Enhanced Cash Market Review

October 6 to October 10
Economic and Macro Trend: The week was light on economic news but heavy on credit events, to say the least. A weekend bank crisis Summit by four leading members of the G8 (France, Germany, Italy and UK) did not produce a US $700 billion-style rescue package, although the leaders pledged to take “all necessary measures” on a country-by-country basis. BNP Paribas took Frotis’s French operations off of the hands of the governments who rescued it in the previous week, while the Belgian government nationalized Fortis’es Belgian bank operations. Hypo Real Estate received a second rescue package from the German government. A number of national governments announced plans to guarantee private bank deposits to prevent the risk of bank runs. The UK authorities unveiled a three-prone plan to support its banking system: direct equity injections of up to 25 billion pounds, a special 200 billion pound liquidity scheme, and a government guarantee of new debt to the order of 250 billion pounds. The Icelandic government seized its two largest banks while contemplating its own solvency. Russia closed its main stock exchange for two days.

Across the Pond, the Federal Reserve took new measures to help stabilize the financial system. It announced the creation of the Commercial Paper Funding Facility as a backstop liquidity provider to top tier (A-1/P-1 rated) asset-backed and corporate CP issuers. It will also start paying interest on bank reserve balances at Federal Reserve to help manage the Fed funds rate. It also increased the TAF program size to $600 billion with a special increase to $900 billion over the 2008 year-end. On October 8, the Federal Reserve and several other key central banks announced the coordinated half-point interest rate cuts to offset the economic damage from a deepening financial shock. The week ended with the U.S. Treasury drafting up a plan to inject $250 billion of capital into the US banking system through direct purchases of bank preferred stocks.

The only significant economic release of the week, consumer credit, surprised the market on the downside with a reduction of $7.9 billion in August, compared to market expectation of an increase of $5.0 billion. As national governments scrambled to shore up their respective financial systems, capital markets had one of the most spectacular sell-offs in history. At one-point, the three major stock indices all experienced the largest point drop in history. The Dow Jones Industrial Average index dropped 18% on the week, while the NASDAQ index lost 15% of its value. Crude oil price also dropped 14%. Panic investors sought refuge in gold, which gained 2%.

Treasury & Yield Curve: Both the Federal Reserve’s interest rate cut and investors’ flight to quality contributed to the rally in short-dated Treasury securities. Heavy expected Treasury issuances in the weeks to come also resulted in sell-offs in the back-end of the yield curve, which has visibly steepened from the previous week. Rates on the three and six-month T-bills rallied 28 basis points, while yields on the 2, 5 and 10-year notes climbed 5, 12, and 27 basis points, respectively. 

Credit Spreads: Credit spreads spiked to the stratosphere for another week. The short-duration Merrill Lynch 1 to 3 Year (A-rated and Higher) Corporate Index spread widened another 139 bps to 764. This is an extreme level even for junk-rated credits. The Lehman Brother Credit Index spread also widened, to 440. 

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.36
    Treasury   0.14 
    US Agencies (AAA-rated)   -0.04
    Corporate (A-Rated & Higher)    -2.83
        Financial (may include BBBs)     -3.32
        Industrial (may include BBBs)     -2.03
    Asset-Backed Securities (AAA-rated)   -1.84
1-Year Treasury Note Index 0.14
6-Month Treasury Bill Index 0.14
3-Month Treasury bill Index 0.03

September 8 to October 3
Economic and Macro Trend: A restructuring plan unveiled by Lehman Brothers set off a dramatic chain of events that caused a near-fatal financial system meltdown on both sides of the Atlantic. After failed efforts to sell itself to Korea Exchange Bank, Lehman announced the plan on September 10 to sell its asset management division and spin off the majority of its commercial properties. Instead of calming the market, the plan set off alarms that the beleaguered Wall Street bank was in desperate need of fresh capital. As Lehman’s “clearing bank”, JPMorgan promptly froze $17 billion in Lehman cash and securities on September 12, as bankruptcy court documents later revealed. Intense discussions among government and Wall Street officials ensued over the weekend to save the securities firm. As Bank of America and Barclays PLC, the two likely suitors, walked away, Lehman’s fate was sealed.

On September 15, Lehman Brothers Holdings filed form bankruptcy protection. The fear of being taken down by the collateral damages forced Merrill Lynch to sell itself to Bank of America. Six days later, Morgan Stanley and Goldman Sachs filed to convert to bank holding companies. Meanwhile, Lehman Brothers debt caused The Reserve Primary money market fund to lose the $1 net asset value and the Putnam Institutional money market fund to freeze redemptions, even though the latter had no Lehman exposure. The Treasury Department unveiled a temporary fund guarantee program for money market funds on September 18 in a effort to stop the run on money funds, although details are still being worked out.

American International Group was the next financial behemoth to fall. Its insurance derivatives exposure to mortgage securities put its double-A credit ratings at risk on September 12. The downgrade risk triggered additional collateral posting requirements of $15 to $20 billion dollars. After efforts by New York State and a private bank consortium failed to secure the necessary liquidity, the insurance giant agreed to give up 80% of its stock ownership to the Federal Reserve Bank of New York in exchange for an $85 billion loan at an interest rate of LIBOR plus 8.50%. 

In the weeks that followed, a number of banks in the U.S. and Europe failed or received government support, including Washington Mutual, the largest US thrift institution, Wachovia, the fourth largest bank holding company, Fortis, the largest Belgian bank, and Hypo Real Estate, the largest German mortgage bank. The Treasury’s Troubled Asset Rescue Program (TARP) to purchase $700 billion impaired assets from financial firms finally went through and became law on October 3. The Irish government was the first European government to provide full guarantees on bank deposits at its six largest banks. The U.K. France, German and other countries all have taken measures to shore up deposit guarantees and provide capital support to financial firms deemed “systemic risk” to their financial systems.

Meanwhile, the Federal Reserve continues to come out with ingenious ways to provide fresh liquidity to break the logjam in the short-term credit markets. These included the ABCP Lending Facility to allow banks to borrow from the Fed with ABCPs purchased from their affiliated money funds, increasing the TAF program to $600 billion and most recently, the Commercial Paper Funding Facility. Despite recent government efforts, equity indices were sharply lower, with the NASDAQ composite index down 14%. Crude oil prices retreated 13% to $93.22 a barrel. 

The fundamental economic picture also grew dimmer. Consumer credit was sharply lower than expected, as did retail and vehicles sales. The S&P CaseShiller Home Price index made new lows. Nonfarm payrolls lost 159,000 jobs. Industrial production, ISM manufacturing and durable goods orders also indicated tough time ahead for the business sector.

Treasury & Yield Curve: Investors again sought the safety of Treasury securities. Despite large T-bill issuance to accommodate the latest Fed and Treasury initiatives, the yield curve rallied strongly, with the front end of the curve benefiting the most. Yields on the 2, 5 and 10-year notes dropped 72, 35, and 10 basis points, respectively. This resulted in the steepening of the yield curve, with the 2-year to 10-year yield spread standing at 2.51%.

Credit Spreads: Credit spreads spiked higher across credit sectors. Investment grade spreads went deeply into junk-bond territory. Credit yield curve also inverted. The Merrill Lynch 1 to 3 Year Corporate Index spread doubled to 625, and the Lehman Brothers Credit Index spread winded 122 bps to 400.  

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.16
    Treasury   1.20
    US Agencies (AAA-rated)   0.97
    Corporate (A-Rated & Higher)    -6.23
        Financial (may include BBBs)     -9.66
        Industrial (may include BBBs)     -1.00
    Asset-Backed Securities (AAA-rated)   -0.93
1-Year Treasury Note Index 0.80
6-Month Treasury Bill Index 0.59
3-Month Treasury bill Index 0.31

September 2 to September 5
Economic and Macro Trend: The first week after Labor Day saw the worst unemployment rate, 6.1%, since the last cyclical downturn five years ago. Moreover, the Labor Department reported that nonfarm payrolls declined a greater-than-expected 84,000 in August, with loss figures in June and July revised higher as well. The pull back in employment was broad-based, including manufacturing, construction and service industries, suggesting that the economy has slipped into a jobs recession. The Fed beige book surveys showed activities weakened across most of the country, as credit remained tight and the housing market still in a bind. A notable slowdown in consumer spending reported by businesses suggests a rough third quarter as consumers face challenges on the labor, housing, credit, and energy fronts. On the positive side, inflation concerns further subsided with higher-than-expected nonfarm productivity growth rate of 4.3% in the second quarter and a decline of 0.5% in unit labor costs. Crude oil prices dropped 8% as hurricane Gustav passed by major oil refineries and pipelines without major damages. After rallying in the first half of the week, equity indices sold off on the payroll numbers. 

Treasury & Yield Curve: Hurricane news, disappointing job numbers, and ongoing credit concerns contributed to the further rally in the Treasury yield curve. Yields on the 2, 5 and 10-year notes rallied 6, 11, and 11 basis points, respectively. The 3-month Bill rate rose 6 basis points. The decidedly flattening move in the shape of the curve communicated the market’s view of lower growth and inflation expectations. News of overseas selling of GSE bonds also contributed to the richness in treasury bonds. 

Credit Spreads: Credit conditions remained tight, especially with high market anxiety over rumored GSE bailout and Korean Development Bank’s interest in Lehman Brothers. Spreads to Treasuries made new highs, with the Lehman Brothers Credit Index spread widened 5 basis points, and the Merrill Lynch 1 to 3 Year Corporate (A rated and higher) Index spread widened 10 basis points on weaknesses in finance and cyclical industries. Despite the fresh talk of a possible interest rate cut this year and the steep LIBOR yield curve, cash investors remained on edge and stayed defensive on the maturity front. 

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.16
    Treasury   0.21
    US Agencies (AAA-rated)   0.11
    Corporate (A-Rated & Higher)    0.11
        Financial (may include BBBs)     0.06
        Industrial (may include BBBs)     0.19
    Asset-Backed Securities (AAA-rated)   0.18
1-Year Treasury Note Index 0.09
6-Month Treasury Bill Index 0.08
3-Month Treasury bill Index 0.06

August 25 to August 29
Economic and Macro Trend: The last summer trading week before Labor Day brought us mixed data on the economy and the minutes from the FOMC meeting in early August. Existing and new home sales rose month-over-month, but median home prices continued to point downwards. The 15.4% decline in the June S&P CaseShiller Home Price Index over the year-ago period, although startling, was less severe than anticipated. The Commerce Department’s report on durable goods orders showed a jump of more-than-expected 1.3% last month, with orders for non-defense capital goods climbing 2.6%. The Commerce Department also revised upward its estimate for second-quarter GDP to 3.3% from an original reading of 1.9%, showing that exports were even stronger than first estimated. Meanwhile, Inflation-adjusted consumer spending dropped 0.4%, suggesting that the economy may waken with the end of government stimulus payments.

Minutes from the Federal Open Market Committee's meeting in early August showed policy makers lowering their expectations for economic growth through the first half of next year. The policy makers saw inflation easing in coming months, suggesting that an interest-rate hike was not imminent. Concerns with Gustav caused Treasuries and crude oil to regain strength. Equity indices, however, held on to their recent gains. 

Treasury & Yield Curve: The rally in the Treasury yield curve was moderate in thin pre-holiday trading, with much of the movement related to the development of Hurricane Gustav in the Golf of Mexico. For the week, yields on the 2, 5, and 10-year notes rallied 2, 5, and 6 basis points, respectively. 

