JP Conklin 704-887-9880 office jp.conklin@pensfordfinancial.com www.pensfordfinancial.

com Leveling the Playing Field October 31, 2011 _______________________________________________________________________ I hope LSU beats Alabama next weekend so Penn State doesnt have to play Bama again in the national championship game. I never thought Id be embarrassed by an 8-1 PSU team. Stocks ended the week up 3.8% following the European summit agreement on a $1.4T EFSF expansion and 50% haircut for Greek bondholders. Rates finished higher across the curve, with the 10yr Treasury up 10bps from last Friday (although down to 2.32% from Thursdays peak of 2.40%). The Feds commitment to low rates and the absence of a European meltdown created a risk-on mentality this week. It should be noted that the European situation doesnt feel at all resolved to us. Its great that a 50% writedown on Greek debt was agreed to, but very few details were announced. Italy is the fulcrum for a Eurozone meltdown. Italys bond market is the third largest in the world, behind only the US and Japan. Let that sink in for a moment. Italys bond market is the third largest in the world. Italy is the 8th largest economy in the world. Italys debt ratio is the second highest in the Eurozone, behind onlyyou guessed it, Greece. Heres the concern Greeces GDP only represents about 1.74% of the Eurozone GDP. Think about how jittery markets have been over this Greek default situation, and yet it represents only a tiny fraction of Europes economy. Italys GDP is 7.26x larger and represents 12.60% of Europes GDP. And with a huge debt market, it may not be an overstatement to say that the survival of the euro as we know it hinges on Italy. One good thing Italy has going for it is 7.9% unemployment. Spain, on the other hand, has 21.5% unemployment and represents 8.38% of Eurozone GDP. Spain is slightly smaller than Italy but the two countries appear to be on the same track toward possible default. CDS pricing for both countries benefitted from the EFSF agreement but remain at pretty elevated levels (405bps and 316bps, see graph below). Additionally, yields on Italys 10yr bond dropped to 5.78% on Thursday. But then on Friday, the Italian 10yr bond auction printed a coupon of 6.06%, a rate that may be unsustainable for a country with $2.69 trillion in debt and $283B due in 2012.

This feels eerily similar to 2008 events in the US. The government backstop helps prevent panic, but the real issues remain. CDS drops because markets believe in the bailout, but yields on debt climb because you want a higher return on a riskier investment. The meltdown scenario is avoided, but things remain ugly.

Compounding this problem was Fridays news that Eurozone economic activity shrank last month for the first time since 2009 and came in at a weak 0.2%. Many economists are now expecting outright contraction before year end. Consumer confidence fell to a two year low and savings rates are on the rise. Merkel said on Friday that the crisis wont be over in a year and the ECBs Stark said that a central bank cannot save any country. Perhaps the biggest concern of all is the moral hazard one now that we know Germany will bail out Greece, what is to stop Ireland, Portugal, Spain and Italy to step up to the plate? Domestically, US debt hit 99.99% of GDP on Wednesday and Treasury auctions were largely mixed. At what point will the Carolina Panthers get sick of moral victories?

LIBOR Outlook Continues to inch higher on year end funding concerns and Eurozone issues.

Fixed Rate Outlook Rates are substantially higher in a short period of time, so theres always a chance for some retracing. We asked our favorite trader what he expected 5 year swaps to do over the next 30 days, and he wrote: I would say risk/reward still favors locking rates in here.there's probably a 50% chance that rates are here or lower by then, but the upside is minimal. But if we continue the large risk rally into year-end, there's a chance that duration gets aggressively shed and rates move significantly higher. So I asked why? Anytime you have an asset that's trading at a negative real yield (yield minus inflation) and a lot of money is parked in it because it's perceived as a 'safe' asset, you're vulnerable to the point where the masses realize they're lighting their money on fire and head for the exits. In other words, investors in Treasurys are locking in a known loss right now because inflation eats away more than the interest earned. That is tolerable when investors are focused on the return of principle rather than the return on principle, but if risk appetite ticks up, everyone flees Treasurys and rates can jump quickly during a selloff. Also note that he puts odds of higher or lower rates in a month at approximately 50% 50%, but its the asymmetric risk aspect that led him to suggest locking in to our client.

This Week Globally, European news will continue to dominate headlines and rate swings. Domestically, the headline this week will be FOMC meeting. We expect the Fed to really enforce its position of easy money to encourage more risk taking. They may also set the table for QE3 to be rolled out in December or January. Biggest data this week comes on Friday as we get the next set of labor data. From BNP economist Julia Coronado, Adjusting for the impact of the Minnesota government shutdown and the Verizon strike, nonfarm payrolls would have been 147k in July, 82k in August and 58k in September, an unfavorable trend.

The Denver Tebows got crushed and it got me wondering whether Tims hometown of Jacksonville is a mecca for overrated men committed to a lifetime of abstinence? If so, how long before we experience a mass exodus from the Federal Reserve to northern Florida? I was going to make a joke about politicians instead but involuntary abstinence has never been an issue in DC.

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ECONOMIC CALENDAR
Economic Data Day Monday Time 9:45AM 10:30AM Tuesday 10:00AM 10:00AM 10:00AM 5:00PM 5:00PM Wednesday 7:00AM 8:15AM 12:30PM Thursday 8:30AM 8:30AM 8:30AM 8:30AM 10:00AM 10:00AM Report Chicago Purchasing Manager Dallas Fed Manufacturing Activity Construction Spending MoM ISM Manufacturing ISM Prices Paid Total Vehicle Sales Domestic Vehicle Sales MBA Mortgage Applications ADP Employment Change FOMC Rate Decision Nonfarm Productivity Unit Labor Costs Initial Jobless Claims Continuing Claims ISM Non-Manufacturing Composite Factory Orders 100k 0.25% 2.8% -0.5% 400k 3700k 53.6 -0.1% Forecast 59.0 -5.0 0.3% 52.0 55.0 13.15mm 10.30mm Previous 60.4 -14.4 1.4% 51.6 56.0 13.04mm 10.17mm 4.9% 91k 0.25% -0.7% 3.3% 402k 3645k 53.0 -0.2%

Friday

8:30AM 8:30AM 8:30AM 8:30AM 8:30AM

Change in Nonfarm Payrolls Change in Private Payrolls Change in Manufacturing Payrolls Unemployment Rate Underemployment Rate (U6)

95k 125k 4k 9.1%

103k 137k -13k 9.1%

Speeches and Events Day Wednesday Thursday Friday Time 12:30PM 8:30AM 1:00PM FOMC Rate Decision Fed's Lockhart opens Emory Economic Conference in Atlanta Fed's Tarullo speaks in Washington on Regulation Atlanta, GA Washington, DC Report Place

Treasury Issuance Day Closing Issues Size