Rates closed very low today. The First economic item out was the NY Empire Index. On the surface it should have caused rates to move much higher. It was forecast to be 17.0 to 18.4. The NY FED published it at 26.46. The devil (angel in this case) was in the details. The NY FED’s report showed a drop in prices paid by businesses.

That kept the 10-year Treasury -.010% to -.020% from Friday’s close.

Around 11:00cdt {16:00gmt} the 10-year Treasury’s price continued to move up, causing rates to drop. Eventually, the 10-year Treasury closed -.066% with the rate at 5.041%. The price was +13/32^nd moving the price to 95-26/32nds.

There were two major reasons for this. First and most important is the shrinking US Government’s deficit. The projected 7 percent increase in tax revenue – that is an increase in revenue not deficit – will help the U.S. budget deficit shrink by 17 percent to about $205 billion for the fiscal year ending Sept. 30.

Commentary: How can that be?!?! President Bush cut taxes. How did Revenue increase?!?!. Fact is, revenues increased when President Kennedy cut taxes. Fact is, revenues increased when President Reagan cut taxes. Fact is, revenues increased when President McKinley(?) cut taxes.

Treasury prices also rallied Monday, pressing yields lower, after an index that measures weakness in the subprime mortgage sector showed further deterioration of loans made in late 2006.

The ABX "BBB" 07-1 index, which gauges risk in the subprime mortgage lending industry, sank to near-record lows in midday trade, amid persistent worries about deteriorating loans in that industry

SHORT-TERM OUTLOOK [16 July 2007]

We are continuing to see some volatility in the bond market. Bond traders and investors are trying to find their footing.  Any important data will give them reason to feel around even more.

A trading range has seemed to emerge around the 5.100% level on the 10-year Treasury. The floor is around the psychological 5.000%. The ceiling looks as if it is just above the Fed Funds rate at 5.250%. The recent high occurred on 12 June at 5.297%. The low around 5.040% has been tested on a few occasions, most recently today.

There are some heavy data items published this week. Many days have more the one item.

Among the important statistics is Tuesday’s Producer Price Index (PPI) and the core-PPI, published at the opening bell. PPI is anticipated to be below last month’s report of +0.9%, with expectations of +0.1% to +0.2%. Core-PPI is expected to match May’s number at +0.2% across the board.

Tuesday also has the very significant Industrial Report which includes Production and Capacity. The Industrial report is out at 08:15cdt {13:15gmt}.

Production measures how much is coming out of the nations factories, mines etc. It is usually an inverse number, a higher than the forecast +0.3% to +0.6% may be good for rates. That does not mean that it indicates a slowing economy in this case. It means that there are more goods chasing the same dollars. That is an anti-inflationary thing.

Industrial Capacity is not an inverse number. It measure what percent of the factories, mines, forests etc. are being used. Anything above 80% is seen as inflationary since new factories need to be built, which means the more dollars chasing the same supply. We could have a bad day for rates if this is higher than the 81.5 to 81.6 predicted.

Net Foreign Purchase is out fifteen minutes before the Industrial Report, but is only seen as low importance and will most likely not affect rates.

The UBS Store Sales Index and Redbook Survey’s are also out in early morning, but are seldom noticed by traders or bond investors.

The NAHB’s Housing Index is published at 12:00cdt {17:00gmt} and has impacted rates recently. There are no estimates for this item.

Also at 12:00 Kansas City Federal Reserve Bank President Thomas Hoenig (an FOMC voting member) is scheduled to speak about monetary policy & the U.S. economic outlook, in North Platte, Nebraska. Audience Q&A possible

Wednesday’s market opening sees the very important Consumer Price Index. Along with the CPI is the recently important Housing Starts and Building Permits numbers.

Thursday starts to quiet down in the morning with the weekly Initial Jobless Claims, the Leading Economic Indicators, and Philadelphia Fed Index.

The activity in the afternoon picks back up with the release of the FOMC Minutes.

There is no significant data on Friday.

MID-TERM OUTLOOK [2 July 2007]

There are a few bright spots and some dark spots for rates for the next few months.

First, the good news. But remember, good news for rates often means bad news for the economy.

A.) On 26 June the Consumer Confidence was slightly below expectations. This could give us strong indication for the mid-term direction of rates. Analysts were looking for 105.0 to 106.0. The Conference Board released the number at 103.9.

Lynn Franco, Director of The Conference Board Consumer Research Center said, "A perceived softening in present-day business and employment conditions are the major reasons behind this month's pull-back in confidence. In fact, the Present Situation Index now stands at levels not seen since the final quarter of last year. Looking ahead, consumers remain rather subdued about short-term economic prospects. All in all, the glass remains half empty and half full."

Consumers' appraisal of present-day conditions was less upbeat in June. Those claiming conditions are "good" declined to 27.4 percent from 29.0 percent. Those saying conditions are "bad" increased to 16.4 percent from 14.6 percent. Consumers were also less positive about the job market.