Credit Spreads: Capital and credit concerns at financial firms continued to affect credit spreads. Spreads on Fannie Mae and Freddie Mac recovered somewhat as a positive sentiment returned to the equity investor community. Lehman Brothers continued to be in the headlines in talks of raising capital through an investment by the Korean Development Bank, the disposal of its mortgage assets, or the sale of its asset management unit. Just prior to the earnings season for investment banks, a deluge of downward earnings estimate revisions by equity analysts also affected spread performance. Additionally, the FDIC disclosed that its "problem list" at the end of June grew to 117 institutions, up from 90 at the end of March, as fallout from the credit crunch continued. For the week, the Lehman Brothers Credit Index spread widened 3 basis points, and the Merrill Lynch 1 to 3 Year Corporate (A-rated and Higher) Index spread widened 5 basis points, continuing its recent widening trajectory for the 5th week in a row.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.15
    Treasury   0.15
    US Agencies (AAA-rated)   0.08
    Corporate (A-Rated & Higher)    0.24
        Financial (may include BBBs)     0.16
        Industrial (may include BBBs)     0.22
    Asset-Backed Securities (AAA-rated)   -0.05
1-Year Treasury Note Index 0.04
6-Month Treasury Bill Index 0.05
3-Month Treasury bill Index 0.03

August 18 to August 22
Economic and Macro Trend: Inflation, housing and GSEs concerns pulled the market in different directions. The producer price index increased by 1.2% in July, double the consensus. Core PPI was also ahead of expectations with a 0.8% month-over-month increase on higher prices in both the consumer and capital goods categories.  Both housing starts the forward-looking permits fell in July, suggesting further downdraft in the months ahead. More speculation on GSEs’ difficulty to raise capital and potential asset sales by Lehman Brothers caused the dollar to reverse some of its recent gains. Commodities also rebounded with the currency strength. Fed Chairman Bernanke spoke at Jackson Hole, saying that he sees inflation pressures to ease amid the slower growth. The futures market is unchanged from the previous week, pricing in a 12% probability that the Fed will tighten rates at the September 16th meeting.  

Treasury & Yield Curve: Despite inflation, GSE concerns and Fed speeches, the Treasury yield curve was relatively unchanged for the week. Except for the yield on the 3-month Treasury bill, which dropped 14 basis points due to financials-related credit concerns, yield changes were moderate throughout the curve, with the 2, 5 and 10-year note yields rising 2, 4, and 3 basis points, respectively. 

Credit Spreads: Weakness in financial names continued to affect liquidity and spreads of short-term credit products. The Lehman Brothers Credit Index spread widened 9 basis points, and the Merrill Lynch 1 to 3 Year Corporate (A-rated and Higher) Index spread rose 5 basis points to 296, another new high in the last 52 weeks. Financials led the sectors wider, rising 9 basis pints, while spreads of industrial names were largely unchanged for the week.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.04
    Treasury   0.01
    US Agencies (AAA-rated)   -0.10
    Corporate (A-Rated & Higher)    -0.06
        Financial (may include BBBs)   -0.11
        Industrial (may include BBBs)    0.02
    Asset-Backed Securities (AAA-rated)   -0.36
1-Year Treasury Note Index 0.00
6-Month Treasury Bill Index 0.07
3-Month Treasury bill Index 0.06

August 4 to August 15
Economic and Macro Trend: Despite on-going financial woes, the overall tone in the market was generally positive on lower oil prices, a rally in the dollar, and the expectation that inflation may retreat in the near future. At its scheduled FOMC meeting on August 5, the Federal Reserve left its target Fed funds rate of 2% unchanged, consistent with market expectations.  Its statement offered a balanced outlook on risks to growth and inflation. The solid 2nd quarter productivity gain of 2.2% quarter-over-quarter eased some worries about the inflation outlook. Although both headline and core CPI came in stronger than consensus, bringing inflation to its highest annual pace in 17 years, recent declines in commodity prices made the CPI report backward looking in the minds of market participants. The July ISM non-manufacturing index of 49.5 was above consensus, meaning that the service sector was essentially flat over the previous month. Pending home sales and retail sales continued to suggest tough times ahead despite the economic stimulus checks delivered through mid-month. The probability of an increase in the Fed funds rate at the September 16th meeting dropped to 12%. 

Treasury & Yield Curve: Building on its previous rallies, the Treasury yield curve had a moderate gain in the two-week period, with the yields on the 2, 5 and 10-year notes down by 12, 10, and 9 basis points, respectively. Despite continued credit concerns in the short-term market, T-bill rates sold off on higher supply, with the 3 and 6-month bill rates rising 14 and 3 basis points, respectively. 

Credit Spreads: Earnings releases from Freddie Mac and AIG, as well as JPMorgan’s preannouncement of a $1.5 billion write-off reminded the market of on-going credit concerns. The stabilization in commodity prices and earnings from Wal-Mart, however, acted as a buffer for non-financial names. The secondary market saw good two-way flows along with some primary issues. The Lehman Brothers Credit Index spread widened 3 basis points, and the Merrill Lynch 1 to 3 Year Corporate (A-rated and Higher) Index spread widened 6 basis points.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.23
    Treasury   0.23
    US Agencies (AAA-rated)   0.23
    Corporate (A-Rated & Higher)    0.20
        Financial (may include BBBs)     0.18
        Industrial (may include BBBs)     0.30
    Asset-Backed Securities (AAA-rated)   0.10
1-Year Treasury Note Index 0.16
6-Month Treasury Bill Index 0.14
3-Month Treasury bill Index 0.01

July 28 to August 1
Economic and Macro Trend: Rising exports and stimulus checks helped the U.S. economy grow 1.9% in the second quarter, below economists’ consensus of 2.3%. The fourth quarter 2007 GDP was revised to negative 0.2%. Nonfarm payrolls declined 51,000 in July, representing the 7th consecutive month of decline and pushing the unemployment rate to 5.7%, a four-year high. Housing continued to struggle, as the S&P CaseShiller Home Price Index showed year-over-year price drop of 15.8% nationwide in May. On the positive side, President Bush signed into law the housing bill that will provide $300 billion in federal insurance to some 400,000 mortgage borrowers struggling to make monthly payments. Treasury Secretary Henry Paulson’s proposal of providing unlimited support to housing GSEs was also rectified by the new legislation. The Federal Reserve also decided to extend its Primary Dealer Credit Facility to January 2009 to maintain current capital market liquidity. Steady oil price at around $125 a barrel also helped stabilize equities and the dollar.

Treasury & Yield Curve: Treasury securities rallied throughout the yield curve on poor housing and jobs data. Despite measures taken by the Treasury and the Fed, the short-term credit market remained tight, setting the stage for gains in Treasuries. For the week, yields on the 2, 5, and 10-year notes rallied 22, 23, and 17 basis points, respectively. The 3-month T-bill rate also rallied 6 basis points. The bull steepening movement in the yield curve reflected the market’s belief that the Federal Reserve would likely leave the short-term rate unchanged and emphasize more on the risk to growth at its upcoming FOMC meeting on Tuesday.

Credit Spreads: Credit spreads resumed their recent ascent, eclipsing previous highs in March 2008. Despite decent earnings releases from some financial firms, there were new concerns with write-downs related to monoline insurance terminations and rising delinquencies in credit card and auto debt. The Lehman Brother Credit Index spread widened 6 basis points and the Merrill Lynch 1-3 Year Corporate (A-rated and higher) Index spread widened 10 basis points.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.35
    Treasury   0.35
    US Agencies (AAA-rated)   0.33
    Corporate (A-Rated & Higher)   0.34
        Financial (may include BBBs)     0.28
        Industrial (may include BBBs)     0.37
    Asset-Backed Securities (AAA-rated) 0.17
1-Year Treasury Note Index 0.14
6-Month Treasury Bill Index 0.06
3-Month Treasury bill Index 0.04

July 21 to July 25
Economic and Macro Trend: Mixed economic indicators, a flurry of earnings releases, pending legislation on a housing rescue package and a further drop in oil prices contributed to a volatile week. Housing was mixed as existing and new home sales data pointed to opposite directions relative to market expectations. Strong durable goods orders confirmed that the business component of the economy continues to outperform the consumer sector. By last Saturday, both chambers of the US Congress had passed the housing rescue bill, which included provisions granting the U.S. Treasury the authority to back Fannie Mae and Freddie Mac explicitly should such need arise. Despite further drops in the oil prices and the US government backstopping mortgage credit, equity indices sold off on the potential impact of a slower economy on the mounting debt problems at US financial institutions. The futures market priced in a 7% probability that the Fed will tighten rates at its August 5 FOMC meeting. 

Treasury & Yield Curve: After a volatile week, the shape of the Treasury yield curve was little changed compared to levels in the previous week. Volatility remained in the money market part of the curve, which saw the 3-month T-bill rate selling off 27 basis points. The 2-year note lost 8 basis points, while the 5 and 10-year notes sold off 3 and 1 basis point(s), respectively. The sell-offs in the shorter parts of the curve may be a sign that cash investors became less hypersensitive on near term credit concerns as Congress went to work on the GSE package.

Credit Spreads: The credit markets were muted in a summer week. Both the Lehman Brothers Credit Index and the Merrill Lynch 1-3 Year Corporate (A-rated and Higher) Index spreads tightened 1 basis point. As the credit crisis approached its one-year anniversary, credit concerns with financial issuers were somewhat offset by large cash balances at money market funds looking for places to invest.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.05
    Treasury   -0.01
    US Agencies (AAA-rated)   0.15
    Corporate (A-Rated & Higher)    0.10
        Financial (may include BBBs)     0.06
        Industrial (may include BBBs)     -0.01
    Asset-Backed Securities (AAA-rated)   0.04
1-Year Treasury Note Index 0.01
6-Month Treasury Bill Index 0.01
3-Month Treasury bill Index -0.03

July 07 to July 18
Economic and Macro Trend: The major theme in the post-July 4th two-week period was the talk on potential government support needed for Fannie Mae and Freddie Mac. Shares of the two housing GSEs sold off after several analyst reports suggested that the firms may need more fresh capital and that their battered share prices might have made their goals more difficult to achieve. Debt investors responded positively to Treasury Secretary Henry Paulson’s Congressional requests to provide direct support to the GSEs and the Federal Reserve’s decision to allow Fannie and Freddie to borrow directly from the Fed discount window. Concerns with GSE capital adequacy also led two mortgage heavyweights (Washington Mutual and National City) to reiterate their “well capitalized” claim. However, the seizure of Alt-A lender IndyMac by the FDIC over the July 13 weekend very much kept the mortgage sector front and center in the market’s mind.

Elsewhere, crude oil prices declined sharply on higher US inventories and the anticipated economic slowdown. Inflation remains a major concern, as the June Core CPI Index of 0.3% (5.0% year over year) exceeded market expectations. The Fed continues to be in a difficult spot as threats to inflation and growth remain at a tug of war.

Treasury & Yield Curve: Higher than expected inflation numbers pushed Treasury yields higher, while concerns with US economic growth also resulted in a steeper yield curve in the front end. Both the 2 and 10-year notes saw their yields spike 11 basis points, while the 3-month T-bill rate rallied 39 basis points. The drop in the T-bill rate reflected the on-going credit concerns among money market investors.

