housing Starts Send Mixed Signals
The Commerce Department reported today that U.S. Housing Starts rose 8.2% to a 1.032 million pace in April. That headline caught most by surprise and initially sent bond prices falling. But it didn't take long for the details to reverse the sell off. The jump in the total starts headline was led by a sharp 36% increase in multi-family units, which followed a 35% decrease in the same category in March. Multi-family construction seems to be getting a boost as rising foreclosures and tighter credit turn former homeowners into renters. Meanwhile, single-family starts fell to an annual pace of 692,000, the slowest pace since January 1991. Even so, starts are still at a level which is adding to an already bloated supply of homes for sale.

Earlier in the week RealtyTrac Inc. reported that U.S. foreclosure filings climbed 65% in April from year ago levels. More than 243,000 properties were in some stage of foreclosure. According to RealtyTrac, banks will seize about 60,000 properties every month through the end of this year, and estimated that banks will own about 1 million of the more than 4 million U.S. homes for sale. This problem is not going away anytime soon.

Univ. of Michigan Measure of Consumer Confidence Plunges
The Reuters/University of Michigan preliminary index of consumer sentiment decreased from 62.6 in April to 59.5 in May, the weakest showing since June 1980. This index averaged 85.6 during 2007. Falling house values, rising loan delinquencies, mounting job losses and increasing costs for food and energy are sapping confidence. According to AAA, the national average price of regular unleaded gas climbed to $3.79 per gallon yesterday, an increase of 24% so far this year. Gas prices are not likely to recede anytime soon as crude oil has topped $127 per barrel. Goldman Sachs recently raised their price forecast for the second half of this year to $141 a barrel.

Fed Stuck Between a Rock and a Hard Place
The Federal Reserve and financial markets are struggling with competing interests. On the one hand, slowing economies would call for additional rate cuts. On the other hand, inflation has become more worrisome. Typically a slowing economy would lessen inflationary pressures, and that is still the general expectation. But central bank officials may want to see some hard evidence of this before they cut rates further. Financial markets are acting more like the Fed is done cutting rates. For more than a year the two-year Treasury yield had been below the prevailing fed funds rate, indicating an expectation for cuts in the funds rate. But during the last month, the two-year Treasury has climbed to 2.40%, 40bps above the current fed funds rate and very close to the historical norm. Fed funds futures imply a 90% chance that the Fed will sit tight at 2.00% at the two next meetings on June 25th and August 5th.

Market Indications as of 11:42 a.m. Central Time
DOW - down 58 to 12,935
NASDAQ - down 15 to 2,519
S&P 500 - down 4 to 1,419
1-Yr T-note unchanged 1.97%
2-Yr T-note up 1/32 to 2.40%
5-Yr T-note up 3/32 to 3.06%
10-Yr T-note up 8/32 to 3.78%
30-Yr T-bond up 20/32 to 4.51%

Retail Sales (ex-autos) Better Than Expected
Retail sales fell by 0.2% during the month of April following a slight rise in March. Although the April overall number equaled the median Bloomberg forecast, sales ex-autos, rose by a strong 0.5%, more than doubling forecasts. The market seemed to interpret this rise as a sign that consumers are in better shape than previously thought, although this is open for debate.

Fed Talk
This morning, Ben Bernanke, in a speech at an Atlanta Fed conference, said that the financial markets remain “unsettled” and “far from normal” and that the Fed stands ready to “increase the size of the (TAF) auctions if further warranted by financial developments.” This shows that the Fed is still very concerned about liquidity, but is not hinting that it will make additional rate cuts in the near future, preferring instead to use alternate methods.

Kansas City Fed President Hoenig, also speaking today, said that inflation was at "unacceptable levels".

This morning in Vancouver, San Francisco Fed President Janet Yellen, like Bernanke, described credit markets as "far from normal" and said that she felt the level of monetary accommodation was appropriate and that she expects inflation to slow as the labor market weakens and commodity prices level off.

Yesterday, Chicago Fed President Charles Evans also described current monetary policy as "appropriate".

There were a number of other Fed officials at podiums singing similar verses. The common theme seems to be that the Fed does not expect to cut rates in the foreseeable future.

Late last week, the Federal Reserve April Senior Loan Officer Survey was released and the results showed that credit conditions were still getting tighter despite 225 basis points of easing in 2008. According to information posted on the Fed's website, about 60% of domestic lenders surveyed indicated that they'd tightened their lending standards on prime mortgages during the prior quarter, while about 75% reported tightening standards on non-traditional mortgage loans, and 80% of domestic banks reported tightening standards on commercial real estate loans in the past three months.

The results of this survey suggest that the downturn will be for a prolonged period.

Market Indications as of 1:40 p.m. Central Time
DOW - down 57 to 12,819
NASDAQ - down 1 to 2,489
S&P 500 - down 2 to 1,402
1-Yr T-note down 5/32 to 2.04%
2-Yr T-note down 8/32 to 2.42%
5-Yr T-note down 19/32 to 3.14%
10-Yr T-note down 23/32 to 3.89%
30-Yr T-bond down 35/32 to 4.60%

The Bloomberg Economic Forecast
From May 2 to May 8, 2008, Bloomberg News polled top US economists on their economic and interest rate forecasts. The participation level was quite low this month which probably reflects the high degree of uncertainty associated with the economic and interest rate outlooks.

Unemployment rate - Average forecast for Q2 2008 is 5.2%. The average forecast for the next three quarters are 5.4%, 5.6% and 5.6%.

The current unemployment rate is 5.00%.

Inflation - YOY consumer prices (includes food and energy) - Average forecast for Q2 2008 is 3.6%. The average for the next three quarters are 3.5%, 2.8% and 2.6%.

Inflation almost always drops during economic downturns ...and that's the expectation among economists. If inflation heats up, instead of cooling off, the Fed will be inclined to raise rates. This is the argument against rates staying low for too long.

Gross Domestic Product (GDP) – Average forecast for Q2 2008 is 0.06%. The average for the next three quarters are 1.6%, 1.4% and 1.8%.

A large number of economists including those at Goldman, Morgan Stanley, Morgan Keegan, Lehman, UBS and Merrill are projecting negative second quarter growth.

The average economic growth forecast (revised) for the first quarter is 0.1%.

GDP growth has averaged approximately 3.1% for the past 15 years.

The Bloomberg Interest Rate Forecast
Overnight Fed Funds – Median forecast for Q2 2008 is 2.00%. The median for the next four quarters are 2.00%, 2.00%, 2.00% and 2.50%.

The current funds rate is 2.00%. The next scheduled FOMC meeting is on June 25th. The markets generally expect that the Fed will not cut rates again during this cycle.

Economists generally do not believe that the Fed will begin raising rates for another year.

2-year Treasury-note – Average forecast for Q2 2008 is 2.20%. The average for the next four quarters are 2.22%, 2.28%, 2.59% and 2.89%.

The current two-year yield is 2.38%.

10-year Treasury-note – Average forecast for Q2 2008 is 3.77%. The average for the next four quarters are 3.81%, 3.88%, 4.09% and 4.22%.

The current 10-year yield is 3.85%

Market Indications as of 10:35 a.m. Central Time
DOW - down 88 to 12,788
NASDAQ - down 13 to 2,475
S&P 500 - down 5 to 1,399
1-Yr T-note down 4/32 to 2.01%
2-Yr T-note down 5/32 to 2.38%
5-Yr T-note down 12/32 to 3.08%
10-Yr T-note down 14/32 to 3.85%
30-Yr T-bond down 20/32 to 4.58%

Inflation Concerns Voiced by KC Fed President
Kansas City Fed President Thomas Hoenig said yesterday in a speech to the Denver Economic Club that the U.S. inflation outlook was "troublesome" and that if it got too high, the economy would "suffer greatly". He also said that the Fed was now focused as much on headline inflation as core inflation due to systematic increases in food and energy prices. Although Hoenig isn't a current voting member, to some degree his sentiment is probably shared by a number of Fed officials who are voting members. Although a number of economists are still expecting 1.0% to 1.50% funds rate sometime in 2009, this seems less and less likely as price pressures mount.