B.) The softness in consumer sentiment may be what has driven the decline in both the Redbook and UBS store Sales in the last few months. To date, the decline in both of these weekly numbers have not affected the more important Retail Sales Report.

C.) Investor Sentiment may be, repeat, MAY BE changing. (‘May be’ cannot be emphasized enough.) The floor-ceiling range mentioned in the Short-Term Outlook has occurred in the last 5 weeks. When the floors and ceilings are tested – which simply means that rates get close to that top and bottom – the bottom has been tested more often that the top. What’s more, rates have been tending to hover at the lower end of the range.

On the negative side:

1.) While investor sentiment may be getting ready for a turn, investor sentiment still leans towards higher rates. The bond market has been in a selling mood since 10 May 2007

A few months back this blog wrote that the bond market seemed to be looking for any excuse to buy bonds and thus drive rates lower. That trend has reversed itself. The bond market is now looking for any reason to sell, and correspondingly raise rates.

On 31 May 2007 there was one such example. There were six items published that day. Even though most of the economic items came in as expected, three did not. Of the three, two were lower than expected and should have moved rates lower. Instead rates continued their upward trend. Clearly, investor sentiment has turned bearish on buying bonds.

Investors are becoming bearish and are starting to realize that inflation exists. They are starting to see that the FED is more determined fight inflation. More and more FED officials are making hawkish comments.

One additional argument that investor sentiment is for higher rates happens on days when there is no data. It has only happened 4 times since 10 May. Two times the bond market was flat, two times it was up some.

2) The housing bubble has ‘burst’. Will housing continue to decline? Is it flattening? Or, is it on the verge of a rebound? The data over the last few months has been a resounding maybe to all three.

IF homeowners start to see a rebound in housing their confidence will increase. As confidence increases, so will spending. Economic growth is moderate now with problematic inflation. Strong growth could renew strong inflation.

The slide in Real estate has not yet seemed to affect retail sales or consumer confidence. Inflation hawks can’t win for losing.

On 08 May 2007 the bond market responded to an unscheduled announcement by the National Association of Realtors (NAR). The NAR reduced its sales forecasts for 2007 and 2008, predicting that stricter lending standards would limit home buying. That only makes sense as stricter guidelines reduce the number of buyers able to get a mortgage. Given the current oversupply of houses, verses the very number of buyers we have a buyers market now as it is. Reducing the number of buyers hits the real estate market with a double whammy.

Sales of existing homes will probably fall about 3% this year to 6.29 million from 6.48 million in 2006. Sales of new homes are projected to fall about 18% to 864,000, compared with a 14% drop predicted last month. Housing starts are expected to drop 19% to 1.46 million.

When there are signs of housing market weakness it helps the price of bonds. Since it is a sing of a slowing economy it instills safe-haven interest.

At the same time, and on the other hand, the bond market seems to have discounted the housing bust. That means that yes, they know that housing is in trouble. They are guessing it will be in trouble for at least the Mid-Term, if not the Long-Term. The bond market has included (which is what economist have in mind when the word ‘discount’ is used) the housing slump into the price. Both bond traders and analysts will need to see a big change in the housing market one way or another before a new rate trend will be established based on residential real estate.

3) The US and the global economy appear to be in recovery. This has to be the shortest, least felt ‘recession ever experienced. (The 2.2% main stream media aside, there never was a recession; GDP never went below 0.0 %.)

A major part of the growing global economy is China. On 12 June, the Chinese consumer price index for May was +3.4% in year-to-year analysis, according to data published by the [Chinese] National Bureau of Statistics. Most of the gains were due to food prices, and haven't spread to a broad range of consumer goods. What we would call Chinese core-CPI was +1.0%. China’s food prices jumped 8.3% from a year ago.

Even though Chinese core-CPI was low, the headline inflation rate is now higher than the interest rate banks pay on deposits, currently set at 3.06% for one year. That gives Chinese consumers a big incentive to spend or invest that money rather than let it sit in the bank.

Further, and of great Long-Term bearing on US interest rates – is how this will diminish demand for US Treasuries. When demand for any commodity decreases, the price also declines. When bond prices deteriorate as they have, rates go up.

4) In February this blog wrote:

“We have one great inflation fear in the mid-term; corn prices. With all the talk of alternate fuel and ethanol, corn futures have nearly doubled. Corn is a staple of most food products that we eat. Increases in corn prices will not just impact corn flakes, but pop/soda, beef, and pig, chicken, candy bars, just about anything we eat.”

Grain stockpiles in many countries have fallen to multiyear lows, even as increased production of biofuels such as ethanol has added a new source of demand.

Commentary: Even the best estimates of corn based fuel say that it will never replace the need for fossil fuels. At best it can only reduce the demand some. It would be much better for us to reduce our demand on foreign oil and decrease the price at the pump by; 1.) Drilling where we know that there is oil, 2.) Build refineries, 3.) Eat food as food.

Steve Boxmeyer [612] 799 – 6858

steve@LendWithIntegrity.com