Credit Spreads: Earnings releases from several large financial institutions provided the market with a glimpse of what’s to come. Better-than-expected results notwithstanding, most of the firms sounded cautionary notes on deteriorating credit conditions in their loan portfolios in addition to distressed home equity loans. Credit spreads of financial firms followed equity prices, which plummeted on the Fannie Mae and Freddie Mac saga. Spreads recovered somewhat after the Treasury announcement and better-than-expected earnings news from large financial firms (Wells Fargo, JPMorgan Chase, and US Bancorp). On balance, the Lehman Brothers Credit Index spread widened 12 basis points. The short-duration Merrill Lynch 1-3 Year Corporate (A-rated and Higher) Index spread widened 17 basis points, exceeding the widest level of 273 reached on March 21, 2008.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.20
    Treasury   -0.08
    US Agencies (AAA-rated)   -0.29
    Corporate (A-Rated & Higher)    -0.40
        Financial (may include BBBs)     -0.62
        Industrial (may include BBBs)     -0.12
    Asset-Backed Securities (AAA-rated)   -0.28
1-Year Treasury Note Index 0.08
6-Month Treasury Bill Index 0.18
3-Month Treasury bill Index 0.15

June 30 to July 03
Economic and Macro Trend: The Independence Day shortened week saw strong manufacturing activities, bolstered by the weak dollar, and the loss of 62,000 nonfarm jobs in June. Major equity indices are officially in bear market territories, as they fell more than 20% from cycle peaks. After a brief recess, crude oil price went back up to end the week at $145.33 a barrel.

Treasury & Yield Curve: With the exception of the 3-month Treasury bill, which went up 18 basis points, the Treasury yield curve had a modest rally, tightening in between 1 and 10 basis points. The sell-off in the equity market benefited Treasuries as the result of flight to quality trades.

Credit Spreads: Credit markets traded down with equity indices as bad news out of the auto and financial sectors suggested more difficult time ahead for the credit sector. The Leman Brothers Credit Index spread widened 5 bps, while the 1-3 Year Merrill Lynch Corporate (A-rated and Higher) Index gave up 12 bps.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.21
    Treasury   0.24
    US Agencies (AAA-rated)   0.21
    Corporate (A-Rated & Higher)    0.11
        Financial (may include BBBs)     0.06
        Industrial (may include BBBs)     0.16
    Asset-Backed Securities (AAA-rated)   0.09
1-Year Treasury Note Index 0.10
6-Month Treasury Bill Index 0.07
3-Month Treasury bill Index -0.01

June 23 to June 27
Economic and Macro Trend: After months of aggressively easy monetary policy, dropping the federal funds rate by 325 basis points to the current 2.00%, The Federal Reserve stood pat on the key short-term lending rate last Wednesday. Despite the 9-1 no-action vote, with Dallas Fed president Richard Fisher opting for an increase, the accompanying FOMC statement was more benign than the market had anticipated, suggesting that rate increases may take longer to arrive. The American consumer economy continued to face a very tough uphill battle, as the S&P/CaseShiller Home Price Index dropped 15.30% in April over the same period last year, the largest to date. The June consumer Confidence Index dropped to 50.4%. May Personal Income, however, came in at an upside surprise of 1.9%. The May Core PCE Index, a favored inflation index by the Fed, was a benign 0.1%.

Treasury & Yield Curve: Battered for weeks, the Treasury yield curve found new strength to rally after the assuring FOMC meeting statement Wednesday. Yields gained across the curve with the 2-year note gained the most, at 27 bps, followed by the 5-year note, which gained 25 bps. The 3-month T-bill rate also rallied 19 bps. The bull-flattening move brought down the steepness of the yield curve between 3-month and 2-year part of the curve by 7 bps to 97 bps.

Credit Spreads: Credit markets weakened for each day of the last week, as the price of crude oil, the stock markets, and news on downtrodden financial firms weighed down the overall market. Going into a new earnings season, speculations have it that banks could see considerable new write-downs.  The Leman Brothers Credit Index spread widened 19 bps, while the 1-3 Year Merrill Lynch Corporate (A-rated and Higher) Index gave up 13 bps.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.39
    Treasury   0.42
    US Agencies (AAA-rated)   0.41
    Corporate (A-Rated & Higher)    0.24
        Financial (may include BBBs)     0.16
        Industrial (may include BBBs)     0.36
    Asset-Backed Securities (AAA-rated)   0.30
1-Year Treasury Note Index 0.06
6-Month Treasury Bill Index 0.09
3-Month Treasury bill Index 0.07

May 19 to June 20
Economic and Macro Trend: After months of gloomy data, the latest economic releases started to show some signs of stability. Goods orders for April came in better than expected. The Chicago Purchasing manager and ISM Manufacturing data also pointed to higher manufacturing activities. The economy lost 49,000 jobs in May, 11,000 fewer than a previous forecast. Wholesale inventories also increased more than anticipated. With the revised first quarter GDP of 0.9%, most economists now expect the second quarter GDP to also be positive. Despite surging oil prices, core inflation statistics largely came in as expected.

Surging crude oil prices, and resulting spikes in gasoline prices, brought the market’s refocus back on inflation, especially since economic signs seemed to suggest that the economy’s growth risk has subsided. After the FOMC’s decision to lower the interest rate by 0.25% at the April 30 meeting, the market now widely expects the next policy move will likely be a tightening one. Despite credit issues in the financial sector, the market now expects the Fed to raise the benchmark rate by the August meeting, and expects the Fed funds rate above 2.50% by the end of the year.

Treasury & Yield Curve: The Treasury yield curve sold off on new inflation worries and the talk of a tightening interest rate environment. Even after the Fed hinted that it may not start raising rates as soon as some feared, the damage has been quite severe especially at the 5-year part of the yield curve, which saw yields backing up as much as 49 basis points. Yields on the 2- and 10-year notes also increased 45 and 32 basis points, respectively.  The 6-month T-bill rate rose 33 basis points, while the 3-month bill rate was essentially unchanged.

Credit Spreads: The strong rally in credit spreads since last March now look premature with troubles at major financial firms again in the spotlight. These include credit write-downs in home equity and leveraged loan portfolios at major regional banks and market jitters on Lehman Brothers’ liquidity positions. The credit downgrades of MBIA and Ambac to below triple-A brought up more questions on financial firms’ exposure to securities wrapped by the monoline insurers. The Lehman Brothers Credit Index spread widened 6 basis points over the last five weeks. Interestingly, the short-duration Merrill Lynch 1 to 3 year Corporate (A rated and Higher) index spread held its own at the unchanged level.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.32
    Treasury   -0.32
    US Agencies (AAA-rated)   -0.32
    Corporate (A-Rated & Higher)    -0.30
        Financial (may include BBBs)     -0.25
        Industrial (may include BBBs)     -0.18
    Asset-Backed Securities (AAA-rated)   -0.61
1-Year Treasury Note Index -0.14
6-Month Treasury Bill Index 0.05
3-Month Treasury bill Index 0.19

May 12 to May 16
Economic and Macro Trend: Housing, retail sales, inflation, and commodity prices and consumer confidence were the headline grabbers of the week. Housing starts in April rose 8.2% to 1.03 million, following an upwardly revised 954,000 in March. Building permits also rose in April, up 4.9% to 978,000. The April retail sales report was stronger than expected, rising by 0.4% ex-auto. Consumer price increases were benign but surging commodity prices pushed import prices up by 1.8% in April and up 15.4% year over year, the highest since 1980. Crude prices were relatively unchanged but gold prices approached $900 an ounce. Industrial production fell 0.7% in April, double the decline expected by the consensus. The overall capacity utilization rate fell to 79.7%, which lessened some of the inflationary concerns. Bearish consumer sentiment continued, as the University of Michigan confidence index dropped to 59.5 in May from 62.6 in April, well below consensus, to the lowest since June 1980.

Treasury & Yield Curve: Stronger housing data, inflation and commodity data caused Treasury yields to back up substantially, led by the 2-year note, which sold off 20 basis points. The 5-year note yield increased 14 basis points, and the 10-year note yield moved 8 basis points higher. The back up in yield was also felt in the Treasury bills market, with both the 3- and 6-month bill rates increasing 15 basis points.

Credit Spreads: Secondary market spreads improved last week, helped by an equity market rally of 2% to 3%. Credit indices tightened across the board, reversing nearly all of the widening in the previous week. On the week, the Lehman Brothers Credit Index spread tightened 5 basis points and the Merrill Lynch 1 to 3 Year Corporate (A-rated and Higher) Index spread tightened 7 basis points. The market continues to digest the record new issue supply in stride, with recent deals continuing to trade well in the secondary market.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.30
    Treasury   -0.34
    US Agencies (AAA-rated)   -0.25
    Corporate (A-Rated & Higher)    -0.21
        Financial (may include BBBs)     -0.20
        Industrial (may include BBBs)     -0.19
    Asset-Backed Securities (AAA-rated)   -0.21
1-Year Treasury Note Index -0.14
6-Month Treasury Bill Index -0.03
3-Month Treasury bill Index 0.01

May 5 to May 9
Economic and Macro Trend: Financial write-downs and record oil prices to $126 softened the mood in the capital markets. Wholesale inventories came in well below market expectations, declining by 0.1% in March after a downwardly revised 0.9% increase the previous month. Pending home sales fell 1.0% in March, in line with consensus expectations. On the other hand, the ISM nonmanufacturing index unexpectedly rose above the 50 mark to 52.0 for the first time since December. The trade deficit narrowed more than market expectations to -$58.2 billion in March, following an upwardly revised -61.7 billion in the prior month. The market still thinks the Fed is at a standstill, pricing in an 18% probability for a 25 basis point cut at the June 25 meeting. 

Treasury & Yield Curve: Treasuries gained as the rally in spread sectors paused. The yield curve steepened with the 2-year note yield dropping 21 basis points and the 10-year note yield dropping 9 basis points. The 3 and 6-month T-bill rates moved up by 18 and 7 basis points, respectively.

Credit Spreads: On the heels of weaker-than-expected earnings and the surge in commodity prices, the secondary market felt a tad softer.  Nonetheless, new issue supplies remained quite strong in the secondary credit market, with most deals trading generally flat or tighter.  The Lehman Brother Credit Index spread rose 1 basis point, while the Merrill Lynch 1-3 Year Corporate (A-rated and Higher) Index spread gained 4 basis points.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.40
    Treasury   0.37
    US Agencies (AAA-rated)   0.34
    Corporate (A-Rated & Higher)    0.54
        Financial (may include BBBs)     0.52
        Industrial (may include BBBs)     0.52
    Asset-Backed Securities (AAA-rated)   0.49
1-Year Treasury Note Index 0.19
6-Month Treasury Bill Index 0.02
3-Month Treasury bill Index -0.01

April 21 to May 2
Economic and Macro Trend: Global food shortages took center stage as there were reports from several continents of deaths and violence related to rice and grain riots. Continued unrest in Nigeria and a worker strike in the U.K. caused crude prices to rise above $120 a barrel before retreating to the unchanged level of $116 a barrel. The inflation backdrop, combined with less pessimistic investor sentiment, contributed to the thinking that the Federal Reserve is getting to end of the easing cycle. Indeed, the Fed lower the benchmark rate by 0.25%, the smallest of its recent moves, at its two-day FOMC meeting, removed the reference to downside risks to the economy, and hinted its concern with inflation. The market consensus seems to point to the Fed going on hold until the effect of the tax rebate checks can be assessed. The market priced in a 16% probability for a 25 basis-point cut at the June 25th meeting. 

Economic news continued to be mix, but several major releases offered slim hope for some that the economy may not be in an outright recession. The economy grew at an annualized rate of 0.6% in the first quarter of 2008, slightly ahead of consensus of 0.5%. About 20,000 jobs were lost in April, compared to the expected loss of 75,000 jobs and March’s loss of 81,000K. Housing market data, though, offered little sings of a turnaround.

