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Market Update -- In the Markets

Written by Derrick Wulf, CFA, Portfolio Manager

July 6, 2007

Here’s a brief summary of what transpired in the economy and the financial markets during the past three months. We hope you’ll find it a handy reference.

Growth
The domestic economy rebounded during the second quarter after a very slow start to 2007, as manufacturers replenished depleted inventories and a weaker dollar led to increases in overseas demand for U.S. exports. Most preliminary estimates of second quarter GDP growth are currently in the range of 3%, following growth of just 0.7% in the first quarter.

Inflation
Core inflation continued to moderate during the second quarter, with the core PCE deflator falling into the Fed’s reported “comfort zone” of 1-2% on a year-over-year basis in May. At 1.9%, the core PCE deflator was at its lowest level in three years. Core CPI, which had reached a ten-year high of 2.9% in September 2006, also fell in the second quarter, slipping to 2.2% on a year-over-year basis in May.

Jobs
The job market remained strong throughout the second quarter, with non-farm payrolls growing by an average of almost 150,000 per month during the period. This pace of job growth was roughly in line with the first quarter’s figures but still lower than the average monthly increase of almost 190,000 jobs in 2006. The unemployment rate, meanwhile, held steady at 4.5% after touching 4.4% in March.

Income
Growth in wage and salary income remained firm in the second quarter amid continued strong demand for skilled workers. According to data compiled by the Bureau of Labor Statistics, growth in average hourly earnings held near 4% on a year-over-year basis. Meanwhile, personal income growth, as reported by the Department of Commerce, stood at a healthy 6.1% on a year-over-year basis through May.

Housing
New and existing home sales continued to decline during the second quarter while inventories of unsold homes swelled to multi-year highs. The National Association of Homebuilders Market Index hit a 16-year low in June and the S&P/Case-Shiller composite home price index registered a 2.13% decline on a year-over-year basis in April.

Confidence
Consumer confidence declined during the second quarter. High gas prices and weak housing markets remained a source of concern for consumers, but strong job markets and rising wages provided comfort.

The Fed
The FOMC met twice during the first quarter, voting both times to maintain the benchmark overnight lending rate at 5.25%. In the statement released after the Committee’s June 28 meeting, the Fed reiterated that inflation risk remained the Committee’s “predominant policy concern.” Despite recent declines in core inflation readings, the FOMC cautioned that “a sustained moderation in inflation pressures has yet to be convincingly demonstrated.”

Fed funds futures closing prices at the end of the second quarter suggested that most investors expect the Fed to remain on hold almost indefinitely, with only a small chance of a rate cut implied by prices on contracts expiring in the second quarter of 2008.

Treasuries
Treasury yields rose and the yield curve steepened during the second quarter. The yield on 2-year notes increased 28 basis points during the period to end the quarter at 4.87%. Five and 10-year notes rose by almost 40 basis points in yield, closing at 4.92% and 5.03%, respectively. The yield on 30-year bonds increased 28 basis points to end the quarter at 5.13%.

Bond Markets
Yields rose, credit spreads widened, and volatility increased during the second quarter, leading to negative returns on most sectors of the U.S. investment-grade bond markets. The Lehman Aggregate Index declined by 0.52% in the period as its yield rose from 5.28% at the end of the first quarter to 5.67% on June 29. Strong overseas growth and a rebound in U.S. manufacturing activity led to sharp increases in Treasury yields during the period, with 10-year notes hitting a five-year high of 5.30% before settling back in at 5.03% at the end of June.

For the second consecutive quarter all of the major sectors experienced a widening of spreads. The incremental yields earned in spread product were not enough to offset the effects of spread widening, and the index underperformed Treasuries by 25 basis points on a duration-adjusted basis for the period. Fears of contagion from the sharp losses in subprime mortgage sector once again set the tone in the structured products markets, while an increase in interest rate volatility led to underperformance among traditional agency-backed mortgages. In the corporate bond market, heavy new issue supply and heightened concerns over event risk, such as leveraged buyouts or debt-financed stock buybacks, contributed to the weakness, causing the average option adjusted spread (OAS) of the Corporate component of the Lehman Aggregate Index to widen by 5 basis points. Relative to Treasuries, mortgage-backed securities were the worst performing component of the index during the period.

The high-yield bond market also experienced spread widening during the second quarter, with the average OAS of the Lehman High Yield Index increasing by 17 basis points. However, due to the higher coupon returns, the high-yield market withstood the impact of rising yields and posted positive total returns for the period, once again outperforming the investment-grade market.

Some further data about the U.S. bond markets are shown in the charts below.