The Fed would prefer to use alternate methods to provide liquidity and jump-start the floundering economy. This morning, Fed Chairman Bernanke requested immediate authority to pay interest on commercial bank reserves. At the moment, according to Bloomberg, the Fed is slated to pay interest "at a rate ...not to exceed the general level of short-term interest rates" beginning in October 2011. I haven't seen any dollar figures on how much this will cost taxpayers.

Pending Home Sales and Auto Sales Plunge
Pending home sales keep falling, dampening the hopes of those few who felt that the bottom had already been reached in the housing market. In March, pending sales dropped another 1%, following a revised 1.9% decline the prior month.

Merrill's Chief Economist David Rosenberg pointed out last week that the home vacancy rate rose to an all-time high of 2.9% in Q1. This is terrible. During the peak of the real estate crisis in the early 90's, unoccupied homes reached a high of 1.9%, which probably seemed really high then. In response, home prices continue to fall. Merrill estimates that every 10% drop in home prices subtracts $105 billion from consumer spending. In addition, the rental vacancy rate jumped from 9.6 to 10.1% in Q1. Rosenberg believes that falling rent prices will have a significantly positive impact on inflation. The drop in consumer spending and the easing of housing-related expenses hint at more rate cuts.

Total auto sales in the U.S. dropped by 4.6% to a 10-year low in April. On a year-over-year basis, sales are down 11.5%. Light truck sales have plunged to their lowest levels in more than 12 years as buyers seek relief from soaring gas prices that are now averaging more than $3.60 per gallon. Unfortunately, oil prices topped $122 per barrel yesterday, so there is little relief in sight as the summer driving season approaches.

Yesterday, the ISM non-manufacturing (service sector) index unexpectedly rose above 50 for the first time this year, rising to 52.0 in April. This is hopeful. On Monday, the ISM manufacturing index rose slightly to 48.6, still contracting, but fairly stable. Poor auto sales don't bode well for a manufacturing upturn.

Short bond yields are roughly 25 bps higher than they were a month ago despite the Fed's recent rate cut. No doubt, rising inflation will cause the FOMC to carefully consider the negative impact of any further easing, but regardless of whether they're done or simply pausing for a while, rate hikes are not in the foreseeable future. A spike in lending rates would further damage the housing market.

Bonds are flat this morning, while the equity market is down in mid-day trading.

Vallejo California Votes to File Bankruptcy
The City Council of Vallejo CA voted unanimously to file for bankruptcy, claiming that it would run out of money by June 30th. They had hoped to gain salary concessions from the City's fire and police labor unions, but were unsuccessful. Compensation to these workers represents nearly 80% of the general operating fund budget. Vallejo, a San Francisco suburb with a population of 117,000 would be the largest California city to ever seek bankruptcy protection.

I'm becoming a pessimist.

Market Indications as of 11:40 a.m. Central Time
DOW - down 57 to 12,967
NASDAQ - down 8 to 2,475
S&P 500 - down 9 to 1,412
1-Yr T-note down 0/32 to 1.94%
2-Yr T-note down 0/32 to 2.38%
5-Yr T-note down 0/32 to 3.16%
10-Yr T-note up 1/32 to 3.91%
30-Yr T-bond up 6/32 to 4.65%

Fed Expands TAF
Over the past few weeks the Fed and the markets have come around to the notion that the rate cuts have not had the impact expected, and to some extent may actually be causing more problems. As rates decline, the value of the dollar against other currencies has fallen to record lows. This has been a primary driver in the rising price of oil, grains, metals, and other commodities. After Wednesday's rate cut the Fed hinted that it would use other measures to alleviate liquidity strains in credit markets. This morning, they did exactly that by announcing an expansion of the Term Auction Facility by 50% to $75 billion. The Fed also increased its currency swap arrangements with the European Central Bank and the Swiss National Bank. In yet another move the Fed said it will accept other AAA/Aaa rated asset-backed securities as collateral for Treasury loans through another program called the Term Securities Lending Facility.

Okay, well enough of that, as I write this the Fed's announcement has just been trumped by the much more important employment report. So let's move on...

Job Losses Smaller Than Feared
The Labor Department reported a loss of 20,000 jobs in April, the fourth straight monthly decline and following a loss of 240,000 jobs during the first three months of the year. But the loss of 20,000 jobs was much smaller than the 75,000 the market was expecting, and frankly we saw several estimates closer to minus 100,000. An average monthly loss of 65,000 jobs is fairly small by historical standards. Recessions would normally be expected to result in job losses of well over 100,000 per month. The unemployment rate also improved slightly to 5.0% from last month's 5.1%.

Although today's report certainly reflects a weak job market, it could have been much worse. Aside from housing, economic data has generally been a little better than expected. First quarter GDP was positive at +0.6%; the ISM manufacturing index for April came in better than the 48.0 expected and at 48.6 is just barely below the critical 50 mark; the DOW has climbed back above 13,000; and oil prices have retreated from their highs. It's way too early to declare that the Fed is done cutting interest rates, but today's payroll report adds to some of the positive signs we are seeing on the economic front.

As one would expect, bond prices have fallen and yields are higher across the board following today's news. The two-year Treasury yield, which hit a low for the week around 2.25% after the FOMC meeting on Wednesday, has traded as high as 2.52% this morning. Stock index futures point to higher openings.

Market Indications as of 7:58 a.m. Central Time
DOW - Not open - 13,010 - Futures up 118
NASDAQ - Not open - 2.480 - Futures up 22
S&P 500 - Not open - 1,409 - Futures up 12
1-Yr T-note down 3/32 to 2.05%
2-Yr T-note down 6/32 to 2.47%
5-Yr T-note down 15/32 to 3.18%
10-Yr T-note down 19/32 to 3.837%
30-Yr T-bond down 24/32 to 4.547%

Another Fed Rate Cut
Today, the FOMC announced its decision to cut the Fed Funds rate by 25 basis points to 2%. The Fed also cut the discount rate from 2.50% to 2.25%. While the cuts were widely anticipated, the financial markets had expected the Fed to more clearly indicate that they had concluded rate cuts or at least intended to pause for some period of time. This didn’t happen. The Fed did describe easing up to this point as "substantial", which suggests that the FOMC doesn't anticipate a great deal more to come. However, officials also acknowledged that the economy “remains weak” and reiterated the expectation that inflation will moderate while saying that “the uncertainty about inflation outlook remains high”. Fed words suggest additional cuts may still be necessary.

Yields have fallen slightly in response to the announcement.

Market Indications as of 2:30 p.m. Central Time
DOW - up 33 to 12,864
NASDAQ - down 10 to 2,415
S&P 500 - down 2 to 1,389
1-Yr T-note down 2/32 to 1.96%
2-Yr T-note down 4/32 to 2.27%
5-Yr T-note down 11/32 to 3.03%
10-Yr T-note down 17/32 to 3.75%
30-Yr T-bond down 32/32 to 4.49%

Economic Growth Rises in Q1 2008
Experts generally believe that the U.S. entered recession in the first quarter of this year, but if the measure of recession was two consecutive quarters of negative GDP growth, it didn't happen. The Commerce Department announced that Gross Domestic Product actually rose by 0.6% during the initial quarter of 2008. In all fairness, the increase had been largely expected when forecasters realized that business inventory numbers had risen. Companies added to inventory stockpiles at a $1.8 billion annual rate. This increase boosted GDP by 0.8%, which was just enough to push the overall number into positive territory. The trouble with inventory build-up is that if sales don't keep pace with inventories, the direction will quickly reverse itself.

Other components of GDP were more recession-like. Residential construction fell at an annual rate of 27%, the most since 1981, while business fixed investment dropped by 2.5%, the biggest decline in four years. Housing subtracted 1.23% from GDP, virtually the same as in prior quarter.