Treasury & Yield Curve: The sell-off in the Treasury yield curve continued, as better investor sentiment resulted in more flight-from-quality trades. Mixed earnings and global food shortages failed to stop or reverse the trend. By the end of the two-week period, the two-year note experienced the most loss, rising 32 basis points in yield, followed by the five-year note, which saw its yield higher by 28 basis points. The 10-year note yield also rose 15 basis points. Treasury bills also retreated, with yields on the three and six month bills rising 15 and 2 basis points, respectively. This flattering movement of the yield corresponded with the increase in probability of a Fed funds rate increase in 2009.

Credit Spreads: Higher food and fuel prices, lower consumer confidence, and more bank write-downs did not prevent credit markets from more rallies for the fourth week in a row with broad-based tightening of bond yields. The Lehman  Brothers Credit Index rallied 21 basis points, while the Merrill Lynch 1 to 3 year Corporate (A-rated and higher) Index tightened 15 basis points.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.13
    Treasury   -0.28
    US Agencies (AAA-rated)   -0.01
    Corporate (A-Rated & Higher)    0.21
        Financial (may include BBBs)     0.31
        Industrial (may include BBBs)     0.17
    Asset-Backed Securities (AAA-rated)   -0.22
1-Year Treasury Note Index -0.03
6-Month Treasury Bill Index 0.09
3-Month Treasury bill Index -0.01

April 14 to April 18
Economic and Macro Trend: The tone of the market was decidedly positive. With the exception of housing data which showed ongoing softness, most economic releases were better than expected, including advanced retail sales of 0.2% in March, benign core PPI and CPI inflation data both at 0.2%, Empire State and Philadelphia Fed data canceling each other out, and strong Industrial Production of 0.3%, which the market had expected to come at -0.1%. It was also a heavy week for earnings releases. Earnings out of General Electric were soft, but banks that reported write-downs and credit provision-related losses also announced capital infusion plans, which were positive for bond investors. The market was relatively strong every day of the week for the first time in months. Equity indices rallied and gold price dropped despite sharp increases in crude prices to a record $116.85 a barrel.

Treasury & Yield Curve: The Treasury yield curve sold off and steepened in the front end, with the 2-year part of the curve backing up the most, or 39 basis points (bps) wider. The 3 and 6-month T-bill rates rose 0.16 and 27 bps, respectively. Yields on the 5 and 10-year notes also lost 33 and 24 bps, respectively. The Fed funds futures market priced in a cut of 25 bps by the June 25 FOMC meeting, although the same market also projected the benchmark rate to go back up to 2.50% by June 2009.

Credit Spreads: The credit market also felt stronger as credit spreads rallied across ratings, maturities and sectors. Respectable earnings from Citigroup, JPMorgan, Wells Fargo and U.S. Bancorp drove financial spreads tighter, although not all names performed as well. As the result of further credit weakness, Wachovia received a negative outlook from S&P and Merrill Lynch went on review for downgrade from Moody’s. New issues were performing well in the secondary market and risk appetite appeared to be coming back indicated by the Lehman Credit Index and the Merrill Lynch 1-3 year Corporate (A-rated and higher) index spreads, which came in 8 and 9 bps, respectively.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.60
    Treasury   -0.61
    US Agencies (AAA-rated)   -0.60
    Corporate (A-Rated & Higher)    -0.52
        Financial (may include BBBs)     -0.49
        Industrial (may include BBBs)     -0.59
    Asset-Backed Securities (AAA-rated)   -0.85
1-Year Treasury Note Index -0.01
6-Month Treasury Bill Index -0.09
3-Month Treasury bill Index 0.02

April 7 to April 11
Economic and Macro Trend: Minutes from the March 18th FOMC meeting showed that the Fed cut its 2008 GDP forecast again, expecting an outright contraction in growth in the first half of the year. The University of Michigan consumer sentiment index plunged again, to 63.2 from 69.5 in March, lowest level since the 1981 recession. Inflation expectations worsened not surprisingly due to higher food and energy prices, with the near-term outlook ticking up to 4.8% from 4.5%. Pending home sales fell 1.9% in February, the third decline in the past 4 months, to be down 17.4% year-over-year. Less-than-expected earnings releases from General Electric and UPS also added the overall softer tone in the market.

Treasury & Yield Curve: The Treasury yield curve re-steepened, with rates on the front end of the curve dropping but relatively unchanged on the long end, reflecting the expectation of further cuts in the Fed funds rate and a softer economy. The 3 and 6–month bill rates dropped 18 and 13 bps, respectively. The 2 and 5-year note yield dropped 7 and 5 bps, respectively. The 10-year note yield, however, remained unchanged. The Fed Funds futures market priced in a 46% probability of a 50-bps cut in the funds rate at the April 30th meeting. 

Credit Spreads: Despite slumping retail sales, news of financial firms finding ways to reduce their balance sheet exposure to at-risk loans was positive for credit spreads. Later in the week, disappointing earnings from General Electric forced spreads to back off from earlier tighter levels. For the week, the Lehman Brothers Credit Index spread tightened 1 basis point, while the short-duration Merrill Lynch 1-3 Year Corporate (A-rated and higher) Index spread gave up 3.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.18
    Treasury   0.16
    US Agencies (AAA-rated)   0.16
    Corporate (A-Rated & Higher)    0.22
        Financial (may include BBBs)     0.22
        Industrial (may include BBBs)     0.30
    Asset-Backed Securities (AAA-rated)   0.04
1-Year Treasury Note Index 0.09
6-Month Treasury Bill Index 0.12
3-Month Treasury bill Index 0.07

March 17 to April 4
Economic and Macro Trend: Since the Bear Stearns’ call to the Federal Reserve on the night of Thursday March 13 about its near-bankruptcy predicament, the Fed instituted a number of rapid-fire actions to prevent bank runs on other investment banks. These included the $30 billion emergency loan to BSC through J.P.Morgan, a 0.25% cut in the discount rate followed by 0.75% cuts in both the Fed funds and discount rates at the Fed’s schedule FOMC meeting on March 18, the arranged marriage between JPM and BSC at a price of $2 (later revised to $10) per Bear share, and the announcement of a Primary Dealer Credit Facility that allows investment banks to borrow directly at Federal Reserve’s discount window. Earnings releases from Lehman Brothers, Goldman Sachs and Morgan Stanley provided some assurance that the larger, more diversified securities firms had sufficient liquidity and that they did not produce the level of write-downs some investors feared. The Fed’s direct involvement in the assumption of Bear Stearns’ trading obligations by JPMorgan provided further comfort to investors who worried about counterparty credit risk. Visa’s successful IPO provided some positive boost to market sentiment. For the time been, the market seemed to have averted another wave of market liquidity crisis.

However, the economy’s fundamental picture remains challenged. Home sales and price data continued to point lower. Expectations in Consumer Confidence data dropped 12 points to 64.5, the lowest level since 1973. Jobless claims spiked, and the labor market shed 80,000 jobs in March, in addition to a net revision of a loss of 67,000 for the prior two months. In his Congressional testimony, Fed Chairman Bernanke acknowledged for the first time that the economy may slip into recession in the first half of the year.

Treasury & Yield Curve: Concerns with all credit investments caused investors flight to the safe havens of Treasury securities, scooping up anything they could find. The three-month bill rate dropped to 0.565% on Wednesday March 19. At one point the one-month bill rate was at a negative yield. Treasury yields started to back up after the Fed rate cuts and as investors felt better about large financial institutions’ (UBS and Deutsche Bank) ability to raise more capital despite large first-quarter write-downs. By the end of the three-week yield, the Treasury curve was significantly flatter, with the 2-year note yield going up 34 bps, followed by the 5-year note, which went up 22 bps. The 10-year note yield was unchanged. The yields on the 3 and 6-month bills increased 20 and 22 bps, respectively.

Credit Spreads: Unconfirmed rumors of the health of some financial institutions after the Bear Stearns news brought uneasiness back into the market. The Fed’s new liquidity facilities provided some relief to the major securities firms, but smaller firms continued to have trouble access the credit markets. CIT drew upon $7.3 billion in its credit facility, which caused uncertainty and volatility.  On balance, however, credit spreads started tightening as earnings from Morgan Stanley, Goldman Sachs and Lehman Brothers pushed yield spreads in a positive direction. Even the announcement by UBS to have lost $12 billion in the first quarter as the result of $19 billion write-downs were viewed positively as the firm planned to raise $15 billion in bank capital. For the three-week period, the Lehman Brothers Credit Index spread tightened 10 bps, while the short-duration Merrill Lynch 1-3 Year Corporate (A-rated and higher) Index spread gave up 12.

Total Return (Merrill Lynch Short-Duration Indices):
(3/14/08 – 4/04/08)
1-3 Year Govt/Corp (A-Rated & Higher) -0.45
    Treasury   -0.54
    US Agencies (AAA-rated)   -0.13
    Corporate (A-Rated & Higher)    -0.54
        Financial (may include BBBs)     -0.31
        Industrial (may include BBBs)     -0.66
    Asset-Backed Securities (AAA-rated)   -1.11
1-Year Treasury Note Index 0.05
6-Month Treasury Bill Index -0.06
3-Month Treasury bill Index -0.04

March 10 to March 14
Economic and Macro Trend: The tumultuous week started with the shocking news of New York Governor Eliot Spitzer’s involvement in a prostitution ring, and ended with the shocking news of Bear Stearns suffering a “bank run”. Already fearful of the credit implications an economic recession would have on financial assets, investors were spooked by the default of Carlyle Capital after it failed to meet increased margin calls. The deeper “haircuts” on repurchase agreements (repo) backed by high-quality mortgage securities resulted in unprecedented liquidity crisis in the repo market, the life blood of securities firms. Bear Stearns, the smallest of the five major US firms, paid the ultimate price and went to the Federal Reserve for emergency funding.

The Fed sprang to action early in the week to provide more liquidity to the capital markets. In addition to upsizing the Term Auction Facility to $100 billion to provide more liquidity to banks, the Federal Reserve announced on Monday the $200 billion Term Securities Lending Facility (TSLF) designed to provide liquidity to broker-dealers by swapping Treasury securities for other AAA-rated securities. The week ended with the news that the Fed was to provide Bear Stearns with emergency funds via JPMorgan Chase. Over the week-end, JPM agreed to buy Bear Stearns for $236 million, which translates into a purchase price of $2 per share. In a further step, the Fed will be providing $30 billion in liquidity to cover Bear’s CMBS, other mortgage-related assets, and leveraged loan commitments. Additionally, the central bank lowered the so-called discount rate by a quarter of a percentage point to 3.25% and will lend directly to the 20 primary dealers through a Primary Dealer Credit Facility (PDCF).

Treasury & Yield Curve: The liquidity crisis ignited a new round of flight-to-quality trades that saw Treasury yields drop across the yield curve. The 3-month Treasury bill was the biggest beneficiary, with its rate dropping 28 basis points to yield 1.16%. The 6-month bill rate dropped 24 basis points to reach 1.31%. The 2, 5, and 10-year note yields rallied 4, 3 and 6 basis points respectively.