RATE MARKET OVERVIEW

Closes...
	6/29/07	3/30/07	12/29/06	9/29/06	6/30/06	12/30/05
Fed Funds Target	5.25%	5.25%	5.25%	5.25%	5.25%	4.25%
1 Month LIBOR	5.32%	5.32%	5.32%	5.32%	5.33%	4.39%

3 Month T-Bill	4.81%	5.03%	5.01%	4.87%	4.98%	4.08%
6 Month T-Bill	4.94%	5.07%	5.08%	5.00%	5.23%	4.38%
2 Year T-Note	4.86%	4.58%	4.81%	4.68%	5.15%	4.40%
3 Year T-Note	4.89%	4.53%	4.73%	4.61%	5.12%	4.36%
5 Year T-Note	4.92%	4.54%	4.69%	4.58%	5.09%	4.35%
10 Year T-Note	5.03%	4.65%	4.70%	4.63%	5.14%	4.39%
30 Year T-Bond	5.13%	4.84%	4.81%	4.76%	5.19%	4.54%

2s-5s Spread	0.06%	-0.04%	-0.12%	-0.11%	-0.06%	-0.05%
2s-10s Spread	0.16%	0.07%	-0.11%	-0.05%	-0.01%	-0.01%
2s-30s Spread	0.26%	0.27%	0.00%	0.08%	0.04%	0.13%

2 Year Swap Spread	49.0	42.1	35.8	42.6	47.3	45.3
5 Year Swap Spread	56.0	45.5	40.3	49.3	55.3	52.3
10 Year Swap Spread	63.8	52.8	47.8	53.8	59.0	55.0

Changes…
	3 Months	6 Months	9 Months	1 Year	From High	From Low
Fed Funds Target	0.00%	0.00%	0.00%	0.00%	0.00%	0.00%
1 Month LIBOR	0.00%	0.00%	0.00%	-0.01%	-0.10%	0.00%

3 Month T-Bill	-0.23%	-0.20%	-0.06%	-0.17%	-0.37%	0.28%
6 Month T-Bill	-0.13%	-0.14%	-0.06%	-0.29%	-0.38%	0.11%
2 Year T-Note	0.28%	0.05%	0.18%	-0.29%	-0.38%	0.35%
3 Year T-Note	0.35%	0.16%	0.27%	-0.24%	-0.32%	0.47%
5 Year T-Note	0.39%	0.23%	0.35%	-0.17%	-0.28%	0.55%
10 Year T-Note	0.38%	0.32%	0.40%	-0.11%	-0.27%	0.60%
30 Year T-Bond	0.28%	0.32%	0.36%	-0.06%	-0.28%	0.58%

2s-5s Spread	0.10%	0.18%	0.17%	0.12%	-0.05%	0.25%
2s-10s Spread	0.10%	0.27%	0.22%	0.18%	-0.06%	0.36%
2s-30s Spread	0.00%	0.26%	0.18%	0.23%	-0.07%	0.37%

2 Year Swap Spread	6.9	13.3	6.4	1.8	-0.5	16.9
5 Year Swap Spread	10.5	15.8	6.8	0.8	-0.5	18.0
10 Year Swap Spread	11.0	16.1	10.1	4.8	0.0	18.5

Highs and Lows…
	12-Mo High	Date	12-Mo Low	Date
Fed Funds Target	5.25%	7/1/06	5.25%	7/1/06
1 Month LIBOR	5.42%	8/4/06	5.32%	3/5/07

3 Month T-Bill	5.18%	2/22/07	4.53%	6/18/07
6 Month T-Bill	5.32%	7/18/06	4.83%	5/14/07
2 Year T-Note	5.24%	7/5/06	4.51%	3/13/07
3 Year T-Note	5.20%	7/5/06	4.42%	12/4/06
5 Year T-Note	5.21%	6/12/07	4.38%	12/4/06
10 Year T-Note	5.30%	6/12/07	4.43%	12/4/06
30 Year T-Bond	5.40%	6/12/07	4.54%	12/4/06

2s-5s Spread	0.11%	6/12/07	-0.19%	11/27/06
2s-10s Spread	0.22%	6/22/07	-0.19%	11/27/06
2s-30s Spread	0.34%	6/22/07	-0.11%	11/27/06

2 Year Swap Spread	49.5	6/25/07	32.1	11/27/06
5 Year Swap Spread	56.5	7/6/06	38.0	1/5/07
10 Year Swap Spread	63.8	6/29/07	45.3	12/5/06

Lehman Aggregate Index: Major Components - Second Quarter 2007
Sector	Credit Quality	Duration	Convexity	Avg OAS	Tot. Rtn	Exc. Rtn

Aggregate	AA1/AA2	4.7	-0.16	0.53	-0.52%	-0.25%

Treasury	AAA/AAA	4.9	0.48	NA	-0.43%	NA
Agency	AAA/AA1	3.67	-0.11	0.35	-0.13%	-0.20%
Corporate	A2/A3	6.13	0.72	0.97	-0.76%	0.04%
MBS Fixed Rate	AAA/AAA	4.13	-1.14	0.65	-0.50%	-0.56%
CMBS	AAA/AA1	4.98	0.35	0.82	-1.05%	-0.44%
ABS	AAA/AA1	2.85	0.14	0.74	0.14%	-0.17%

High Yield*	B1/B2	4.57	0.07	2.92	0.22%	0.50%
Source: Lehman Brothers Global Family of Indices. Excess returns represents returns over duration-matched Treasuries. *The Lehman Brothers U.S. High Yield Index is not a component of the investment grade U.S. Aggregate Index

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