Equity prices continue to show healthy gains from year-end levels. The Dow is up 5.2 percent, surpassing increases in the S&P 500 (+4.4 percent) and the Nasdaq composite (+4.9 percent). It is matching the year-to-date gain in the Wilshire 5000. The small cap sector is outperforming the rest of the market by a wide margin with the Russell 2000 up 12 percent from year-end levels.

BONDS
Fed Chairman Ben Bernanke addressed the Economics Club of New York on Monday night giving his thoughts on the yield curve and monetary policy. In my view, the speech was covered in an academic fashion - giving several sides to the story. The bottom line was that Bernanke didn't believe that the flat or inverted yield curve that we are currently experiencing is signaling an upcoming recession. He also debunked, to some extent, the view that long-term U.S. security yields have been dampened by strong foreign demand for our securities since long term rates appear to be low globally. After all was said and done, he suggested that whether the yield curve is signaling recession - or is inverted because of special factors - will depend on what other economic indicators tell us.

Many market players were upset by Bernanke's comments because he did not signal that the Fed would soon stop raising rates. In fact, Wall Street economists have not really changed their views about Fed policy after hearing the new Fed chairman. Among the 22 U.S. primary dealers, everyone believes that the Fed will raise the fed funds rate target to 4.75 percent next week. The majority of primary dealers (with only a few dissenters) believe the FOMC will raise rates to 5 percent at the May 10 meeting. Only a couple of economists among this group believe the Fed will raise the target rate to 5.25 percent at the June 29 meeting. But among those economists who believe the Fed will pause in June, some still expect the target to rise further and peak at 5.5 percent this year.

Last week the yield curve was slightly normal in that long rates were higher than short rates (although the middle of the curve was lower than either long end or the short end). This week, the curve flattened again with the 2-year note yield higher than both the 10-year and 30-year yields. After Bernanke's speech on Monday, bond investors became more jittery in advance of the upcoming FOMC meeting.

Markets at a Glance

The Economy
PARTIAL RECOVERY IN DURABLE GOODS ORDERS
New orders for manufacturers' durable goods rose 2.6 percent in February - which sounds solid until one considers that new orders plunged 8.9 percent in January. However, even the revised January figure is less dire than the initial report which showed a 10.2 percent drop. Faithful readers of this column can surmise that aircraft orders are the culprit. These rose nearly 60 percent in February after plunging roughly 80 percent in January. But what about the rest of the durable goods sector?

Once again, the bulk of manufacturers' orders are concentrated in transportation and computers & electronics. Total transportation orders (which includes motor vehicles and ships in addition to aircraft) jumped 13.4 percent in February but averaged monthly gains of 1.5 percent over the past six months. Over the past three months, transportation orders averaged monthly declines of 4.1 percent. New orders for computers & electronics jumped 4.2 percent in February, although the six-month average for these orders was a negative 0.4 percent. Over the past three months, however, these orders have averaged monthly gains of 1.3 percent. All other durable goods sectors were down in February.

Primary metals fell 2.5 percent in February, are showing no growth over six months, and are averaging monthly declines of 1.8 percent over the past three months. Fabricated metals declined 1.9 percent in February but are posting average monthly gains of 0.3 percent over the past six months and average monthly gains of 1 percent over the past three months. Machinery orders dropped 6.3 percent in February. Over the past six months, machinery orders have averaged monthly gains of 0.2 percent but averaged monthly decreases of 0.2 percent over the past three months. Electrical equipment fell 3.2 percent in February, but averaged monthly gains of 0.6 percent over the past six months and 1.7 percent hikes over the past three months.

The sectors with average monthly increases over three months and six months show more promise (fabricated metals and electrical machinery). Otherwise, the bulk of the durable manufacturing sector is hardly growing.

HOME SALES RISE IN FEBRUARY
Sales of new single-family homes plunged 10.5 percent in February after posting a revised 5.3 percent drop in January. February new home sales fell in the South and West, although they rose in the Northeast and Midwest. In contrast, January sales fell in the Northeast, Midwest and South, but rose in the West. Sales of new homes were 13.4 percent lower than a year ago.

Sales of existing homes surprised market players with a 5.2 percent rise in February. Since sales are counted at closing, this means that most of these sales were generated in January when unseasonably warm weather had boosted housing starts as well. Since existing home sales are a much larger share of the housing market than new home sales, total single-family homes increased 2.7 percent in February. This brought sales almost, but not quite, back to December levels.

Rather than focus on February sales alone, it's best to look at the trend in the housing market. And the trend is decidedly down. Home sales peaked in June and have edged down slowly but surely ever since. A more dramatic decline is evident in the MBA purchase index, which also appears to have peaked during the summer. From time to time this index did post gains in the fall and winter, but generally, the trend was down.

Refinance activity is somewhat more stable than home purchases. But refinance activity is down from this summer as well. Given that mortgage rates are roughly 75 basis points higher than they were in June when home sales peaked, it makes sense that refinance activity has diminished. A slower pace of refinance activity means that consumers will have to satisfy themselves by spending within their income - and not use their homes to enhance their cash flow. Perhaps the saving rate will rise in this environment. Borrowing is less desirable, after all.

PPI SHOWS MIXED VIEW ON INFLATION
The PPI plunged 1.4 percent in February as energy and food prices both fell sharply during the month. Energy prices fell 4.7 percent while food prices dropped 2.7 percent; both had been steady in January. Excluding these two volatile components, the so-called core PPI increased 0.3 percent in February, just a bit less than last month's 0.4 percent hike. On a year-over-year basis, the PPI rose 3.7 percent in February, showing steady improvement from the peak inflation rate of 6.6 percent seen last September. The core PPI is up 1.7 percent from a year ago, a slight acceleration from the past month. It too is down from the peak core rate of 2.8 percent registered last July. Over the past 10 years, the core PPI approached 3 percent only once - in 2005.