Credit Spreads: The widening in secondary market spreads accelerated with more financial names including Lehman Brothers and National City coming under stress. S&P released a report anticipating subprime-related write-downs to increase to $285 billion from $265 billion ($150 billion has been reported). The revision will likely be followed by ratings actions on more MBS ratings that relied on the previous estimate. The Lehman Brothers Credit Index spread widened 11 basis points, and the Merrill Lynch 1 to 3 Year Corporate (A-rated and higher) Index spread widened 34 basis points.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.11
    Treasury   0.21
    US Agencies (AAA-rated)   0.22
    Corporate (A-Rated & Higher)   -0.37
        Financial (may include BBBs)     -0.67
        Industrial (may include BBBs)      0.05
    Asset-Backed Securities (AAA-rated)   0.27
1-Year Treasury Note Index 0.08
6-Month Treasury Bill Index 0.15
3-Month Treasury bill Index 0.06

March 3 to March 7
Economic and Macro Trend: An overall weak sentiment prevailed, driven by Fed Chairman Ben Bernanke’s statement on Tuesday, MBA mortgage delinquency report on Thursday, an unstable auction rate securities market throughout the week and the big negative payroll number on Friday. Commodity prices were again a focal asset class as oil, gold and silver all reached all-time highs.

For the first time since September 2002, the Beige Book says that economic growth has overall slowed. The ISM manufacturing index dropped to 48.3 in February from 50.7 in January, again signaling that activity in the sector is contracting. The ISM non-manufacturing composite index rose to 49.3 in February from the extremely weak 44.6 print in January, but remained below the breakeven mark.  Non-farm Payrolls fell in February at its fastest rate in five years, suggesting that the housing and credit crunch is gripping the broader economy.

Treasury & Yield Curve: Treasuries rallied again on disappointing economic news, led by strong showing in the short-maturity Treasury bills. The yield curve continued to steepen with the 3-month bill’s rate gaining 40 basis points and the 6-month rate declining 27. Yields on the 2 and 5-year notes declined by 10 and 4 basis points, respectively. The 10-year note, however, saw its yield increased by 2 basis points, partly on soaring commodity prices.

Credit Spreads: Secondary market spreads widened dramatically again as illiquidity persisted. News of financial funds unable to make margin calls, insurer Ambac receiving less capital infusion than initially expected, reinvigorated fears in Alt-A mortgage credit quality as well as solvency of mortgage GSEs all played into an increasingly nervous credit market. Large new issue deals, particularly from financial names, demonstrated weak performance in the secondary market. Despite the Fed’s indication to dramatically increase its Term Auction Program size, the Lehman Brothers Credit Index spread widened 27 basis points, while the short-duration Merrill Lynch 1 to 3 Year Corporate (A-rated and higher) Index spread widened 25 basis points.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.10
    Treasury   0.23
    US Agencies (AAA-rated)   0.02
    Corporate (A-Rated & Higher)   -0.21
        Financial (may include BBBs)    -0.41
        Industrial (may include BBBs)    -0.04
    Asset-Backed Securities (AAA-rated)  -0.52
1-Year Treasury Note Index 0.12
6-Month Treasury Bill Index 0.17
3-Month Treasury bill Index 0.13

February 25 to February 29
Economic and Macro Trend: Bernanke’s Congressional testimony primarily focused on the “downside risks to growth” with less concern on inflation. Despite weaknesses in the economy, oil reached an all-time high on Thursday at 102.59 per barrel.  Moody’s and S&P’s confirmation of MBIA’s AAA ratings started the week off on a positive tone, but Thursday’s 4Q GDP report of 0.6% soured investor appetite. The dollar also hit an all-time low against the Euro (1.52). The Fed Funds futures market priced in a 68% probability that that the Fed will cut 75bps at the March 18th meeting.

Treasury & Yield Curve: Recessionary-like economic data caused Treasuries to rally. The yield curve continued to steepen with the yield spread between the 2 and 10-year notes at 189 basis points, almost double its steepness on January 1, 2008. The 2, 5, and 10 note yields ended the week down 40, 36 and 29 basis points, respectively. Both the 3 and 6-month Treasury bills rallied as well, compressing 35 and 31 basis points, respectively.

Credit Spreads: Rating confirmations of MBIA and an expected rescue of Ambac provided a strong backdrop for the credit market early in the week, but sentiment changed after the GDP report caused spreads to widen and the equity market to sell off. The Lehman Brothers Credit Index spread widened 3 basis points and the Merrill Lynch 1-3 year Corporate (A-rated and Higher) Index spread widened 7 basis points.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.57
    Treasury   0.59
    US Agencies (AAA-rated)   0.52
    Corporate (A-Rated & Higher)    0.58
        Financial (may include BBBs)     0.52
        Industrial (may include BBBs)     0.48
    Asset-Backed Securities (AAA-rated)   0.57
1-Year Treasury Note Index 0.10
6-Month Treasury Bill Index 0.16
3-Month Treasury bill Index 0.09

February 19 to February 22
Economic and Macro Trend: The January Consumer Price Index increased 0.4% (0.3% for Core CPI) and the very negative Philly Fed report (-24.0) brought back renewed inflation fears amidst a period of slow growth. The main takeaway from FOMC’s January 29-30 meeting minutes were the lower GDP forecast for 2008 (from 2.0% to 1.3%) and higher Core CPI estimate (between 2% and 2.2% from 1.8%-2.5%). However, the Fed is open to cutting rates further if needed, the minutes said.  The Fed Funds futures registered a slight drop of probability of a 50-bps cut at the March 18 meeting initially, but still ended the week with a 100% probability.  Gold and commodity prices moved higher and equity indices sold off.

Treasury & Yield Curve: The Treasury yield curve whipsawed throughout the week, and ended it higher in short maturities but unchanged at the long end, resulting in a flatter yield curve. Yields on the two, five, and 10-year notes rose 11, seven and three basis points, respectively. The three-month Bill rate was unchanged and the six-month Bill rate increased six basis points.

Credit Spreads: A weaker economic outlook, as indicated by the week’s economic releases, caused credit spreads to widen again to record levels. The short-duration market saw little relief in the auction rate securities market, while corporate and non-mortgage consumer loans also started to make headlines. The Lehman Brothers Credit Index lost four bps, and the Merrill Lynch 1-3 Year Corporate Index spread widened two basis points.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.09
    Treasury   -0.09
    US Agencies (AAA-rated)   -0.10
    Corporate (A-Rated & Higher)    -0.08
        Financial (may include BBBs)     -0.08
        Industrial (may include BBBs)     -0.10
    Asset-Backed Securities (AAA-rated)   -0.27
1-Year Treasury Note Index 0.05
6-Month Treasury Bill Index 0.03
3-Month Treasury bill Index 0.05

February 11 to February 15
Economic and Macro Trend: Bond investors had a lot thrown at them in a week. Market moving events included the $168 billion economic stimulus package signed into law by President Bush, widespread auction failures in the municipal market, more talk (but no substance) of bailout options for bond insurers, Warrant Buffet’s offer to reinsure municipal bonds, the deteriorating SIV situation, the talk of more write-downs at investment banks should bond insurers split into separate entities, and the previously announced large subprime losses by UBS. Adding downward earnings revisions from Best Buy and the big drop in the University of Michigan’s consumers-sentiment index, the week’s news made for a very difficult week for fixed income investors. The Fed funds futures market fully priced in a 50-bps cut at the FOMC’s March 18 meeting, and another 50-bps reduction by its August meeting.

Treasury & Yield Curve: The yield curve steepened sharply again as more data pointed to the inevitable economic slowdown and possible recession. The yield on the two-year Treasury note fell one basis point to 1.91, while yields on the five and 10-year notes rose seven and 12 bps, respectively. The three and six-month bills rates dropped three and four bps, respectively.

Credit Spreads: Spreads widening continued, as one would expect in an environment where no immediate relief is in sight. The Lehman Brothers Credit Index spread widened two bps and the Merrill Lynch 1 to 3 year Corporate (A-rated and Higher) Index spread widened three bps, both continuing their records to the widest levels since late 2002. Spread softness was seen across all major sectors.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.04
    Treasury   0.06
    US Agencies (AAA-rated)  -0.01
    Corporate (A-Rated & Higher)    0.01
        Financial (may include BBBs)     0.00
        Industrial (may include BBBs)     0.01
    Asset-Backed Securities (AAA-rated)    -0.356
1-Year Treasury Note Index 0.08
6-Month Treasury Bill Index 0.05
3-Month Treasury bill Index 0.03

January 14 to January 25
Economic and Macro Trend: Threats of major bond insurers’ losing their coveted AAA ratings and Swift actions by the FOMC and the U.S. Congress to prevent the economy from going into a nosedive were the highlight of the holiday-shortened two-week period. After steep losses in overseas stock markets, the Bernanke Fed responded quickly by engineering a surprise, inter-meeting, 75-basis point cut in the Fed funds rate. The first inter-meeting cut since 2001 came barely a week before the FOMC’s scheduled meeting on January 29. The House of Representatives quickly followed with a $150-billion bipartisan economic stimulus package expected to become law in a few weeks. Global markets reacted favorably to the U.S. moves, but lingering concerns remain as to the effectiveness of both moves. News of New York Insurance Department superintendent with major banks on a solution to save the bond insurers also lifted the market’s spirit before the superintended caution the lengthy process of a workable solution. The revelation of the $7.2 billion trading scandal at Societe Generale also called into question whether the Fed prematurely reacted to the precipitous fall in overseas markets partially caused by the bank unwinding unauthorized stock trades.

Treasury & Yield Curve: The rally in the Treasury market accelerated, resulting in outsized gains for securities across the yield curve. After rallying 10-25bps in the first week, the curve caught fire with the steep drop in short-term rates. The 10-year benchmark yield sank to a four-year low of 3.44% before ending the week at 3.55%. Both the three-month bill rate (2.25%) and the two-year note yield (2.18%) were substantially below the Fed funds rate after the cut (3.50%). The probability of a further cut in the Fed funds rate by 50-bps to 3% stood at 100%.

Credit Spreads: Corporate spreads continued to widen, with the Lehman Brothers Credit Index spread widening 14 bps and the Merrill Lynch 1 to 3 year Corporate (A-rated and Higher) Index spread losing 11 bps, both at their widest levels since late 2002. Not surprisingly, real estate and insurance credits led the decline, widening 26 and 21 bps, respectively. Technology, telecom, and banking names also experienced negative spread movements. Despite index widening, secondary market liquidity improved somewhat, especially in certain financial names, as the market responded favorably to actions from the Fed and insurance regulators.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.76
    Treasury 0.77
    US Agencies (AAA-rated)   0.75
    Corporate (A-Rated & Higher)    0.69
        Financial (may include BBBs)     0.62
        Industrial (may include BBBs)     0.65
    Asset-Backed Securities (AAA-rated)   0.48
1-Year Treasury Note Index 0.64
6-Month Treasury Bill Index 0.41
3-Month Treasury bill Index 0.27

January 7 to January 11
Economic and Macro Trend: The market paid little attention to economic data in the first full week of the New Year. Instead, most of focus was on corporate news and Fed speeches. Concerns with more mortgage-related charges and recessionary fears from consumer spending slowdowns caused equity markets to slump. This negative market sentiment was somewhat offset by Fed Chairman Bernanke’s hints of more aggressive rat cuts and by Bank of America’s announced purchase of Countrywide Financial.

Treasury & Yield Curve: With the market expectation of more aggressive cuts in the Fed funds rate, the Treasury yield curve steepened. The two-year note yield rallied 19bps while the 10-year yield came in eight. The funds futures market priced in a 100% chance of a 50 bps ease at the January 30th FOMC meeting. 

