MBS MID-DAY: 10/3/2011

Economic activity in the manufacturing sector expanded in September for the 26th consecutive month, and the overall economy grew for the 28th consecutive month, say the nation's supply executives in the latest Manufacturing ISM Report On Business®.

"The PMI registered 51.6 percent, an increase of 1 percentage point from August, indicating expansion in the manufacturing sector for the 26th consecutive month, at a slightly higher rate. The Production Index registered 51.2 percent, indicating a return to growth after contracting in August for the first time since May of 2009. The New Orders Index remained unchanged from August at 49.6 percent, indicating contraction for the third consecutive month.

The Backlog of Orders Index decreased 4.5 percentage points to 41.5 percent, contracting for the fourth consecutive month and reaching its lowest level since April 2009, when it registered 40.5 percent. Comments from respondents generally reflect concern over the sluggish economy, political and policy uncertainty in Washington, and forecasts of ongoing high unemployment that will continue to put pressure on demand for manufactured products."

(Reuters) - U.S. construction spending unexpectedly rebounded in August from a drop in July as outlays on state and local government building projects rose sharply, a government report showed on Monday.

Construction spending rose 1.4 percent to an annual rate of $799.15 billion, the Commerce Department said. Economists polled by Reuters had forecast a 0.3 percent drop after July construction spending fell by a revised 1.4 percent.

Private construction spending in August rose 0.4 percent, with residential spending up 0.7 percent and nonresidential spending up 0.2 percent. Spending on public construction rose a strong 3.1 percent, registering its biggest monthly gain since February 2009. State and local spending rose 3.5 percent, while federal construction spending fell 0.5 percent. (Reporting by David Lawder; Editing by Neil Stempleman)

MBS began this morning's trading at higher levels than Friday's latest and have kept adding on the gains. Longer maturity Treasuries are also improving as Operation Twist is in effect and last week's quarter-end position-squaring constraints are behind as. Here are levels:

- Fannie 3.5's are up 9 ticks on the day at 103-02
- Fannie 4.0's are up 5 ticks to 105-01
- Ginnie 3.5's are up 9 ticks at 104-26
- 10yr yields are down 4 bps to 1.876

Elsewhere in the yield curve, 2's are unchanged while 30's are the most changed, down over 7 bps.

There's more of the same from the usual suspects overnight. Greece announced they wouldn't hit their deficit targets. Stocks in China fell to their lowest level since May 2009 as the US Senate is expected to pass legislation forcing them to allow their currency to appreciate.

Apart from NFP this Friday, this morning's ISM data at 10am is the other heavy-hitter of the week. With month/quarter-end constraints off the table and Operation Twist officially kicked off, it'll be a good opportunity to see how much impact domestic economic data might have (assuming it's not an equivocal result). It certainly appeared that the impact was limited last week.

Rate sheets stand a good chance to be improved over Friday's already aggressive offerings. This assumes that current levels in MBS hold relatively close to where they are now.