After rallying earlier in the week on month end extensions and continued concern about the path of economic growth, yields reversed course later in the week on better-than-expected economic data. The yield curve steepened and inflation expectations rose on relief related to employment and manufacturing. August marked a meaningful move lower in interest rates and the market is now normalizing as investors ascertain the future direction of the economy and inflation.

The stock market registered its first weekly increase in four weeks as the employment report and retail same-store sales data highlighted a week of better-than-expected economic data. The S&P 500 index rallied approximately 3% for the week, while the Dow Jones Industrial Average index rallied 2.4%. Small-cap stocks modestly outperformed large-cap stocks. In terms of style, large-cap value stocks outperformed large-cap growth stocks. The best-performing sector was financials and the worst-performing sector was utilities. The mergers and acquisitions market remained active as Intel, 3M, Hewlett-Packard, and Burger King all announced deals. In August, M&A activity rose to 2-year highs after transactions worth approximately $230 billion were announced during the month.

Investment grade primary activity slowed to a crawl as most issuers played hooky prior to Labor Day. Next week, the market should see a profuse amount of issuance as summer unofficially ends. New issue concession should also return to the market as most recent deals have priced on top or even inside of existing paper. Notable deals this week included Korea Development Bank ($900 million) and Sara Lee Corp ($800 million).

Investment grade corporates widened slightly this week. Issuers are expected to heavily access the market in the coming month in advance of the 3rd quarter earnings blackout period. We anticipate demand for bonds to be very strong and for most new deals to be several times oversubscribed. The Barclays Credit Index Option-Adjusted Spread (OAS) finished the week at +169, four basis points wider on the week. Financials widened three basis points (banks +3, insurance +3); industrials widened by five, (basic materials +7, capital goods +7, telecom +3, consumer cyclical +5, consumer non-cyclical +7, energy +3); and utilities widened by four basis points.

Agency mortgages outperformed Treasuries as the bond market rally stalled and retraced on stronger-than-consensus economic reports. Mortgage spreads narrowed seven-to-ten basis points (bps) across the coupon stack with premiums besting their lower coupon cousins. Although the refinance application index rose again to a year-to-date high of 5,085, investors felt more comfortable owning higher coupons during the rate backup. The lower coupons were hit hard by origination pipeline clearing but still held in relative to Treasuries on a drop in volatility and money manager bottom fishing. Ginnie Mae mortgages posted strong results relative to Fannie Mae and Freddie Mac mortgages on steady buying from Asia and a more subdued prepayment outlook. According to Freddie Mac, the primary mortgage rate fell to another record low of 4.32%. As for the current coupon versus Treasury basis, the spread rested at 75 bps after reaching a six-month wide of 91 bps.

Despite a brief rally early in the week, treasuries continued to fall as housing and jobs data indicated a continuing – albeit moderate – recovery is taking place in the economy. The municipal market experienced one of the slowest weeks this year as a mid-week month-end and an upcoming 3-day weekend combined to prompt a light primary calendar (only $1.5 billion in negotiated deal volume) and an even lighter secondary market. Lack of activity resulted in thin markets and sparse information to justify shifts in the benchmark muni AAA General Obligation yield curve. The 10 and 30 year maturities on the benchmark curve are expected to end the week between 5 to 7 basis points higher in yield than last week.

The largest tax-exempt deal of the week was the AAA-rated Harris County Flood Control District, which sold $180 million in bonds maturing between 14 and 29 years. The longest dated bonds were priced to yield 3.94%, 0.25% above a benchmark AAA-rated G.O.

The high yield market continued its late summer slumber with subdued secondary trading volumes and no new issues being priced. High yield prices moved slightly higher with spreads tightening versus Treasuries. Generally positive economic data and the resultant rally in stocks led to greater buying of risk. Other investors were content to let their cash balances stay higher than normal in anticipation of a large new issue calendar when market participants return from the long Labor Day weekend. The prospect of this profusion of new issue has led investors to focus more on tidying up portfolios and less on bonds offered in the secondary markets. Accounts were seen to be trimming both low-beta bonds with little yield and high beta bonds with little prospects for improvement. As much as $10 billion in high yield new issue may be announced next week with up to $20 billion possible for the month of September as a whole.