The FOMC will announce any change in monetary policy early this afternoon. The most likely scenario will be to cut the overnight rate by another 25 basis points to 2.00%. Today's GDP announcement should not alter this decision. After today, the Fed should be able to lay low until the next scheduled FOMC meeting which isn't until June 25th. The bond market is trading as if the Fed were done easing rates. Most Primary Dealers do not share this view, but instead expect a prolonged pause by the Fed, followed by more rate cuts in late 2008 or early 2009.

Housing Woes Continue
The S&P Case-Shiller home price index plunged by 12.7% year-over-year, the biggest decline since the index began in 2001. Nineteen of the 20 cities that make up the index fell, with Las Vegas (-23%) and Miami (-22%) leading the way. Charlotte was the only city to show an increase, rising by 1.5%. Other home price indices show similar results with new and existing home prices falling by 13.3% and 7.7% over the past 12 months. The problem with the severe drop in home prices is that it makes refinancing high interest rate loans extremely difficult. The positive aspect is that over time, affordability rises and home sales pick up again.

Market Indications as of 9:15 a.m. Central Time
DOW - up 38 to 12,870
NASDAQ - up 5 to 2,430
S&P 500 - up 2 to 1,393
1-Yr T-note up 1/32 to 1.96%
2-Yr T-note up 1/32 to 2.33%
5-Yr T-note up 4/32 to 3.08%
10-Yr T-note up 6/32 to 3.79%
30-Yr T-bond up 10/32 to 4.53%

Yields Up in Anticipation of a Fed Pause
Treasury prices have gotten absolutely hammered (yields up) as investors turn their concerns to rising inflation and increasingly expect that next week's Fed rate cut will be the last. Bloomberg reported that the 72 basis point increase in the two-year T-note yield (form low point to high point) was the biggest two-week move since 1982. The interesting thing about this general shift in thinking is that it comes during a period when the economic data being released is still very bleak. Granted, there have been marginal improvements in durable goods orders and weekly initial unemployment claims, but the housing data has abysmal and consumer sentiment is sinking like a rock. It's quite possible that the Fed could soon pause as the Wall Street Journal suggested yesterday in a front-page story, but there’s little reason to anticipate that the economy will improve significantly anytime soon. A pause may be a prudent, credibility-gaining measure so that the Fed can best assess the inflation picture. But a pause shouldn't imply that the Fed is totally done easing. In fact, UBS's chief economist is still calling for a 1.50% funds rate, and Lehman forecasts a long pause after next week's meeting and then expects the Fed to gradually cut to 1.25% in 2009. Merrill's chief economist hasn't backed off of his aggressive forecast for a 1.0% overnight floor by early next year.

Most Eco Data is Still Plenty Weak
This morning, the Michigan Consumer Sentiment Index tumbled to its lowest level in 26 years, dropping from 69.5 to 63.2. Consumers are worried about rising unemployment, skyrocketing gas prices and deteriorating personal balance sheets.

Yesterday, March new home sales plunged another 8.5% to a 17-year low of 526k annual units. Earlier this week existing home sales fell 2% in March to a 4.93 million unit annualized pace. The inventory of new homes for sale rose from 10.2 months to 11 months and now represents the worst inventory overhang since 1981. Existing home inventories are also bloated at 9.6 months. The rash of foreclosures will only make it worse. Obviously, Fed rate increases before housing completely turns the corner wouldn't be welcome at all.

The first quarter economic growth rate is now expected to be slightly positive, although the primary growth contributor is business inventory build-up, which if it isn't sold off, will reverse itself in the following quarter and actually subtract from GDP. Thus, despite the huge monetary and fiscal stimulus in the pipeline, second quarter growth is generally expected to be negative. If we're in the midst of a recession, it's not entirely clear. In fact, it's quite possible that the U.S. experiences a much longer period of anemic growth instead of the traditional two or more consecutive quarters of negative growth (which we've yet to see). Either way, the sudden and dramatic increase in yields seems premature.

Market Indications as of 9:30 a.m. Central Time
DOW - down 33 to 12,816
NASDAQ - down 22 to 2,406
S&P 500 - down 5 to 1,392
1-Yr T-note 0/32 to 1.96%
2-Yr T-note down 2/32 to 2.39%
5-Yr T-note down 6/32 to 3.17%
10-Yr T-note down 10/32 to 3.87%
30-Yr T-bond down 20/32 to 4.60%

Housing Starts Plunge
U.S. housing starts fell another 11.9% in March, reaching a 17-year low as bloated inventories of available homes, along with mounting foreclosures discourage new construction. Builders broke ground at a 947,000 home annualized pace, quite a bit lower than the median Bloomberg forecast of 1.01 million starts. Building permits, a measure of future construction, also fell more than expected. The National Association of Home Builders announced yesterday that they expected starts would ultimately fall 30% in 2008. The weak housing data suggests a slow recovery.

Inflation Notes
This morning, the March consumer price index (CPI) rose by 0.3%, while core CPI rose by 0.2%. Both exactly matched expectations. On a year-over-year basis, core consumer inflation is running at a 2.4% pace. This is a little bit high, but should allow the Fed enough latitude to cut rates further. A number of other inflation measures are less friendly. The March producer price index, released yesterday, was up 1.1% month-over-month and 6.9% year-over-year. Both of these were well above forecast. Oil prices climbed above $114 per barrel this morning, while rice, corn, wheat and soy are all alarmingly high due to a combination of increased global demand and price speculation. It's hard to imagine the Fed won't factor in the runaway commodity prices as they set monetary policy. Inflation concerns could put an early end to rate cuts ...but the end hasn't arrived yet. Another cut later this month is certain.

Retail Sales are Better-Than-Expected (Monday's Release)
Retail sales were expected to be unchanged in March after a 0.6% drop in February. As it turned out, sales were actually up 0.2%, while the February reading was revised upward from negative 0.6% to negative 0.4%. That's the good news, but the bad news was that the entire increase was accounted for by gasoline station receipts which rose by 1.1% during the month, not because motorists bought more gas, but because the cost of the gas was higher. Auto sales dropped by 1.7%, but parts sales rose enough by themselves such that combined motor vehicle and auto parts were up 0.2%.

Business inventories were higher-than-expected in the first quarter. Combining the inventory build-up with slightly better-than-expected consumer spending, could actually push first quarter GDP into positive territory. That doesn't necessarily mean the recession isn't happening, or won't happen, but it does suggest that the worst may still be months away.

A number of important Fed officials are speaking today and later this week. It's hard to imagine that they'll have encouraging words to say about the economy. They should give us a better indication of whether the April 30th rate cut will be 25 or 50. Right now, it's a toss-up. The next meeting is on June 25th.

The DOW is up in early trading as Intel, JP Morgan and Coca Cola all reported results above forecast.

Market Indications as of 9:09 a.m. Central Time
DOW - up 111 to 12,474
NASDAQ - up 37 to 2,317
S&P 500 - up 13 to 1,349
1-Yr T-note up 1/32 to 1.58%
2-Yr T-note up 1/32 to 1.84%
5-Yr T-note up 2/32 to 2.68%
10-Yr T-note up 6/32 to 3.58%
30-Yr T-bond up 7/32 to 4.43%

The Bloomberg Economic Forecast
From April 2 to April 9, 2008, Bloomberg News polled 70 top US economists on their economic and interest rate forecasts. It seems that fewer experts choose to participate when the outlook becomes less certain. It's very uncertain now. Thus, while 62 experts feel comfortable forecasting out the next two quarters, only 51 venture a guess for a year from now.

Unemployment rate - Average forecast for Q2 2008 is 5.4%. The average for the next three quarters are 5.5%, 5.5% and 5.5%.

The March unemployment rate was 5.1%. In February, it was 4.8%. The labor market is just now reflecting the downturn. Employment conditions are expected to worsen.