Credit Spreads: Corporate secondary spreads widened as recessionary concerns increased. The Lehman Brothers Credit Index spread widened six bps and the Merrill Lynch 1 to 3 year Corporate Index spread widened five bps. Financial spreads were hurt by pre-earnings announcements from a number of firms including National City Corp, American Express, and Capital One. Rumors of Citigroup and Merrill Lynch doubling their write-down estimates also contributed to spread underperformance of financial names.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.28
    Treasury   0.28
    US Agencies (AAA-rated)   0.30
    Corporate (A-Rated & Higher)    0.23
        Financial (may include BBBs)     0.48
        Industrial (may include BBBs)     0.21
    Asset-Backed Securities (AAA-rated)   0.27
1-Year Treasury Note Index 0.23
6-Month Treasury Bill Index 0.11
3-Month Treasury bill Index 0.07

December 17, 2007 to January 4, 2008
Economic and Macro Trend: Year 2007 ended with more financial firms posting additional losses and an economy besieged by a soft housing market and a credit crisis. The Fed’s first two $20 billion term-funding auctions were met with solid demand and were considered successful in bringing short-term inter-bank lending rates (LIBOR) down by as much as 0.50% to 4.50%. The New Year begins with another string of weak economic data, large equity declines, and increased global political instability. The Treasury Department and several major banks dropped the M-LEC Super SIV plan due to lack of interest. A disappointing payrolls report and poor manufacturing data suggest that the U.S. economy is nearing a tipping point. With the Fed minutes from the December 11th meeting more dovish than the policy statement indicated, the Fed Funds futures market now price in as much as an 80% chance of a 50bps ease for the January 30th FOMC meeting to ward off the risk of a recession. Oil traded above $100 a barrel briefly before settling at $97.76.

Treasury & Yield Curve: With financial firms posting additional losses, the economy at the brink of recession and higher geopolitical risk, the movement to the safety of treasuries continued.  The two-year yield dropped 56 bps, followed by the five and 10-year notes, which came in 45 and 37 bps, respectively.

Credit Spreads: Secondary market spread widening in the credit sectors continued as the market focused on broker earnings, bond guarantors’ AAA credit ratings in jeopardy, and what an economy in recession would mean for corporate profitability. The Lehman Brothers Credit Index leaked another basis point. The Merrill Lynch 1 to 3 Year Corporate (A-rated and Higher) Index spread widened two basis points, both at the widest point of the current credit cycle.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 1.14
    Treasury   1.12
    US Agencies (AAA-rated)   1.15
    Corporate (A-Rated & Higher)    1.14
        Financial (may include BBBs)     1.10
        Industrial (may include BBBs)     1.27
    Asset-Backed Securities (AAA-rated)   0.87
1-Year Treasury Note Index 0.55
6-Month Treasury Bill Index 0.22
3-Month Treasury bill Index 0.15

December 10 to December 14
Economic and Macro Trend: The Fed lowered the benchmark rate by 25 basis points on Tuesday to 4.25%. While the cut was expected, investors were expecting a bigger cut in the discount rate, which they did not get. Fed officials removed the growth vs. inflation risk language, but mentioned “strains in financial markets,” hinting more cuts on the way. Then on Wednesday, the Fed announced a “temporary auction facility” program that would initially add $40 billion of term liquidity to the financial system this month and then in January 2008. The Fed also will provide $24 billion in currency swap lines to European and Swiss Central Banks. The market reacted to the Fed’s action positively initially, with the Dow and Treasury yields both up, but the day closed relatively unchanged to where it opened. The Fed Funds futures market ended the week pricing in an 80% chance of a 25bps ease for the January 30th meeting. 

Inflation was another headline grabber for the week. Both core CPI and PPI exceeded expectations with PPI increasing 3.2%, double economist forecast of 1.5%, and CPI increasing 4.3%. On the positive side, U.S. retail sales surprised on the upside, rising twice as fast as forecast and easing some recession concern among investors. 

Treasury & Yield Curve: Despite a rate rally on Tuesday after the Fed cut rates by 25 bps, Treasury markets sold off nine to 31 bps across the yield curve for the week. What carried the Treasury market to higher rates were the surprisingly strong economic releases in CPI and PPI. For the week, yields on the two, five and 10-year notes rose 21, 14 and 13 bps, respectively. The Three-month bill rate dropped 20 bps as the result of the rate cut, while the six-month bill rate was unchanged.

Credit Spreads: The good news from the Fed and the bad news on US inflation canceled out each other and left secondary spreads mostly unchanged on the week. The theme continued to be weak financial sector earnings.  MBIA received a $1 billion capital infusion from Warburg Pincus. Ambac reinsured $29 billion of its portfolio to maintain its AAA rating.  Countrywide’s foreclosures doubled as late and delinquent mortgage payments rose in November. These events, together with news from Citigroup, UBS and Washington Mutual caused more spread widening in financial names. Lehman Brothers earnings, while down 12% year-over-year as the result of its subprime exposure, did beat Street estimates. For the week, the Lehman Brothers Credit Index spread tightened three bps while the Merrill Lynch 1 to 3 Year Corporate (A-rated and Higher) Index spread widened one basis point.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.18
    Treasury   -0.21
    US Agencies (AAA-rated)   -0.08
    Corporate (A-Rated & Higher)    -0.22
        Financial (may include BBBs)     -0.25
        Industrial (may include BBBs)     -0.27
    Asset-Backed Securities (AAA-rated)   -0.13
1-Year Treasury Note Index -0.04
6-Month Treasury Bill Index 0.10
3-Month Treasury bill Index 0.11

December 3 to December 7
Economic and Macro Trend: After weeks of behind-the-scene negotiations with major mortgage servicers and securitization investor groups, the Bush Administration unveiled its plan to help subprime homeowners facing foreclosures. Details of the self-billed “private sector solution” to the subprime crisis are limited at this time, but equity investors viewed the government-brokered plan favorably and sent shares of home builders, consumer products and financial firms higher. As hinted by Fed officials in the previous week, the market fully priced in another cut in the Fed funds rate at its December 11 FOMC meeting. The hope for a 50-bps cut diminished somewhat after Friday’s better-than-expected, but not stellar, non-farm payroll addition of 94,000 in November.

Treasury & Yield Curve: Investors were less concerned with the prospect of the economy slipping into recession after efforts from the Administration and with the expected Fed funds rate cut. As a result, Treasuries gave back some of its gains in posting the first weekly yield increase in the last six weeks. Yields on the two, five and 10-year note rose 11, 11 and 17 bps, respectively. The three and six-month T-bill yields were lower by eight and nine bps, respectively.

Credit Spreads: Despite a healthy rally in the equity market for financials, home builders and consumer products, bondholders remained less euphoric. The overhang of structured investment vehicles, the year-end liquidity issue, and news of subprime problems appearing in non-mortgage areas continued to widen credit spreads. The Lehman Brothers Credit Index spread widened 16 bps to 187 and the Merrill Lynch 1 to 3 Year Corporate (A-rated and Higher) Index spread widened six bps to 162. The AAA-rated ABS index spread is now 200 bps over Treasury yields.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.10
    Treasury   -0.08
    US Agencies (AAA-rated)   -0.09
    Corporate (A-Rated & Higher)    -0.17
        Financial (may include BBBs)     -0.18
        Industrial (may include BBBs)     -0.21
    Asset-Backed Securities (AAA-rated)   -0.43
1-Year Treasury Note Index -0.01
6-Month Treasury Bill Index 0.11
3-Month Treasury bill Index 0.08

November 19 to November 30
Economic and Macro Trend: A flurry of generally weak economic releases kept nervous investors on edge and Treasuries well-bid. While the FOMC minutes said the October 25-bps rate cut was a “close call”, its members did see “substantial downside risks to the economic outlook” and used the cut as an “insurance against an unexpectedly serve weakening in economic activity.” It appeared that credit market conditions deteriorated some more since then that investors demanded at least another 25-bps cut at the December 11 meeting. Fed officials including Chairman Ben Bernanke seemed to agree and left the door open for another cut. A plan championed by Treasury Secretary Henry Paulson and a number of mortgage servicing companies to freeze interest rates on some subprime adjustable-rate mortgage loans gave hopes to lower mortgage defaults and home foreclosures than previously feared.

In the two-week period that included the Thanksgiving Holiday, data from home sales and home constructions showed no signs of a housing recovery. Consumer confidence slipped to 87.3 in November from 91 in the previous month. Both personal income and personal spending fell as well, by 0.2% each in October. Retailers’ reports from Black Friday showed decent sales volume, albeit at deeply discounted prices.

Treasury & Yield Curve: The fear that the mortgage credit crisis may spill over to consumer spending and that the economy may slip into recession provided fuel for Treasury securities to have a strong rally. The 2-year note yield dipped below 3%, a level not seen since November 2004. The yield spread of the 2 and 10-year notes steepened to 94 bps, suggesting investors’ expectation of more interest rate cuts ahead. For the two-week period, yields on the 2, 5, and 10-year notes dropped 35, 23, and 16 bps, respectively. The 3 and 6-month Treasury bill yields also dropped by 27 and 21 bps, respectively. 

Credit Spreads: In a light trading week that included the Thanksgiving Holiday, there was plenty of bad news to impact credit spreads. HSBC’s decision to bring two of its structured investment vehicles back on its balance sheet and to book related mark-to-market losses raised speculation that other firms including Citigroup would follow, thus further pressuring bank capital. Freddie Mac’s $2.2 billion third-quarter loss and its need to raise capital caused financial spreads to widening further. Capital injection by Abu Dhabi in Citigroup, Paulson’s rate-freeze plan and Fed officials’ indications of an imminent rate cut brought back some market confidence. On balance, however, credit investors remained more cautious about the economic outlook than their equity counterparts. For the two-week period, the Lehman Brothers Credit Index widened 12 bps to 171. The Merrill Lynch 1-3 year Corporate (A-rated and Higher) Index spread widened 16 bps to 156. Much of the spread widening came from economically sensitive sectors including energy, consumer cyclical and non-cyclical, and capital goods.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.50
    Treasury   0.55
    US Agencies (AAA-rated)   0.47
    Corporate (A-Rated & Higher)    0.35
        Financial (may include BBBs)     0.27
        Industrial (may include BBBs)     0.21
    Asset-Backed Securities (AAA-rated)   0.42
1-Year Treasury Note Index 0.24
6-Month Treasury Bill Index 0.27
3-Month Treasury bill Index 0.16

November 12 to November 16
Economic and Macro Trend: Housing and credit concerns continued to be at the top of the list of downside risks to the economy.  Not much market-moving economic data, but additional subprime related write-downs, corporate earnings and retail sales drove the flight to quality rally in Treasuries. Federal Reserve Governor Randall Kroszner explicitly stated that the central bank is reluctant to lower interest rates any further.  CPI came in as expected, with a 0.3% increase in total and a 0.2% m/m rise in core for October.  Retail sales and ex-autos each advanced by 0.2% m/m in October.  Pending home sales came in fairly flat for September.

On Wednesday, Fed Chairman Bernanke said that the Fed plans to increase its transparency.  The Fed plans on releasing its economic projections four times a year, up from twice a year.  In addition, starting with the most recent FOMC minutes, the horizon will increase from two years to three years.  The Fed is no longer pushing for an explicit inflation target, but they will be placing increased emphasis on headline inflation, particularly energy and food prices, the Fed Chairman said.

Pending home sales were practically flat in September. Retail sales came in softer than expected after downward revisions to August and September are taken into account.  Both PPI and CPI inflation gauges came in within expectations.