The Fed monitors all inflation indicators. They surely have models how inflation rates in one index might affect inflation rates in other indexes. The chart below depicts the core PPI relative to the core CPI. Notice that consumer price inflation is generally, although not always, higher than producer price inflation. This occurs because the CPI is primarily made up of service prices, while the PPI is primarily goods prices. Prices for goods are more sensitive to the business cycle than prices for services. While it is likely that a downward trend in the core PPI will lead to a downward trend in the core CPI, there does not appear to be a rule of thumb relationship (one to one, two to one, etc.).

The Bottom Line
Market players focused on Ben Bernanke's speech this week and probably over interpreted his remarks. Most likely this occurred because: 1) Bernanke is new and market players need to learn to interpret his remarks, like they did for Greenspan. The general conclusion thus far is that he appears to speak clearly, but like an economist, he gives all sides of the issue. (Hey, what's wrong with that?) But market players are beginning to think that he may prove as difficult to decipher as Greenspan. Well, perhaps that will be true. But let's cut him some slack - he hasn't even presided over his first FOMC meeting yet. That comes next week. 2) Market players focused on Bernanke because economic news releases were slim and they had nothing else to talk about during most of the week.

Durable goods orders are weak - and these will have to improve if we expect better manufacturing activity in the next several months. As I've said before, aircraft alone can't keep this economy afloat. The housing figures are somewhat mixed in that home sales are generally showing much more moderation than housing starts (which were still rising on trend through February). This could set us up for a sharp reversal in the housing market if real estate developers are stuck with new houses - and fewer buyers. Yes, housing is very location specific, so not all regions of the country will face the same housing misallocations, but there will be some shakeout.

Economic indicators will be slight again next week, but everyone will of course focus on the Fed. Investors are all expecting a rate hike, but the post-meeting statement will get even more attention than usual. Will Bernanke use this occasion to change the tenor of the statement, or will the changes be more gradual?

Looking Ahead: Week of March 27 to March 31

Tuesday
The Conference Board's consumer confidence index declined 5 percentage points in February to 101.7. The University of Michigan's consumer sentiment index remained unchanged in early March and this suggests that The Conference Board's attitude survey might also stop falling. However, these two surveys can be at odds with one another.

Consumer confidence Consensus Forecast for Mar 06: 102
Range: 99.8 to 105.0

The Fed is not likely to surprise market players on Tuesday when they announce a rate hike of 25 basis points in the federal funds rate target at the end of their FOMC Meeting. While the rate hike will probably not surprise investors, Ben Bernanke could set some new communication trends and market players around the globe will anxiously await the post-meeting statement.

Fed funds rate target Consensus Forecast for Mar 28, 06: 4.75 percent (+0.25 pct)
Range: None

Thursday
New jobless claims fell 11,000 in the week ended March 18 to 302,000, bringing the 4-week moving average up to 303,500. This was the first drop in four weeks and the third straight week for a level over the 300,000 mark.

Jobless Claims Consensus Forecast for 3/25/06: 305,000
Range: 300,000 to 315,000

The Commerce Department's preliminary estimate revealed that real GDP expanded at a sluggish 1.6 percent rate in the fourth quarter of 2005 with weakness in consumption expenditures and investment spending. While a large revision between the advance and preliminary estimates is not unusual, a large revision between the preliminary and final estimates is not likely.

Real GDP Consensus Forecast for Q4 05: 1.7 percent annual rate
Range: 1.4 to 1.9 percent annual rate

GDP deflator Consensus Forecast for Q4 05: 3.3 percent annual rate
Range: 3.2 to 3.3 percent annual rate

Friday
Personal income increased 0.7 percent in January, faster than recent monthly gains. Look for a similar gain in February based on the employment situation. Personal consumption expenditures rose 0.9 percent in January boosted by durable and nondurable goods spending. The retail sales report showed that consumption expenditures plunged in February.

Personal income Consensus Forecast for Feb 06: 0.4 percent
Range: 0.3 to 0.6 percent

Personal consumption expenditures Consensus Forecast for Feb 06: 0.0 percent
Range: -0.3 to 0.4 percent

At the mid-March reading, the University of Michigan's consumer sentiment index remained unchanged at 86.7. While labor market conditions remain healthy, consumers may be feeling the pinch of higher energy costs for their cars and homes.

Consumer sentiment Consensus Forecast for Mar 06: 87.0
Range: 85.5 to 88

Factory orders decreased 4.5 percent in January, but look for a reversal in February. Durable goods orders rose 2.6 percent during the month, primarily due to increased aircraft orders. Manufacturers' durable goods outside the aircraft sector have not been very strong, but perhaps the nondurable goods sector will perform better.

Factory orders Consensus Forecast for Feb 06: 1.4 percent
Range: 0.2 to 2.2 percent

The NAPM-Chicago's business barometer fell 3.6 percentage points in February to 54.9. This index, which measures both manufacturing and non-manufacturing activity in the Chicago region, is often considered a leading indicator for the ISM manufacturing index. The New York Fed survey was higher in March than in February, although the Philadelphia Fed survey dipped slightly during the month.

NAPM-Chicago Consensus Forecast for Mar 06: 56.5
Range: 52.5 to 60