Inflation - Core Personal Consumption Expenditures (PCE) - Average forecast for Q2 2008 is 2.2%. The average for the next three quarters are 2.2%, 2.0% and 2.0%.

Inflation almost always retreats during a recession ...and that's the expectation (or hope) here, although increased global demand may throw a wrench into the equation. If inflation heats up, instead of cooling off, the Fed will be inclined to raise rates. This is the argument against rates staying low for too long.

Gross Domestic Product (GDP) – Average forecast for Q2 2008 is 0.0%. The average for the next three quarters are 2.0%, 1.8% and 2.0%.

The average economic growth forecast for the recently completed first quarter is also 0.0% ...although many expect a negative number. The upturn in the third quarter is the expected result of the massive stimulus that is already in place.

The Bloomberg Interest Rate Forecast
Overnight Fed Funds – Average forecast for Q2 2008 is 1.79%. The average for the next four quarters are 1.74%, 1.76%, 1.92% and 2.25%.

The current funds rate is 2.25%. The Fed is expected to cut between 25 and 50 bps on April 30th. The next scheduled FOMC meeting after that is on June 25th. By that time, a mild recovery could well be asserting itself. The Fed is probably nearing completion of its easing.

2-year Treasury-note – Average forecast for Q2 2008 is 1.73%. The average for the next four quarters are 1.90%, 2.08%, 2.37% and 2.73%.

The current two-year yield is 1.81%. It's been as low as 1.46% in recent weeks. The expected rise in yields reflects expectations for economic improvement later in the year.

10-year Treasury-note – Average forecast for Q2 2008 is 3.57%. The average for the next four quarters are 3.72%, 3.84%, 4.01% and 4.19%.

The current 10-year yield is 3.52%

Market Indications as of 9:00 a.m. Central Time
DOW - down 8 to 12,568
NASDAQ - down 12 to 2,337
S&P 500 - down 6 to 1,365
1-Yr T-note up 2/32 to 1.60%
2-Yr T-note up 4/32 to 1.81%
5-Yr T-note up 8/32 to 2.67%
10-Yr T-note up 8/32 to 3.53%
30-Yr T-bond up 12/32 to 4.36%

Labor Market Conditions Worsen
U.S. businesses cut jobs for the third consecutive month in March as non-farm payrolls fell by 80,000 following a revised 76,000 drop in February. The median forecast was for a decline of only 50,000. Predictably, construction jobs disappeared in mass as builders eliminated 51,000 jobs during the month. Manufacturing was also hit hard as factories lost a net 48,000 workers. Much of the factory decline was attributed to a walkout by autoworkers that shelved half of the domestic workforce at General Motors. Financial firm payrolls fell by only 5,000, but could accelerate later this year. The unemployment rate jumped from 4.8% to 5.1%, the highest level since September 2005.

The labor report was bad across the board ...but that's to be expected when in the midst of a recession. In fact, from a historical perspective, this job loss isn't nearly as severe as six years ago, when the March 2002 decline capped a 12-month period in which business payrolls fell by a whopping 2,080,000.

The market seems to be taking today's data release in stride. The market rally is much smaller than might normally be expected (2-year T-note yield is down from 1.90% to 1.84% in early trading and equities are off slightly). Perhaps investors realize that inflation is hardly under control which should give the Fed pause in their rate cutting efforts. However, recent comments by Fed officials don't suggest the Fed is done easing. In fact, far from it. Earlier this week, Fed Chairman Bernanke assured lawmakers that the Fed was "ready to respond to whatever situation evolves". San Francisco Fed President Janet Yellen said just yesterday that "economic prospects remain unusually uncertain and the downside risks ...are significant." On Wednesday, New York Fed President Timothy Geithner said that the capital markets were "substantially impaired" and that the Fed must "act forcefully" to stem the crisis.

The FOMC next meets on April 30. The markets are currently expecting only a 25 bp cut. Based on comments by Fed officials, a larger move may be a better bet. Regardless, it could be a longer stretch of time before rates reverse and finally move higher.

Market Indications as of 8:50 a.m. Central Time
DOW - down 38 to 12,588
NASDAQ - down 1 to 2,265
S&P 500 - down 4 to 1,370
1-Yr T-note up 2/32 to 1.70%
2-Yr T-note up 3/32 to 1.84%
5-Yr T-note up 12/32 to 2.65%
10-Yr T-note up 22/32 to 3.49%
30-Yr T-bond up 32/32 to 4.32%

Chairman Bernanke Testifies
It’s getting increasingly hard to follow or make sense of the financial markets these days. There’s just too much going on. So, the toughest part of writing any type of summary e-mail these days is determining where to start...

Chairman Bernanke’s testimony in front of the House Joint Economic Committee this morning was dramatic in what was said, but offered little information that the markets didn’t already know. Bernanke virtually admitted that he thought the economy was in recession when he said that “it now appears likely that real GDP will not grow much, if at all, over the first half of 2008 and could even contract slightly.” He also tempered the Fed expectation for a 2009 recovery in saying that “…the uncertainty attending this forecast is quite high and the risks remain to the downside.” Bernanke also found himself defending the Fed’s decision to provide an emergency loan to facilitate the purchase of Bear Stearns by JP Morgan in saying that the loan was made in order to “prevent a disorderly failure ...and the unpredictable but likely severe consequences of such a failure on market functioning and the broader economy.”

It seems apparent based on the Fed’s downbeat assessment of the economy that their rate cutting campaign is not yet over. It’s also become less likely that the Fed will begin raising rates within the foreseeable future. Rates may be low for a while. The next Fed meeting is on April 30th. A cut at this meeting looks fairly certain, but the size is yet to be determined.

A Proposed New Fed (Old News)
On Monday, Treasury Secretary Henry Paulson announced proposed significant structural changes to U.S. banking and financial market regulation. His detailed 212-page plan titled “Blueprint for a Modernized Financial Regulatory Structure” would grant the Fed much broader authority in providing financial market oversight. It would formally gain regulatory authority to act as “Market Stabilizer Regulator” and have the stated ability to “take corrective actions when necessary in the interest of overall financial market stability”. Paulson’s plan would also combine the SEC and Commodities Futures Trading Commission (CFTC), create a Federal mortgage origination commission to provide supervision to state regulators of mortgage lenders and centralize insurance regulation into a Federal institution. The Fed would then apparently relinquish its traditional role of providing supervision and regulation over member banks. Paulson’s plan has already met major opposition. It’s unlikely that whatever changes ultimately are enacted will look remotely similar to the original proposal. It’s also unlikely that anything will change in the near future. In the mean time, it’s become clear over the past quarter that the Fed’s powers to do whatever is necessary to stabilize the financial markets are already much broader than most might have imagined.

Other Economic News
Yesterday, the ISM factory index for March was released, and surprisingly rose from 48.3 to 48.6. Although the number is still below 50 (indicating contraction), the median forecast was for a bigger drop to 47.5. A number below 45 is consistent with recessionary conditions. Not there yet.

Also released yesterday was a gloomy report by global consulting firm Oliver Wyman and primary dealer Morgan Stanley that said “the (financial) industry is facing the most severe investment banking crisis in 30 years”. The report stated that investment banking revenue could still drop by another 20 percent in 2008 due to continued mortgage-related write-downs.

There has been so much negative housing data that it's become almost redundant to trot out the latest. Yes - home sales are still weak, inventories are still extremely high and the foreclosure rate is shocking. On the bright side, 30-year loan rates are finally heading lower - last week, the average 30-year mortgage rate according to Freddie Mac was 5.85%, down from 6.24% a month earlier. Hopefully, the bottom is near.

Motor vehicle sales continue to fall. This morning, total sales of cars and trucks were reported down from 15.3 to 15.1 million units in March. As recently as December 2007, the pace was a healthy 16.3 million.

