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Wednesday, January 02, 2008 12:31 PM

Manufacturing Contracts & Treasuries Rally

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Taking a sharp as well as unexpected" turn for the worse, factory production shrank in December for the first time in nearly a year as tighter lending conditions and a slowing economy took their toll, according to a national survey published on Wednesday.

The Institute for Supply Management's manufacturing index, which had already slipped considerably in the second half of 2007, plunged to 47.7 last month, its weakest since April 2003. A reading below 50 points to contraction.

A drop in new orders also hinted at softening demand, even as companies paid higher prices for their inputs. The report darkened the outlook for the overall economy.

"This will fan recession concerns," said Stephen Gallagher, U.S. chief economist at investment bank Societe Generale.

The surprisingly weak factory report sent stocks lower and bond prices sharply higher.
My Comment: Why should anyone be surprised by this?
The economic data further muddies an unclear interest rate outlook. On the one hand, Federal Reserve officials seem reluctant to continue cutting interest rates given persistent price pressures, including those reported by ISM survey participants.

At the same time, the retrenchment in factory activity seems to require further stimulus from the central bank, if only to prevent the entire economy for hitting a more prolonged slump.
My Comment: Anyone who think this muddies the interest rate outlook cannot be thinking clearly. Interest rates are headed lower. If Jobs are weak we may see a half point cut in January.
"Manufacturing leads the rest of the economy," said Norbert Ore, chair of the ISM manufacturing business survey committee.

Already, weekly reports from chain store sales pointed not only to a lackluster holiday shopping season but also to weak post-holiday bargain hunting. Chain store sales fell 0.2 percent in the latest week, according to the International Council of Shopping Centers, while data from Redbook Research pointed to a 0.7 percent decrease.
My Comment: Those who thinks retailers are going to expand into this environment better think again.

Curve Watchers Anonymous is watching the yield curve and mortgage rates.

Yield Curve As Of January 2, 2008

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The 10 year treasury is once again below 4.00, sitting at 3.90.

Mortgage & LIBOR Watch

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The credit crunch in LIBOR appears to be easing. A few weeks ago 1 month LIBOR was over 5. Now it is sitting at 4.57. Normal would be something like 8-10 basis points higher than the Fed Funds Rate. In this case normal would be something like 4.35. Nonetheless, this is a move in the right direction. Those in LIBOR based mortgages will benefit.

In spite of a substantial rally in treasuries (lower yields), 15 year mortgages are only 17 basis points lower than a year ago, while 30 year rates and 1 year arms are still higher. This is reflective of a disconnect between treasuries and mortgage rates. Risk premiums are being priced in.

Also remember that mortgage lending standards, fees, down payments, etc, are much different than a year ago. All things considered, mortgage rates are way higher for most than they were a year ago. Treasury yields will have to drop much further for those with rates tied to treasuries to benefit. More than likely it will be too little, too late for most struggling homeowners. Rising unemployment will exacerbate this problem.

Mike "Mish" Shedlock
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