Treasury & Yield Curve: Treasuries continued to rally in the 4-day week on credit and subprime worries. Yield on the 2, 5 and 10-year notes dropped 9, 6, and 5 bps, respectively. The Fed Funds futures market currently prices in a 100% chance of a 25bps ease for the December 11 meeting, and a 3% chance of a 50bps ease. 

Credit Spreads: The secondary credit market continued to be choppy this week. Major stock indices finished the week higher, but not without large down days on Wednesday and Thursday. Many retailers were downbeat on the holiday shopping season, notably Wal-Mart, J.C. Penney's, Williams-Sonoma, Macy's, Home Depot and Starbucks. FedEx cut their earnings outlook, and Wells Fargo said its home equity losses are to remain "elevated" through 2008. The Lehman Brothers Credit Index spread widened another 12 bps. The Merrill Lynch 1-3 year Corporate (A-rated and Higher) index spread sold off 6 bps. Unlike in previous weeks, industrial spreads widened more than financials, led by telecommunications, real estate and consumer non-cyclical names. Asset-backed commercial paper outstanding slipped just 0.1% for the week, after the previous week's outsized 3.3% drop. This dip was the smallest weekly decline since the credit crisis began last August.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.22
    Treasury   0.26
    US Agencies (AAA-rated)   0.14
    Corporate (A-Rated & Higher)    0.18
        Financial (may include BBBs)     0.13
        Industrial (may include BBBs)     0.09
    Asset-Backed Securities (AAA-rated)   -0.06
1-Year Treasury Note Index 0.19
6-Month Treasury Bill Index 0.11
3-Month Treasury bill Index 0.05

November 5 to November 9
Economic and Macro Trend: In the week the country’s largest financial institution lost its CEO due to credit problems, more banks and brokers updated their subprime CDO exposure, and charges to fourth-quarter earnings. As the crude oil futures price climbed steadfastly towards the psychologically important $100 a barrel, equity markets caved in, losing between 4% and 6% on the week, lead by financial and technology shares. Fed Chairman Bernanke said “indicators of overall consumer sentiment suggested that household spending would grow more slowly, a reading consistent with the expected effects of higher energy prices, tighter credit, and continuing weakness in housing.”

The week’s economic releases included some upbeat news for the economy, including the better-than-expected October ISM non-Manufacturing index of 55.8 and 3Q nonfarm productivity of 4.9%. The cheaper dollar helped narrow the trade gap to $56.5 billion in September. On the other hand, the impact of the credit and housing market corrections may partially explain the sharply lower consumer credit of $3.7 billion and the University of Michigan confidence index of 75.0 compared to an expectation of 80.0.

Treasury & Yield Curve: What’s pain for other markets is gain for the Treasury market. Treasuries rallied again on more credit concerns. The two-year note yield dropped 25 bps to 3.42%, the lowest level since February 2005. Yield on the five and 10 year notes also dropped by 20 and 10 bps, respectively. The continued bull-steepening move of the yield curve, or a more pronounced downward shift in the front maturities, indicated a strong likelihood of more Fed easing in the months ahead. This despite Fed officials’ inflationary concerns from higher commodities prices. The 3-month T-bill saw its yield plunge 35 bps. The futures market now prices in a 63% chance of at least a 25 bps ease at the December 11 FOMC meeting.

Credit Spreads: Both corporate and ABS credit spreads sold off, with their index spreads making new highs. The Lehman Brothers Credit Index spread widened 9 bps. The Merrill Lynch 1-3 year Corporate (A-rated and Higher) index widened 19 bps to 134, or more than three times the level it began the year at 43. Spreads of financial firms gapped out 23 bps as Citigroup, Merrill Lynch, Morgan Stanley, Ambac, AIG, Washington Mutual, Wachovia, JPMorgan Chase and Bank of America all made headline news in credit exposure related to subprime mortgage and leveraged loans.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.31
    Treasury   0.38
    US Agencies (AAA-rated)   0.21
    Corporate (A-Rated & Higher)    0.14
        Financial (may include BBBs)     0.07
        Industrial (may include BBBs)     0.31
    Asset-Backed Securities (AAA-rated)   0.12
1-Year Treasury Note Index 0.28
6-Month Treasury Bill Index 0.15
3-Month Treasury bill Index 0.16

October 29 to November 2
Economic and Macro Trend: The FOMC meeting, third-quarter GDP, nonfarm payrolls and busy earnings made last week one of the most watched and most active in recent times. The market expected the 25-bps rate cut the Fed delivered on Wednesday, but the “balance of risks” language somewhat surprised the markets as being too hawkish.  With renewed attention on inflation as the result of surging energy and commodity prices and a weak dollar, the Fed gave no assurance of future policy easing the market came to expect among credit jitters. Some of the week’s economic releases were surprisingly strong, with the third-quarter GDP at 3.9%, and nonfarm payrolls growing by 166,000 in October, the fastest pace in 5 months. Inflation appeared well contained with core PCE index came in at 0.2%.

On the other hand, there were plenty of releases that suggested the headwinds for the economy, including lower consumer confidence to 95.6 from 99.5 in September, lower Chicago Purchasing Manager to 49.7 from 53.0 and ISM manufacturing to 50.9 from 51.5. the widely-followed August Case-Shiller Home Price Index fell -0.7% to a weaker than expected -4.4% year-over-year rate in August. With crude oil futures rising 4% to a new record of $95.75, equity indices declined for the second week in a row.

Treasury & Yield Curve: Treasuries rallied on more credit concerns from the financial sector. The Treasury market was relatively stable going into the Fed meeting. The yield curve’s reaction to the Fed rate cut was initially negative as the language sounded more hawkish than some had expected. Quickly the concerns of more CDO related write-downs by financial firms caused equity markets to falter and bond investors to flock back to Treasury securities. Yield on the 2, 5, and 10-year notes rallied 10, 10 and 8 bps, respectively for the week. The 2-year note yield stood at 73 bps below the Fed funds rate, indicating the market’s expectation that the Fed easing was not done. The futures market now prices in a 71% chance of a 25bps ease for the December 11 meeting.

Credit Spreads: Despite the Fed action and a strong employment report, credit spreads failed to gain any momentum.  Banks and broker-dealers continued to be at the forefront of both equity and bond investors' worries.  Fueling the concern, equity analysts cut the ratings of a number of banks. The Lehman Brothers Credit Index spread widened 6 basis points to reach 138. The Lehman Brothers 1-3 year Corporate (A-rated and Higher) Index spread surge 8 bps to the highest level in the past year, as did the Merrill Lynch ABS Master, which rose 1 basis point to reach 143.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.30
    Treasury   0.32
    US Agencies (AAA-rated)   0.26
    Corporate (A-Rated & Higher)    0.29
        Financial (may include BBBs)     0.19
        Industrial (may include BBBs)     0.29
    Asset-Backed Securities (AAA-rated)   0.00
1-Year Treasury Note Index 0.22
6-Month Treasury Bill Index 0.21
3-Month Treasury bill Index 0.15

October 15 to October 26
Economic and Macro Trend: From Fed speeches to housing data to deteriorating credit market conditions, investors increased their bets for further Fed easing, fully pricing in at least one 25-bp rate cut at the October 31 FOMC meeting. In an October 15 speech, Chairman Bernanke emphasized the downside risks to growth from the expected next large leg down in the housing sector.  Both he and Treasury secretary Henry Paulson spoke of the many aspects of the credit and mortgage market not functioning properly, and the spillover effect on business investment decisions and consumer spending.  The Treasury’s involvement in setting up a $100 billion “super conduit” to purchase mortgage securities from structured investment vehicles (SIV) reminded the market of the viral effect should more of the SIVs go into forced liquidations. Geopolitical factors pushed crude-oil futures to surge 10% to a record close of $91.89. Despite a late Friday rally helped by Countrywide’s earnings outlook, equity market indices were flat to slightly down during the two-week period.

The Fed beige book noted that credit conditions continue to tighten. Existing home sales and home prices are falling, while inventories of unsold homes are rising. Although new home sales rose 4.8% in September, data was soft based on revisions to previous month’s data.  New orders of durable goods fell 1.7% in September, below expectations of a 1.5% rise. Following the benign CPI and PPI reports, inflation became less of a concern. Jobless claims ticked up two weeks in a roll, with prior-week revisions also on the rise. The October University of Michigan confidence reading dropped to 80.9 from the preliminary 82.0 mid-month read.

Treasury & Yield Curve: Worsening credit conditions and gyrating equity markets caused a massive rally in Treasuries. The front end of the yield curve benefited the most, with the 2-year note rallying 45 bps to 3.77%, or 98 bps below the Fed funds rate. Yield on the 3, 5, and 10-year notes dropped 46, 28 and 20 bps, respectively. The typical bull-steepening move of the yield curve signaled the market’s clear expectation of more interest rate cuts in the future. Yield on the 3 and 6-month T-bills also dropped 25 and 24 bps, respectively.

Credit Spreads: Corporate secondary spreads widened as the result of larger-than-expected investment banking results, the fall of equity market indices, high oil prices and continued weakness in the dollar. Also contributing to a weak backdrop was a slew of weak earning announcements. The Lehman Brothers Credit Index spread widened 9 bps, and the Merrill Lynch 1-3 year Corporate (A-rated and Higher) Index spread widened 6 bps. Financial spreads, especially those of bond guarantors and broker-dealers came under attack as more write-downs of mortgage related securities were announced.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.85
    Treasury   0.89
    US Agencies (AAA-rated)   0.69
    Corporate (A-Rated & Higher)    0.89
        Financial (may include BBBs)     0.77
        Industrial (may include BBBs)     0.97
    Asset-Backed Securities (AAA-rated)   0.85
1-Year Treasury Note Index 0.60
6-Month Treasury Bill Index 0.28
3-Month Treasury bill Index 0.20

October 9 to October 12
Economic and Macro Trend: Last Tuesday's FOMC minutes proved to be the economic highlight of the week.  The minutes suggested the Fed saw greater weakness in the housing market than previously anticipated.  The Fed noted "the impaired functioning of financial markets might persist for some time or possibly worsen, with negative implications for economic activity."  It also cut its GDP and PCE inflation forecasts for the fourth quarter and 2008.

Among releases friendly to the economy, retail sales came in better than expectations, at 0.6% and 0.4% ex-auto. After two weeks of decline, mortgage applications rose 2.4%.  Wholesale inventories fell less than expectations at 0.1% from 0.2%. The August trade balance was -$57.6 billion, better than expectations of -$59.0 billion.  On the other hand, the Producer Price Index rose from -1.4% last month to +1.1% this month. Business inventories fell to 0.1%, weaker than the expected 0.2% and a decline from last month's 0.5%.

Treasury & Yield Curve: The Columbus Day-shortened trading week saw the Treasury markets selling off 3 to 15 bps, led by the front end of the curve. Strong retail sales and upward revision to Wal-Mart earnings led to the Fed futures market pricing in less probability (now at 32%) of a 25 bps ease at the October 31 meeting, down from 48% in the prior week. The 2-year, 5-year and 10-year notes ended the week with yields up 15, 12 and 8 bps, respectively.

Credit Spreads: The winning bid by the Royal Bank of Scotland-led consortium for ABN Amro and the midweek UAW/Chrysler agreement were the credit highlights of the week. Although long-term directions of the market remained unclear, both long-term and short-term credit spreads tightened. The Lehman Bothers Credit index spread came in 6 bps, and the Merrill Lynch 1-3 year Corp (A-rated and Higher) Index gained 3 bps, respectively. Mortgage sector continues to impact performance of financial firms with Countrywide Financial announcing an increase in overdue loans. 