The DOW rose nearly 400 points yesterday after several large financial firms reported large capital infusions. This was a welcome relief only a day after the DOW closed its worst quarter in 5½ years during which it fell by a huge 7.6%. The 1002 point decline was the largest in the history of the index. The NASDAQ and S&P fared even worse in percentage terms falling by 14% and 10% respectively during the first quarter, and off 20% and 16% from October highs. Unfortunately, the equity markets are down so far today.

Bond market yields have risen in the past few days with the two-year Treasury yield climbing from a close of 1.58% on Monday to 1.90% earlier this afternoon.

Market Indications as of 2:15 p.m. Central Time
DOW - down 69 to 12,585
NASDAQ - down 10 to 2,352
S&P 500 - down 7 to 1,364
1-Yr T-note down 3/32 to 1.74%
2-Yr T-note down 5/32 to 1.87%
5-Yr T-note down 9/32 to 2.71%
10-Yr T-note down 4/32 to 3.57%
30-Yr T-bond down 8/32 to 4.38%

Housing Weakness Spreads
The economy continues to receive dismal news, this week we got data on new and existing home sales, as well as durable goods orders, which although not entirely bad is far from uplifting. Existing home sales reversed trend to show the first increase in seven months, to 5.03 million units for February from January’s low of 4.89 million units. New home sales fell to the lowest figure since 1995 at 590,000 annual units - 30% below February of 2007 levels. For comparison, existing home sales peaked at 7.25 million in September 2005 and new home sales peaked in July 2005 at almost 1.4 million. The months supply of new homes for sale remained steady at 9.8 months, the highest since October 1981, while existing home supply fell slightly to 9.6 months.

Durable goods orders were well below expectations falling 1.7% in February after a 4.7% decline in January. The core capital goods component, which feeds directly into GDP, fell 2.6% month-over-month. The housing recession is clearly spilling over into the broader economy. Fewer houses being built and sold means there is less demand for durable goods- things like ovens, air-conditioners, refrigerators, washers & dryers, and so on. This is not a comforting trend.

The final revisions to Q4-2007 gross domestic product were released this morning and showed a paltry advance of 0.6%. At this point it is common knowledge that Q1-2008 will be much weaker than Q4, which means you can pretty well count on a negative GDP print for the current quarter.

Initial jobless claims fell to 366,000 last week, pushing the 4-week moving average up to 358,000, the highest level since October 2005. A year ago the 4-week moving average was 312,000. This is another indication of a weakening economy and portends more job losses and an higher unemployment rate.

Finally, the Conference Board’s Consumer Confidence index fell to 64.5 from 76.4 in February. The index has fallen a shocking 29% from December’s 90.6 reading. Consumers are obviously nervous as they face a constant bombardment of bad news: rising food prices, gas over $3 per gallon, oil above $100, stock markets falling, house values plummeting, foreclosures rising, the demise of Bear Stearns, on and on it goes.

Lowering Forecasts
Economists have once again been busy lowering their forecasts for future growth and interest rates as recent data points to a sharp deterioration in economic conditions. Lehman Brothers, Merrill Lynch, Morgan Stanley, UBS, Citigroup, and Deutsche Bank are but a few of those calling for the overnight fed funds target rate to fall to 1.50% or lower. Fed funds futures currently indicate a 52% chance of a cut to 2.00%, and a 48% chance of a deeper cut to 1.75% at the next FOMC meeting on April 30th.

Market Indications as of 2:23 p.m. Central Time
DOW - down 67 to 12,355
NASDAQ - down 31 to 2,293
S&P 500 - down 8 to 1,333
1-Yr T-note down 1/32 to 1.53%
2-Yr T-note down 2/32 to 1.70%
5-Yr T-note down 11/32 to 2.57%
10-Yr T-note down 19/32 to 3.53%
30-Yr T-bond down 1-10/32 to 4.39%

Mortgage Markets Gets a Big Boost
The Office of Federal Housing Enterprise Oversight (OFHEO), the regulator charged with overseeing Fannie Mae and Freddie Mac, announced today that it would immediately reduce the existing 30% surplus capital requirement to 20%. The initiative is expected to provide up to $200 billion of immediate liquidity to the mortgage-backed securities market. Freeing up this capital will allow Fannie and Freddie to issue more debt, the proceeds of which can then be used to purchase mortgages and mortgage-backed securities. OFHEO also said that both agencies had agreed to raise a significant amount of new capital.

You may recall that OFHEO recently removed portfolio caps on the two GSE's, which had limited the size of their holdings. At the time the removal of those caps was largely symbolic as both agencies were effectively limited by the surplus capital requirements. Now, the removal of those caps and the relaxing of the capital requirement will free the agencies up to purchase or guarantee additional mortgages.

The loan size limits were also recently increased. Previously, loans eligible for the GSE's guarantee and MBS programs were limited to $417,000. Larger loans were called jumbo loans and they typically made their way into private label MBS. But with the recent turmoil the market for private label MBS dried up, making it much harder for lenders to obtain funding and therefore much more difficult for borrowers to get loans. By increasing the GSE loan limits, Fannie and Freddie will now be able to participate in this market. The limits depend on the geographic area and local house values, but in many cases are now above $700,000.

Increasing defaults on sub-prime and to some extent even prime mortgages has led to a mass exodus of capital from the mortgage-backed market. Many investors, not trusting the quality of the paper, short on capital, facing write-downs and margin calls, have been staying out of this market, leading to a liquidity crises. The Federal Reserve, Congress, and the Administration have been working to mitigate this problem. The combination of OFHEO's recent steps- increased loan limits, removal of portfolio caps, and relaxation of surplus capital requirements- will allow the GSE's to step in and help fill the void that has been left by the departure of other investors.

Massive, Coordinated Action Beginning To Help
In the last two weeks, it seems that the Fed and other government agencies and officials have finally recognized the depth of problems facing this market and have begun to take some very concrete steps to help. Rate cuts themselves are a benefit, but they have not eased the credit crunch entirely. Last week, the Fed announced a $200 billion Term Securities Lending Facility which will allow dealers to effectively swap MBS collateral for Treasury collateral. Following the collapse of Bear Stearns they took an even more important step of allowing primary dealers to borrow directly from the Fed. With yesterday's rate cut, those dealers can now borrow directly from the Fed at the 2.50% discount rate (fed funds target is 2.25%). It has been reported today that Goldman Sachs, Morgan Stanley, and Lehman Brothers have all taken them up on the offer. Now we add in the ability of Fannie Mae and Freddie Mac to increase MBS purchases. All of this is likely to go a long way in slowing the vicious cycle of selling that was beginning to grip the mortgage-backed market.

Perhaps most importantly, the combination of events should lead to lower mortgage rates. This is in turn will allow more troubled borrowers to refinance. Lower mortgage rates combined with lower house prices will also increase affordability and might bring potential buyers into the depressed housing market.

Market Indications as of 9:40 a.m. Central Time
DOW - down 54 to 12,339
NASDAQ - down 15 to 2,253
S&P 500 - down 3 to 1,327
1-Yr T-note up 1/64 to 1.52%
2-Yr T-note down 1/32 to 1.62%
5-Yr T-note up 5/32 to 2.42%
10-Yr T-note up 22/32 to 3.40%
30-Yr T-bond up 1-18/32 to 4.26%

FOMC eases by another 75 bps. Stocks Rally.
Although the financial markets had braced for “the largest single day rate cut in a generation”, it got slightly less as the Federal Open Markets Committee eased by only 75 basis points instead of 100. The overnight fed funds target, the rate at which banks trade short term reserve funds amongst themselves, now stands at 2.25%. The Committee also cut the discount rate, the interest rate at which banks (and now Primary Dealers) can borrow directly from the Fed by 75 basis points to 2.50%. Recall that Fed officials also cut the discount rate two days ago, in a rare weekend meeting by 25 bps. Two regional Fed presidents, including Dallas Fed President Richard Fisher, dissented from the decision, preferring to see “less aggressive action”.