The CECE index of equities traded in Central Europe (Czech Republic, Hungary and Poland) gained 3.5% over the past week, while the Russian stock index RTS rose by 3.2%.

Poland’s government plans to reduce the central budget deficit by 20% next year, helping to keep public debt below 55% of GDP and avoiding mandatory spending cuts. The draft budget seeks to squeeze more savings from cash management than previously forecast and anticipates record dividends from state companies as the government avoids spending cuts. It adopts the 4-year plan’s forecast for 3.5% economic growth this year and an inflation rate of 2.3%.

Hungary’s Economy Minister Gyorgy Matolcsy said that the country cannot use fiscal stimulus to boost growth after the worst recession in 18 years because it must control its budget deficit. Talks with the International Monetary Fund and the European Union failed in July after the Hungarian government refused to commit to the previous administration’s goal of reducing the shortfall to less than 3% of GDP in 2011. The Economy Minister assured that Hungary is committed to meeting this year’s 3.8% of GDP target without giving a budget-deficit goal for next year.

Yields in the world’s major non-US government bond markets fell early in the week, but subsequently rose to end the week higher. The trigger for this turnaround was the announcement of stronger-than-expected US manufacturing data, which prompted an increase in risk appetite and a sharp rally in stock markets. This, together with the previous week’s comments from Mr Bernanke that the Federal Reserve was prepared to take further steps as necessary to support growth, reduced the attractiveness of government bonds as a safe haven.

Friday’s stronger-than-expected US employment report put further upward pressure on bond yields. The German yield curve steepened, with 10-year yields rising by 17 basis points on the week while 30-year yields were 29 basis points higher. Short-term yields were up by less than 10 basis points as the European Central Bank (ECB) kept rates on hold at 1% and extended their emergency lending measures into 2011 from the previous mid-October expiration. The ECB raised its estimate for growth this year to 1.4-1.8% from 0.7-1.3%.

Strong second-quarter growth in Europe was supported by export growth of 4.4% and a 1.8% rise in corporate spending. Spanish government bonds received a boost from a successful five-year auction and signs of a narrowing of the budget deficit. Japanese 10-year and 30-year bond yields rose by 14 and 20 basis points respectively on fears that Ichiro Ozawa, a candidate for leadership of the ruling party, would encourage higher deficit-spending. UK Gilt yields were also between 10-15 basis points higher on the week, despite evidence of a weakening housing market and a slowdown in manufacturing growth. The Swedish central Bank raised its benchmark lending rate by a further 0.25% to 0.75% in response to the strength in the domestic economy and exports, and further rate hikes are likely.

In the currency markets, the growth differential between the Eurozone and the US continued to provide support to the euro, which ended the week approximately 0.5% higher versus the US dollar. The yen, however, having tested multi-year highs earlier in the week, ended little changed versus the US dollar as the currency lost some of its safe-haven appeal. There has been widespread scepticism as to the potential effectiveness of possible currency market intervention by the Japanese authorities should they attempt to limit their currency’s strength. The British pound fell by 0.7% versus the US dollar and by 1.2% against the euro on evidence of slower growth in manufacturing, construction, services and a weakening housing market.

Emerging market dollar-pay debt spreads tightened marginally this week as risk markets in general performed well on the back of some better-than-expected global data releases.

In Brazil, the central bank kept its benchmark interest rate (Selic) unchanged at 10.75% in a unanimous decision by policy committee members. In a statement following the announcement, they indicated that the current Selic rate is sufficient to keep inflation in line with the targeted trajectory. Local rates were higher and the currency was stronger following the announcement.

In China, the headline Purchasing Managers Index (PMI) rose by 0.5% to 51.7% for August, a larger-than-expected increase. New orders for metal products were one of the main contributors to the rise. Risk appetite increased following the announcement as investors saw this as a sign that the global economic recovery is still intact.