Benchmark Treasury yields ticked higher yesterday in a quiet trading environment as stocks rallied for the third straight session.  The 10-year note went out -15/32 at 98-11 yielding 2.312% (+5.1bps) while the Fannie Mae 4.0 MBS coupon ended the day -10/32 at 103-30.

Equity futures are however pointing lower as a new day begins. The S&P 500 is set to almost erase yesterday's 19.75 gain with a 17.25 loss this morning, leaving the September settle contract at 1181.50.  The Euro is 0.60% worse against the dollar at $1.4360 and Light Crude is -1.45% at $86.61/barrel.  Meanwhile Comex Gold is bid 1.20% higher at 1,776.50. Risk-off is indeed a theme and a flight to safety is rallying rates...

The 10-year note is +10/32 at 98-22 yielding 2.274% and the 2s/10s curve is 3bps flatter at 208bps wide. Based on our hedge ratios the Fannie Mae 4.0 coupon will open around +6/32 at 104-05. 

The day ahead holds housing data and a look at industrial production but the main event will likely be events in Europe....

High pressure on Sarkozy-Merkel talks (Reuters) - The leaders of France and Germany meet for high-pressure talks on Tuesday to discuss what further measures they can take to shore up investor confidence in the euro zone following a dramatic market sell-off last week. President Nicolas Sarkozy and German Chancellor Angela Merkel are under pressure to show financial markets they are in agreement on doing more to shore up the embattled currency union -- or risk watching the euro zone unravel. Many experts say the only way to ensure affordable financing for the bloc's most financially distressed countries would be for the euro area to issue joint euro bonds. But officials in Paris and Berlin have tried to play down expectations over the 10 a.m. EDT talks and 12 p.m. EDT news conference, saying euro bonds are not on the agenda, and many analysts cautioned their clients not to expect too much.

We see rally resistance in the 10-year note at 2.25% and 104-11 in Fannie 4.0s. Last night we pointed out a consolidation pattern in 10s and production MBS coupons. CHECK IT OUT

Key Events in the Day Ahead...

8:30 - It's tough to predict what will happen with July Housing Starts given that the June report was such a mystery. Housing starts somehow soared 14.6% June - beating forecasts by 12 percentage points - with single-family starts jumping 9.4% and multi-family starts rocketing 30.4%. The news was welcomed, yet the number of permits issued in the month, which tend to anticipate starts. rose only 0.2% and suggested the jump was only temporary.

Economists at Citigroup said this mismatch indicates a pullback in housing starts this month.

"The June figures for both single- and multi-family starts jumped surprisingly," they wrote. "However, fundamentals in housing have not improved materially and the recent weakness in the economy suggests that housing construction will remain soft."

Economists at IHS Global Insight added: "Our view is that the spike was probably a bad reading. For July, we are likely to see an offsetting drop."

The median forecast anticipates a drop in the annualized rate of starts to 600k, down from 629k a month before but still up from the 549k rate from two months previous.

9:15 - Warm weather, new manufacturing jobs, and auto assembly plants reopening should all help Industrial Production to climb 0.5% in July. The gain would follow a meagre 0.2% posting in June and a 0.1% cut in May. Second-quarter production had been disrupted by the earthquake-tsunami disaster in Japan, but motor vehicle output rebounded in July and suggests optimism for this index.

"We look for a huge rise in July industrial production, led by gains in motor vehicle assemblies," said economists at Citigroup, citing auto production and predicting a print of 0.8%. "Although plants were shut down for retooling for the new model year, production ramped up later in the month to a pace higher than before the Japan tragedy. The lift in auto sector output accounts for most of the expected gain in overall production."

Economists at Janney Capital Markets were a little more reserved, expressing much uncertainty about the report.

"The outlook for auto industry output, a major portion of the industrial production results, has gotten somewhat complicated by ongoing supply chain disruptions from the Japanese earthquake," they wrote. "Even U.S. auto manufacturers rely on parts produced in Japan, including many built in factories affected by the Sendai earthquake and aftermath. Adding to the complexity was an unusually hot July ... July was actually the fourth warmest month for the US ever recorded. We believe the auto and weather trends are mostly offsetting, however, and production will track relatively closely to its recent levels."

Treasury Auctions:

• 11:30 - 4-Week Bills