The Fed would prefer to find alternative methods (aside from rate cuts) to provide critical liquidity to the markets. After all, there’s only 225 basis points to go until the funds target reaches zero. Although zero is an unlikely scenario, Lehman is now calling for a 1.0% overnight rate by the beginning of next year while many others are calling for 1.50% …which isn’t really a stretch considering that the target is now 2.25%.

Bad news has gotten worse, fears and uncertainties are mounting, and to compound things several prominent forecasters have made especially dramatic statements - Harvard Economist, Martin Feldstein, a member of the committee that officially determines whether a recession has or has not occurred, said last week that the current recession could turn out to be the most severe since WW2. Former Fed Chairman Greenspan, who allegedly retired two years ago, has made similar comments.

Bernanke has already provided a number of essential liquidity vehicles to the troubled markets. A week ago, the Fed introduced its $200 billion Term Securities Lending Facility (TSLF) plan to lend Treasury securities to Primary Dealers for up to 28 days in exchange for less-liquid debt including mortgage-backed securities. Just two days ago, they announced the establishment of a program they deem the Primary Credit Dealer Facility (PCDF) which will offer overnight loans to Primary Dealers “in exchange for a specified range of collateral including investment grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.” And this past weekend, the Fed agreed to provide up to $30 billion to JP Morgan Chase to help finance the “less liquid assets” of Bear Stearns and help facilitate the sale at the bargain price of $2 per share.

Interestingly enough, the share price of Bear stock is currently up to $6.50 as investors are now expected to negotiate a more favorable sale price. The equity markets seem pleased with the Fed action as the DOW is up well over 300 points. The bond market has backed off following yesterday's huge rally, pushing yields slightly higher.

Benign CPI Paves the Way for the Cut
Late last week, there was some good news on the inflation front - Both overall CPI and core CPI were reported unchanged in February. Analysts had predicted 0.3% and 0.2% rises respectively. It was the first time in 15 months that the core rate didn’t increase. On a year-over-year basis, the core rate was up 2.3%, the smallest 12-month increase since October. This lack of inflation gave the Fed leeway to make today’s cut.

Market Indications as of 2:35 p.m. Central Time
DOW - up 345 to 12,317
NASDAQ - up 82 to 2,259
S&P 500 - up 42 to 1,321
1-Yr T-note down 8/32 to 1.49%
2-Yr T-note down 13/32 to 1.56%
5-Yr T-note down 29/32 to 2.40%
10-Yr T-note down 36/32 to 3.44%
30-Yr T-bond down 22/32 to 4.33%

Bear Stearns Becomes Latest Victim
Last summer, the collapse of a Bear Stearns hedge fund was one of the first signs of the severity of the credit and liquidity crises that currently grip the market. Since that time things have only gotten worse and over the course of the last few days Bear Stearns finally succumbed to the market. The simple explanation is that Bear Stearns was highly leveraged, using collateral such as mortgage-backed securities to obtain financing, much of it short-term in nature. With the value of those securities falling, Bear's creditors began demanding more collateral. Bear was unable to liquidate enough assets to pay off the debt and unable to post additional collateral. It has been reported that lenders withdrew $17 billion in financing in two days last week. On Friday, Bear Stearns obtained emergency financing from the Federal Reserve through JPMorgan. Investors, smelling trouble, sent shares plummeting. Bear's stock, which reached a high of $159 last April, fell from $57 on Thursday to $30 on Friday. Over the weekend, fears rose that the inevitable collapse of Bear Stearns could lead to even greater problems in the broader financial markets so federal regulators quickly pushed for a deal to be made. JPMorgan agreed to purchase the firm for $2 per share, which shockingly amounts to a total cost of only $236 million.

This is just the latest in a string of significant problems for the financial markets, the roots of which can be traced back to irresponsible sub-prime lending practices. Even more concerning is the notion that it is not over yet. The problems that began with sub-prime lending initially spilled over into asset-backed commercial paper and then to collateralized debt obligations. Bond insurance companies were next as the projected losses on sub-prime asset-backed securities they insure could exceed the insurers ability to pay claims. That spilled over into the municipal bond market as investors began to doubt the value of the insurance. Now the prime mortgage market is feeling the effects as falling prices for those securities are leading to margin calls, forced selling, and perhaps another wave of write-downs. This is a vicious cycle with no apparent end in sight.

The Fed's Latest Measure
Somewhat lost in the news surrounding Bear Stearns was a very important decision by the Federal Reserve. First of all, in a very rare weekend move, they lowered the discount rate by 25bps from 3.50% to 3.25%, reducing the so called penalty for borrowing directly from the Fed at the Discount Window rather than from other banks in the fed funds market. More importantly, the Fed also announced that securities dealers would be allowed to borrow directly from the Fed. Previously, this ability was made available only to Fed regulated banks. Although too late for Bear Stearns, this action might help other troubled investment banks as it opens up another source of liquidity.

Fed funds futures have ramped up rate cut expectations and currently indicate 80% odds of a 100 bps rate cut at tomorrow's FOMC meeting. The other 20% call for a deeper cut of 125bps.

The major stock indices are lower and the familiar flight-to-quality has sent Treasury yields even lower. Three-month T-Bills are trading below 1.00% and the two-year T-Note is down to 1.34%.

Market Indications as of 11:19 a.m. Central Time
DOW - down 118 to 11,833
NASDAQ - down 43 to 2,170
S&P 500 - down 23 to 1,265
1-Yr T-note up 4/32 to 1.32%
2-Yr T-note up 8/32 to 1.34%
5-Yr T-note up 24/32 to 2.23%
10-Yr T-note up 1-7/32 to 3.32%
30-Yr T-bond up 1-15/32 to 4.275%

Extreme Volatility Continues
Stock and bond markets remain extremely volatile with large intraday movements. For example, after closing at 1.62% yesterday the 2-year Treasury Note yield traded as high as 1.64% and as low as 1.47% before settling in at 1.60%. The long-end is all over the place as well, with the 10-year Note fluctuating between a low of 3.38% and a high of 3.56%. Stocks have moved wildly as well with the Dow falling over 200 points early in the day, only to rebound to up 38 as I write. While equity market moves of this magnitude are fairly common, it used to be rare to see such volatility in bond markets. These days it seems to be the norm. As investors, it is getting very difficult to determine where the value is when the price changes so dramatically in a matter of minutes.

Today's News
The headlines make for some poor reading today. Retail sales unexpectedly fell by 0.6% in February with broad based weakness. The dollar fell to a 12-year low versus the Japanese Yen and set a record low against the Euro. Gold briefly traded above $1,000. Oil has topped $110. February home foreclosure filings jumped 60% over last year. RealtyTrac reported that more than 223,000 properties, or 1 in every 557 U.S. households were in some stage of default. The Carlyle Group, a large and well respected hedge fund manager, said creditors will seize the assets of its mortgage bond fund after it failed to meet margin calls. Chrysler announced that it would shut down the entire company for two weeks in July. Okay, I think you all get the point. Somehow, despite all the gloom, stock markets did finish the day higher.

FOMC Meets Next Week
The Fed's FOMC meets next week and is expected to cut the overnight fed funds rate by 75bps. Fed funds futures currently imply an 80% chance of a 75bps cut and 20% odds of a smaller 50bps cut. The official announcement is expected at 1:15 p.m. Central time on Tuesday the 18th.

The initial reaction to the Fed's big announcement on Tuesday was favorable. You may recall that the Fed will effectively allow primary dealers to swap mortgage-backed collateral for Treasury collateral. After further review many of the dealers and economists we follow are saying that the Fed should have done this months ago and the general feeling seems to be that it is too little, too late. At the same time, everyone seems to appreciate the efforts and the lengths the Fed is going to. I think we can expect more of these types of actions as the Fed looks for ways to stabilize the credit markets.

A few of the primary dealer economists we follow have revised their forecasts in recent days. Lehman Brothers is now calling for a recession into 2009 and projects the fed funds rate will be cut to 1% by early 2009. Several others are calling for cuts down to 1.50%. Time will tell.