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.11
    Treasury   -0.14
    US Agencies (AAA-rated)   -0.01
    Corporate (A-Rated & Higher)    -0.09
        Financial (may include BBBs)     -0.08
        Industrial (may include BBBs)     -0.06
    Asset-Backed Securities (AAA-rated)   -0.01
1-Year Treasury Note Index -0.05
6-Month Treasury Bill Index 0.06
3-Month Treasury bill Index 0.03

October 1 to October 5
Economic and Macro Trend: The September non-farm payroll report, the economic indicator that was the markets’ center of attention, came above expectations at 110,000. Even more significant was the upward revision to August payroll growth of 89K from a reduction of 4,000. After the strong release, the probability of a Fed ease at its October 31 meeting dropped to 48% from 72% on Thursday.  Some investors viewed the report as creating more long term uncertainty, as the Fed may continue to steer the economy through divergent economic data. The week’s economic releases, including the ISM surveys, housing and auto sales data, all came in softer than the previous month’s data, although auto sales surprised on the upside by 300,000.

Treasury & Yield Curve: Treasuries were relatively stable throughout the week until the Friday jobs numbers which caused the yield curve to sell off, led by the front end of the curve.  The bear-flattening move of the curve caused yields on the 2, 5 and 10-year Treasury notes to rise 9, 9 and 5 bps, respectively. The 3 and 6-month T-bills rates experienced even bigger sell-offs, by 18 and 12 bps, respectively, after the employment data.

Credit Spreads: Following two months of contraction, commercial paper debt outstanding rose $4.5bn last week, indicating that the turmoil in the overall CP market may be stabilizing. The amount of ABCP continued to decline, falling $6.1bn last week. Longer-term corporate secondary spreads tightened, with spreads on both the Lehman Brothers Credit and the Merrill Lynch 1-3 year Corporate (A-rated and Higher) indices tighter by 3 bps on the week.  Financials’ yield spreads continued to tighten despite preannouncements from Citigroup, UBS, Deutsche Bank and Merrill Lynch, indicating the market’s acceptance of the firms’ front-loading of doubtful credits.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.14
    Treasury   -0.16
    US Agencies (AAA-rated)   -0.11
    Corporate (A-Rated & Higher)    -0.08
        Financial (may include BBBs)     -0.09
        Industrial (may include BBBs)     -0.10
    Asset-Backed Securities (AAA-rated)   -0.09
1-Year Treasury Note Index -0.14
6-Month Treasury Bill Index 0.02
3-Month Treasury bill Index 0.04

September 24 to September 28
Economic and Macro Trend: A week after the surprise cut of 50 basis points in the Fed funds rate, commentaries from Fed officials, and a former Fed official, continued to dominate market trading. Former Chairman Greenspan said that "the danger of recession has obviously risen" and the chance of recessions is "less than 50-50", higher than the one-in-three odds he gave in March.  A number of Fed presidents defended the Fed move, leaving the door open for, but made no promise of, more cuts in the future.

Meanwhile, the Fed and the European Central Bank are again pumping large amounts of liquidity into the banking system to help short-term liquidity and to fund the rolling off of previous temporary Repo operations.  With the Fed funds rate above its target of 4.75%, and the 3-month LIBOR significantly higher at 5.23%, pressure in the inter-bank markets continued because banks remain hesitant to lend at quarter-end.

On the economic front, the final revision to the second quarter GDP was 3.8% due to an increase in exports. Weak residential construction, Case-Shiller home price, existing and new home sales data led some economists to believe that the quarter's growth rate will be the strongest of the year. Durable goods orders fell more than expected in August by 4.9%, the most in seven months.  Consumer confidence fell to 99.8, 4.5 lower than expected. Rounding out the week’s releases was the core PCE Price Index of 0.1% in August.

Treasury & Yield Curve: Treasuries staged a modest rally, gaining 3 to 8 basis points led by the short end of the curve.  Yields on the 2, 5, and 10-year notes gained 5, 5, and 3 bps, respectively, capping the biggest quarterly rally in the 2-, 3- and 5-year Treasuries since 2002.  The 3-month T-bill rate rose 4 bps, while the 6-month rate stayed at the same level.

Credit Spreads: Since the Fed rate cut, the credit market improved overall, but spreads in the secondary market were mixed this week compared to last.  The Lehman Brothers Credit Index spread was unchanged, while the Merrill Lynch 1-3 Year Corporate (A-rated and Higher) Index spread rallied two bps. The market opened on a positive tone ahead of the GM strike and homebuilder Lennar’s biggest quarterly loss in its history.  The positive momentum from the announcement of an accord between the UAW and GM was offset by heavy corporate issuance for the balance of the week.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.26
    Treasury   0.26
    US Agencies (AAA-rated)   0.21
    Corporate (A-Rated & Higher)    0.31
        Financial (may include BBBs)     0.29
        Industrial (may include BBBs)     0.28
    Asset-Backed Securities (AAA-rated)   0.13
1-Year Treasury Note Index 0.15
6-Month Treasury Bill Index 0.08
3-Month Treasury bill Index 0.05

September 17 to September 21
Economic and Macro Trend: The Federal Reserve’s surprise move to lower the Fed funds rate by 50 bps to 4.75% was the headline news of the week. The FOMC statement noted that there is still the risk of inflation in the economy but that risk has been overwhelmed by the tightening of credit conditions and the increased uncertainty surrounding the economic outlook. The cut gave the market much-needed liquidity that resulted in the 3-month LIBOR rate down more than 50 bps from its peak a few weeks ago. Additionally, the Fed statement noted "the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully." This left the market uncertain over the near-term Fed actions.

Both core PPI and core CPI inflation gauges remained at 0.2%, at the top range of the Fed’s comfort zone. Housing continued to be dismal as suggested by the NAHB housing market index and new housing starts and permits.  Leading indicators fell 0.6% in August. After the Fed action, the U.S. dollar fell to a record low against the euro ($1.41), and the Canadian dollar traded above $1 for the first time since 1976. 

Treasury & Yield Curve: The Treasury market’s reaction to the Fed funds rate cut was a steepening of the yield curve, with the 2-year Treasury rallying 8 bps on Tuesday and the 30-year bond yield selling off 5 bps. This move continued for the rest of the week that result in the 3-month bills rate down 23 bps, the 2-year yield unchanged, and the 5 and 10-year notes yield up 12 and 17 bps, respectively. The spread between the 2-year and the 10-year Treasuries ended the week at 58 bps, the largest spread since May 2005. The long end of the market has been selling off because of fears that the cuts may reflate the economy and reignite inflation pressures.

Credit Spreads: Secondary spreads in the corporate market tightened significantly following the Fed rate cut and the nearly 3% rally in the equity indices on the week. The Lehman Brothers Credit Index spread rallied 9 bps to 132, and the Merrill Lynch 1-3 Year (A-rated and Higher) Index spread compressed 3 bps to 109.

Following the term credit market, the commercial paper market also exhibited much less volatility. The yield on the 30-day asset-backed CP index was down almost 100 bps to the pre-crisis level of 5.27%. The 30-day dealer-placed corporate CP yield moved down to 4.90%, or about 40 bps lower than its July 31 level. However, the contraction in outstanding paper continued with the total amount of CP outstanding falling $48bn after just an $8.2bn decline last week.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) 0.13
    Treasury   0.09
    US Agencies (AAA-rated)   0.22
    Corporate (A-Rated & Higher)    0.14
        Financial (may include BBBs)     0.22
        Industrial (may include BBBs)     0.13
    Asset-Backed Securities (AAA-rated)   0.18
1-Year Treasury Note Index 0.17
6-Month Treasury Bill Index 0.13
3-Month Treasury bill Index 0.14

September 10 to September 14
Economic and Macro Trend: Other than a few minor economic releases, the week felt like the calm before the storm. Many traders stayed put ahead of the FOMC interest rate decision and earnings results from four major brokerage firms. A flurry of speeches by Fed officials provided little clue on the certainty of a rate cut, but the sharply lower July consumer spending and August retail sales figures seemed to provide the key ingredients for a 25 bps ease. On the other hand, better-than-expected jobless claims and high capacity italicization rate were clear reminders of the inflation pressure. Geopolitical and natural factors resulted in the crude oil prices to reach an intraday high of $80.18 before closing the week at $79.10. Equity markets were higher on an expected Fed rate cut, with the VIX volatility index down by 5% to 24.9.

Treasury & Yield Curve: Treasury rates backed up significantly as the “safe haven” trade became less intense and funds started to flow back into part of the distressed commercial paper market. For the week, yields on the 2, 5, and 10-year notes were up 13, 13, and 7 bps, respectively, in a bear-flattening move. This was a somewhat counter-intuitive movement ahead of an expected Fed ease in the upcoming FOMC meeting, perhaps an indication of the economy’s lower probability of slipping into a recession. The 3-month T-bill rate was down 7 bps, but the 6-month rate was up 2 bps.

Credit Spreads: After a momentary pause, credit spreads continued their skyward move, with the Lehman Brothers Credit Index spread widening 2 bps and the short-duration Merrill Lynch 1-3 year (A-rated and Higher) Index spread winding 4 bps. In addition to subprime worries, investors’ attention returned to the major banks and brokerages in their ability to renegotiate financing terms with private equity firms on recently announced leveraged deals.

Total Return (Merrill Lynch Short-Duration Indices):
1-3 Year Govt/Corp (A-Rated & Higher) -0.18
    Treasury   -0.18
    US Agencies (AAA-rated)   -0.11
    Corporate (A-Rated & Higher)    -0.27
        Financial (may include BBBs)     -0.27
        Industrial (may include BBBs)     -0.23
    Asset-Backed Securities (AAA-rated)   -0.16
1-Year Treasury Note Index -0.02
6-Month Treasury Bill Index 0.07
3-Month Treasury bill Index 0.08

September 4 to September 7
Economic and Macro Trend: After weeks of subprime credit anxiety, credit investors returned from the Labor Day holiday only to find the worsening housing market finally showed up in the employment numbers. In addition to 4,000 jobs lost in August, the first monthly loss since August 2003, numbers in the previous two months were revised down to average fewer than 50,000 jobs added in the last three months. ISM manufacturing data also confirmed less expansion in the economy, although the Fed Beige Book suggested limited spillover effect of the housing downturn to the broader economy. The payroll disappointment convinced many market participants that a rate cut at the upcoming FOMC is all but a certainty, but the rate relief may provide little comfort to stock and bond investors as the probability of the economy slipping into a recession has increased. As a result, all major stock and bond indices sold off, and the US dollar lost ground against the Euro and the Yen. 

Treasury & Yield Curve: Treasury securities had a strong rally during the week, with the 10-year yield reaching its lowest level since 2005. The biggest move of the week occurred on Friday after the payroll release. Credit worries and concerns with the economy were behind most of the yield curve rally. For the week, yields on the 2, 5, and 10-year notes were down 23, 20, and 15 bps, respectively. The front-end 3 and 6-month T-bills rates were down 5 and 2 bps, respectively.

Credit Spreads: Investors are still concerned about the credit crunch and expect the Fed to inject more liquidity into the market.  The spread between LIBOR and Fed Funds reached 45 bps, compared to the usually relationship of 10-15 bps.  Three-month LIBOR rose to 5.85%, up 50 bps from early August and the highest level since January 3, 2001, the last time the Fed began to ease rates. Pressures are building on Structured Investment Vehicles (SIVs) because of the shortage of