The Day Ahead: Revised Q2 GDP, Fed Chairman Speaks, Consumer Sentiment

Recap of Yesterday

U.S. Treasuries got off to a strong start yesterday but gains were quick to reverse course after a better than expected report on Weekly Jobless Claims.  An improved read on the labor market helped cheapen benchmark debt just before the final Treasury auction of the week where $29 billion 7-year notes were scheduled to be sold. While direct bidder participation continued to fade,  7s turned out to be the best auction of the week...mostly thanks to a steller turnout from indirect bidders (again).   The long end of the yield curve never looked back after that....

Treasuries rallied into the close as stocks  sold into their session lows. The 2.625% coupon bearing 10-year TSY note went out +0-17 at 101-09 yielding 2.481% (-5.9bps). The long bond was the best performer on the curve, ending the day +1-04 at 106-22 yielding 3.512% (-6bps).  2s/10s were 6bps flatter at 196bps.  The 10 year interest rate swap was 0.50bps tighter to TSYs. Open interest rose in TSY and stock futures. A significant increase in Treasury options open interest and trading volume was noted.

Mortgages traded better vs. TSYs early in the session but began to lose ground against longer duration benchmarks following the strong 7-year note auction. Production MBS price levels managed to stay in the green all day before rallying from their session lows into the close...mostly thanks to the post auction TSY rally. New origination supply was meager, topping out under $2bn with the majority of offers being 4.0 coupons.  MBS are set up to perform well against TSYs heading into month end, which is normally a supportive time for MBS valuations (relative to TSYs). Reprices for the better were noted yesterday afternoon.

Overnight Events...

UK Q2 Growth Unexpectedly Revised Up to 9 Year High (Reuters) - Britain's economy grew faster than originally thought in the second quarter of the year, with growth hitting a nine-year high, official data showed on Friday, but analysts doubt the pace of recovery can be sustained. The Office for National Statistics said the economy grew by 1.2 percent in the three months to June, up from its preliminary estimate of 1.1 percent, after construction output proved stronger than first estimated. Analysts expected no revision. On the year, the economy grew 1.7 percent in the second quarter -- 0.1 percentage points higher than the ONS's first estimate and economists' forecasts.

Japan PM Kan Vows Firm Moves Against Strong Yen (Reuters) - Japan's prime minister said on Friday he will take firm measures on currencies when needed and will meet the Bank of Japan governor, increasing the possibility the central bank will ease policy soon as it confronts a surging yen. The yen edged lower after Kan's remarks as Japanese policymakers struggle over how to put a cap on the currency, which hit a 15-year high against the dollar this week and threatens to derail an export-led recovery.  BOJ Governor Masaaki Shirakawa is scheduled to attend the Federal Reserve's seminar in Jackson Hole, Wyoming, until Aug. 30, and Kan said he would meet Shirakawa after he returns to Japan.

Key Events in the Day Ahead...

US Growth Seen Revised Down on Imports, Inventories  (Reuters) - The Commerce Department is due to release its second estimate of GDP at 8:30 a.m.  The GDP data follows a series of disappointing reports on the housing sales this week and will add pressure on the Obama administration, which already is worried about a slowing economy ahead of November congressional elections.

GDP, which measures total goods and services output within U.S. borders, grew at a a much more robust 3.7 percent rate in the first quarter.  U.S. economic growth likely was much weaker than initially thought between April and June, hurt by surging imports and as rebuilding of business inventories softened, a government report is expected to show on Friday. Gross domestic product now is estimated to have grown at a 1.4 percent annual rate during the second quarter, rather than the 2.4 percent estimated in the government's first reading last month, according to a Reuters survey.

Imports of goods and services in June grew to their highest level since October 2008, leaving a much wider trade deficit than the government had assumed in its advance estimates last month for second-quarter growth . Economists are at a loss to explain the jump in imports, which occurred at a time when domestic demand is very anemic. Import growth is usually associated with strength in underlying domestic demand.

The government is expected to report the contribution to growth from inventories in the second quarter was much smaller than the 1.05 percentage points it estimated last month. Growth excluding inventories is expected to have increased at a 0.9 percent rate, instead of 1.3 percent. Business spending is expected to be revised up, although investment in structures could be pared back. While businesses have been reluctant to hire new workers, they have been using their cash piles to splurge on equipment and software. The GDP report is expected to show corporate profits rose 4.2 percent in the second quarter after increasing 5.8 percent in the first three months of the year. Consumer spending growth, which has been dampened by high unemployment, was likely to be left unchanged at the 1.6 percent rate reported last month, economists said.

Markets Await Directional Guidance from Fed Chairman (MND) - The market's attention turns to Jackson Hole, Wyoming where Ben Bernanke will deliver his economic outlook  at 10am.  Some market participants anticipate the Fed Chairman will hint at the potential for further Quantitative Easing to restore investor confidence, others feel a move like this would only "spook the market". While I do believe Ben will spend a paragraph or two explaining the Fed's recent decision to buy Treasuries,  I do not think he will explicitly mention any new QE programs (CMBS, Non-Agency MBS, Corporates). I do however feel the market needs a confidence boost though, economic data has not been investor friendly in anyway lately. Uncertainty is abundant and it's keeping capital in risk averse assets (principal protection). I'd expect Ben to gently repeat that we need to get comfortable with the notion of a long, slow economic recovery. He should also remind us to expect periods of volatility. In the end I can only hope he provokes some sort of positive feelings with rhetoric indicating the world is not coming to an end.

Pre-Data Market Levels...

S&P 500 Futures are +3.25 at 1048.00.

The 2.625% coupon bearing 10-year Treausry note is -0-06 at 101-02 yielding 2.500% (+1.9). The 2s/10s curve is 2bps steeper and the 10yr interest rate swap is 0.75bps wider at +1.25bps.

The October Delivery FNCL 4.0 is -0-02 at 102-27 and the FNCL 4.5 is -0-02 at 104-13. Production coupon MBS are tighter to the curve to start the session.