Market Indications as of 3:48 p.m. Central Time
DOW - up 35 to 12,146
NASDAQ - up 20 to 2,263
S&P 500 - up 7 to 1,315
1-Yr T-note down 0/32 to 1.61%
2-Yr T-note unchanged to 1.62%
5-Yr T-note down 7/32 to 2.51%
10-Yr T-note down 18/32 to 3.53%
30-Yr T-bond down 19/32 to 4.45%

Out of the Box
In recent days the crisis gripping the credit markets had begun to heat up. The short version is that rising defaults on sub-prime mortgages caused the value of sub-prime mortgage-backed-securities (MBS) to fall. That led to selling as investors who had borrowed money to buy sub-prime MBS faced margin calls. With few buyers willing to take on the sub-prime debt at any price, those facing margin calls were forced to sell other higher quality mortgage securities. The wave of selling caused prices on these higher quality securities to fall, which resulted in more margin calls and more selling. The vicious cycle of declining prices and selling was beginning to have a huge impact all across the market. The fear is that this will push banks into another wave of write-downs as they are forced to adjust the value of their holdings to the market.

The Federal Reserve had been widely expected to cut the fed funds rate at next week's FOMC meeting by 75bps to 2.25%. In recent days there has been some talk of a rate cut before the meeting. The Fed, which is staring at credit markets that are freezing up, a rapidly deteriorating economy, increasing inflation, and a weakening dollar that has helped to send oil prices to an all time high at around $110 per barrel, needed something bigger than a simple cut in the fed funds rate. This morning they announced a new program which should provide some immediate relief to the mortgage market. The new program is an expansion of its securities lending program and will be called the Term Securities Lending Facility (TSLF). Under this program, the Fed will "lend up to $200 billion of Treasury securities to primary dealers secured for a term of up to 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private label residential MBS." The stated intent is to foster liquidity and the functioning of financial markets. This seems to be a great step as the Fed's program will apparently allow dealers to use their portfolio of MBS as collateral to borrow Treasuries.

Yields Up Sharply
The Fed's announcement has sent short-term rates sharply higher. The two-year Treasury traded as low as 1.41% intraday yesterday. This morning, it has been as high as 1.77%, a stunning 36bps swing. Longer term yields have also moved higher. With the Fed providing up to $200 billion in Treasury securities some of the pressure that had been pushing prices higher has been relieved. As for the fed funds rate, a cut of 75bps is still widely expected with the fed funds futures implying 64% odds of a 75bps cut and a 36% chance of a smaller 50bps cut. That's down sharply from yesterday when the futures were showing a 14% chance of a 100bps cut and an 86% chance of 75bps. Stock futures are pointing to a sharply higher open.

Market Indications as of 8:20 a.m. Central Time
DOW - not open 11,740 - futures up 241
NASDAQ - not open 2,169 - futures up 31
S&P 500 - not open 1,306 - futures up 30
1-Yr T-note down 5/32 to 1.67%
2-Yr T-note down 12/32 to 1.68%
5-Yr T-note down 31/32 to 2.59%
10-Yr T-note down 29/32 to 3.56%
30-Yr T-bond down 20/32 to 4.50%

Yields Tumble Along with Payrolls

The February labor market report was unexpectedly weak as non-farm payrolls dropped by 63,000 jobs, the biggest single month decline in nearly five years. The Bloomberg median forecast was for a gain of 23,000. Prior month business payrolls, originally reported as a 17,000 loss, were revised to an even larger loss of 22,000.

Negative non-farm payrolls are somewhat rare - The January decline was the first in 4½ years. Job growth is a reliable indicator of economic growth, so today’s data strongly supports the notion that the U.S. is near, or even in the midst of a recession.

Predictably, the lousy housing market had a big negative impact on the labor market. Builder payrolls fell by 39,000, the eighth consecutive monthly drop. Factory weakness was also reflected in the February data as manufacturing jobs plunged by 52,000, the biggest job loss in this sector since July 2003. Retail jobs fell by 34,000 as consumer spending slowed down. Only government jobs showed a significant increase, rising by 38,000.

The unemployment rate, calculated based on a separate household survey, actually fell from 4.9% to 4.8%. Experts had predicted a slight increase to 5.0%. Unfortunately, the drop in unemployment isn’t good news at all. The reason that the rate dropped had to do with a large number of discouraged workers leaving the workforce.

The bond market has keyed on the negative payrolls and rallied even further, carrying the two-year Treasury note yield down as low as 1.42% in early trading. Only two weeks earlier, the two-year closed at 2.11%. The already battered equity markets are holding up fairly well this morning, seeming to take some comfort in the idea that the Fed will surely cut short-term interest rates by at least 50 bps on March 18th. In fact, today’s really bad news increases the possibility that the FOMC could slash the overnight funds rate by 75 bps, down to 2.25%.

The Fed is trying just about everything it can think of to provide liquidity to the jittery financial markets. Just minutes before the labor market release, Fed officials (who had probably already seen the ugly employment numbers), announced that they would expand the size of this month’s short-term auctions from $60 to $100 billion to address “heightened liquidity pressures.”

Market Indications as of 9:00 a.m. Central Time
DOW - down 25 to 12,016
NASDAQ - up 13 to 2,234
S&P 500 - down 6 to 1,301
1-Yr T-Note up 1/32 to 1.47%
2-Yr T-Note up 2/32 to 1.46%
5-Yr T-Note up 7/32 to 2.43%
10-Yr T-Note up 14/32 to 3.53%
30-Yr T-Bond up 26/32 to 4.51%

The March 18th FOMC Meeting and Friday's Labor Market Report

The next scheduled Fed meeting is now two weeks away on March 18. Market expectations are for either a 50 or a 75 bp cut. The Fed has not indicated that the larger cut is even on the table, but a significantly bad employment report (released this Friday) could quickly change that. A number of economists have forecast a negative payroll number for February. The loss of 17,000 payroll jobs in January had represented the first outright decline in 4 ½ years. Another negative number in February would make a compelling case that the economy is currently in recession.

With the overnight funds rate already at 3%, the Fed only has 300 bps left to work with and would probably prefer to keep some powder dry. Bernanke has shown creativity in the past and today was no exception. In a speech to Orlando bankers, he asked that mortgage holders voluntarily forgive portions of principal owed by homeowners so that they could more easily refinance and thereby avoid foreclosure. Yesterday, the Fed sent letters to institutions they supervise asking them to report any mortgage loans that they’d modified to lower risk of default. The Fed Chairman’s words initially spooked the financial markets as his suggestion appeared quite desperate.

Yesterday, the ISM factory index, a reliable leading indicator of the health of the manufacturing sector, and by proxy the economy as a whole, dropped from 50.7 to 48.3 in February, the lowest level since April 2003. Any number below 50 indicates contraction.

Market Indications as of 4:00 p.m. Central Time
DOW - down 45 to 12,214
NASDAQ - up 1 to 2,260
S&P 500 - up 4 to 1,330
1-Yr T-Note down 1/32 to 1.66%
2-Yr T-Note down 1/32 to 1.66%
5-Yr T-Note down 5/32 to 2.54%
10-Yr T-Note down 19/32 to 3.61%
30-Yr T-Bond down 38/32 to 4.51%

No Good News on the Economic Front Today
Virtually all of the headline economic news was terrible this morning -

Defaults on privately-insured mortgages jumped 31% in January.

AIG reported a $5.3 billion dollar loss for the fourth quarter, the largest in its 89-year history after writing down $11 billion in derivative losses related to sub-prime mortgages.

UBS reported that it believes financial firms may face at least $600 billion in mortgage-related credit losses. This number keeps getting worse.

Freddie Mac reported a $2.45 billion dollar loss and warned of further mortgage-related losses to come. Sister mortgage giant Fannie Mae had reported a $3.55 billion dollar loss only days before.

The Chicago purchasing managers index fell from 51.5 in January to 44.5 in February, a level consistent with recession. Most economists believe the U.S. is in recession right now.

Yields on top-rated, 30-year municipal fixed-rate bonds rose to the highest rate since August 2004 according to Municipal Market Advisors.

Oil closed at a record $102.59 per barrel yesterday on the NY exchange. According to the WSJ, this was up 12% for the year. The Journal pointed out that natural gas (up 26%), coal (up 56%), wheat (up 32%) and cocoa (up 38%) were also experiencing extreme price pressure. In addition to increased global demand for commodities, much of the reason for the raging inflation has to do with the battered U.S. dollar, which is hitting new lows against the euro and a 12-year low against a broad basket of global currencies. Imported goods, purchased with weak dollars, simply cost more in relative terms.

There’s an alarming disconnect between Fed rate cuts and mortgage and consumer lending rates. Since September, the Fed has cut 225 basis points from the overnight funds rate, but according to Bloomberg, the average 30-year fixed rate mortgage is now 6.05%, 5 basis points above the September level, while 5-year new car loans now average 6.97%, 6 basis point more than they did in September. Credit card rates have actually declined by 1.32% according to cardweb.com, although credit standards have increased. Merrill Lynch economist David Rosenberg pointed out that average loan costs for businesses and individuals have declined by only 45 bps since September, which means that for every 5 bps in Fed cuts, only 1 trickles down to the consumer.

So, the Fed is in a really tight spot. The U.S. economy is experiencing significant problems and inflation is moving higher. (Typically, a weakening economy reflects lower demand and an easing of inflationary pressure.) And thus far, Fed rate cuts have not had the desired effect. In fact, the cuts have contributed to a very weak dollar, which itself is fueling further inflation. So, even though the economy is probably in recession, the Fed may not want, or be able to cut rates too much further.

The financial markets are having a hard time digesting all the bad news this morning, with the DOW falling more than 200 points in early trading. There is a corresponding flight-to-quality that has driven short Treasury yields down to 4-year lows.

The good news is that in addition to all the monetary stimulus that the Fed has contributed so far, there's an estimated $70 billion in income tax refunds that will reach consumer pockets in the next couple of months along with over $100 billion in tax rebates. This massive front-loaded stimulus is expected to shake the economy out of recession in the second quarter.

Market Indications as of 10:10 a.m. Central Time
DOW - down 211 to 12,371
NASDAQ - down 41 to 2,290
S&P 500 - down 23 to 1,342
1-Yr T-Note up 6/32 to 1.77%
2-Yr T-Note up 7/32 to 1.70%
5-Yr T-Note up 20/32 to 2.55%
10-Yr T-Note up 26/32 to 3.57%
30-Yr T-Bond up 42/32 to 4.44%

Producer Prices Soar
The overall Producer Price Index jumped by a full 1% in January, while core PPI (ex food and energy) rose by 0.4%. Both numbers doubled forecasts. On a year-over-year basis, PPI increased by 7.4%, the biggest jump since October 1981. Recall that the Consumer Price Index also came in above forecast in January. This price data is important to the financial markets because rising inflation could prompt the Fed to curtail its rate-cutting campaign. Usually, inflation slows down along with the economy. But not this time. The U.S. economy may well be in the midst of a recession, but price pressures aren't yet showing signs of easing. An apparent rise in inflation would normally push yields higher, but so far this morning, that hasn't happened. Yields are actually a tiny bit lower. The prevailing sentiment is that the economy is such bad shape that the Fed won't have any choice but to cut rates until the economy is fixed.

Housing and Other Eco News
Yesterday, the National Association of Realtors reported that sales of existing homes fell by 0.4% to an annual rate of 4.89 million in January, the lowest level in at least nine years (record keeping for this particular series began in 1999). In related news, the inventory of existing homes rose 5.5% in January to a 10.3 month supply. This is already near record highs ...and it could get worse - RealtyTrac announced today that home repossessions increased by 90% over the same period last year, bringing more than 233,000 U.S. homes to some stage of default in January. Not a good start to 2008. Last year, more than 1% of all U.S. households entered foreclosure. This year, an estimated one million foreclosed homes could add to already bloated inventories.
Late last week, the Philadelphia Fed general economic index fell to minus 24 in Feb, the lowest since Feb 2001, a date which corresponds with the last recession. The prior month Philly Fed reading was a similarly ugly minus 20.9.

Market Indications as of 9:00 a.m. Central Time
DOW - down 10 to 12,560
NASDAQ - down 4 to 2,323
S&P 500 - down 7 to 1,365
1-Yr T-Note up 2/32 to 1.97%
2-Yr T-Note up 2/32 to 2.06%
5-Yr T-Note up 5/32 to 2.93%
10-Yr T-Note up 2/32 to 3.89%
30-Yr T-Bond down 8/32 to 4.67%

CPI Unexpectedly Rises
The consumer price index (CPI) rose more than the experts had predicted in January, suggesting the possibility of an early end to Fed rate cuts.

January CPI rose by 0.4%, topping the 0.3% median forecast, while December CPI was revised from a previously reported 0.3% to 0.4%. Fuel costs were up 4.5% while food costs rose by 0.7%. Core CPI (which extracts food and energy costs) rose by 0.3% for the month and 2.5% year-over-year, higher than median forecasts of 0.2% and 2.4%.

In theory, the Fed stokes inflation as an unwanted bi-product of its interest rate cuts. In the past six months, they’ve trimmed the overnight rate by 225 basis points. This morning’s data release should instill some caution, but the Fed is still expected to cut the overnight funds rate by another 50 bps at the March 18th FOMC meeting. Unfortunately, easing on the short end hasn’t had the desired effect on the longer end of the yield curve. The 10-year Treasury-note yield is up 50 basis points in the past month as investors build in an inflation premium.

Oil Tops $100
The price of oil closed above $100 per barrel yesterday for the first time, so at the moment it’s tough to make a compelling argument that the slowing economy will stem price pressures going forward.

And the equity markets aren’t taking kindly to signs of rising inflation. The DOW is down 100 in early trading which has actually given a bid to bonds and sparked a flight-to-quality rally, the opposite of expected bond market reaction to higher-than-expected inflationary readings.

The bond market continues to price in 100 bps worth of future rate cuts ...which may or may not actually occur.

Market Indications as of 9:00 a.m. Central Time
DOW - down 90 to 12,246
NASDAQ - down 12 to 2,294
S&P 500 - down 12 to 1,343
1-Yr T-Note up 3/32 to 1.91%
2-Yr T-Note up 4/32 to 2.00%
5-Yr T-Note up 6/32 to 3.88%
10-Yr T-Note up 4/32 to 3.88%
30-Yr T-Bond up 7/32 to 4.65%

Overnight Rate to Increase Later in 2008?
Bond market yields (on the short end) reversed course and increased significantly this afternoon following the release of the January FOMC minutes in which some Committee members noted that "when prospects for (economic) growth had improved, a reversal of a portion of the recent easing actions, possibly even a rapid reversal, might be appropriate."

In other news, Bill Gross, the manager of PIMCO, the world's largest bond fund, said today that rising inflation, a weak dollar and the fact that all of the Fed's easing moves have yet to have the desired effect, will prevent the Fed from cutting rates too much further in 2008.

There is an unprecedented amount of both monetary and fiscal stimulus already in the pipeline and tens of millions of IRS tax refund checks will soon be mailed. All of this should combine to ignite a quick fix in consumer spending, allowing the Fed to potentially reverse some of the emergency cuts that they were forced to make in January and shift their attention to an apparent inflation problem.

Market Indications as of 4:25 p.m. Central Time
DOW - up 90 to 12,427
NASDAQ - up 21 to 2,327
S&P 500 - down 1 to 1,358
1-Yr T-Note down 3/32 to 2.05%
2-Yr T-Note down 3/32 to 2.13%
5-Yr T-Note down 6/32 to 2.98%
10-Yr T-Note up 1/32 to 3.89%
30-Yr T-Bond up 28/32 to 4.61%