BONDS
Rates were mixed, jumping at mid-week but falling back after the weak June payroll number was released on Friday. Bond rates were little changed on Monday despite news of moderation in the ISM report. Tuesday markets were closed for Independence Day. Rates mirrored equity movement on Wednesday, jumping in response to the same events that pushed equities down. On Thursday, weakness in the ISM non-manufacturing index and in weekly retail sales helped interest rates partially ease off Wednesday's jump. Rates on Friday fell significantly after the jobs report with long rates falling more than short rates.

Net for the week there was little change despite large swings within the week. The yield curve moved 2 basis points or less on a net basis.

Markets at a Glance

The Economy
June payrolls soft but household data conflict
Non-farm payrolls rose a very moderate 121,000 in June, below revised expectations of a 185,000 gain. May's payroll gain was revised up 17,000 while April's payroll increase was revised down 14,000 for essentially no net change from revisions. Payroll gains have been sluggish all year - averaging increases of 165,000 per month. This pattern of weak jobs growth is what turned market sentiment negative based on a new belief that economic growth may be too slow. A sharp increase in wages raised fears that the Fed will raise rates even with the slower job growth.

Within the payroll survey, gains were led by government, professional & business services, manufacturing, and transportation. Manufacturing employment rebounded 15,000 from an 8,000 dip in May. Construction slipped 4,000 after consecutive gains in prior months. Aggregate hours in manufacturing rose 0.4 percent suggesting a gain in industrial production later this month.

According to the household survey, labor markets remain tight. The unemployment rate was unchanged at 4.6 percent in June. Household employment rose 387,000 while the labor force increased 330,000 and the number of unemployed fell 58,000. The employment-to-population ratio, which is a reading not clouded by uncertainties over labor force participation, edged up to 66.2 percent from 66.1 percent in May.

Both the low unemployment rate and the relatively high employment-to-population ratio indicate that labor markets are still somewhat tight - at least for key occupations and job positions.

But the household data wasn't given much attention by markets. For the first six months of 2006, household employment growth has averaged 264,000 while payroll growth has averaged only 142,000 per month. There are two key reasons why near-term household employment growth might be outstripping payroll growth. First, household employment includes the self-employed while payroll numbers do not. The current economy simply may be generating a greater proportion of self-employed jobs than in the past. Second, current year estimates for payroll job growth include a highly judgmental component estimated by the Bureau of Labor Statistics. This is the birth bias factor. It is related to estimating how many new businesses (net of closing) occur during the current year. Current year payroll numbers are based on a sample of businesses as known to exist when the sample was picked. Current year numbers cannot include new businesses since they were not known when the sample was picked. Hence, the BLS estimates growth in new business establishments for the current year. Later for annual revisions, more complete information is known for new businesses. If the BLS underestimates (or overestimates) the business birth/closing effects, then this can create divergence from household employment.

Evaluating the divergence between the weak payroll and strong household employment numbers is a quandary facing the Fed. If the household numbers are "true," then that is an argument that the economy is not yet in a stagflation mode - growth is stronger than indicated by payroll employment. If the payroll numbers hold true, then as indicated by CPI numbers - and lesser by wage data - then the economy may be headed toward at least a temporary period of stagflation. But this problem would be mild compared to the 1970s.

Wage pressures continue
From the payroll survey, average hourly earnings jumped 0.5 percent, following a 0.1 percent rise in May. Average hourly earnings are up 3.9 percent on a year-on-year basis, up from 3.7 percent in May. The low unemployment rate is keeping wage increases a little on the high side.

Over the long run, earnings and CPI inflation do tend to track each other - but the correlation is not 100 percent. Productivity gains can allow for wage increases without leading to CPI inflation pressure. Currently, productivity gains have kept unit labor cost inflation low, though energy costs have boosted overall inflation figures.

Recent wage numbers and continued strength in CPI numbers will place greater emphasis on productivity and unit labor costs to help determine if recent wage gains are inflationary or are being offset by productivity increases.

Manufacturing still positive but prices an issue
The ISM manufacturing index weakened in June to a reading of 53.8 from 54.4 in May. This suggests slower output growth during the month. A reading above the break-even point of 50 is positive. The new orders index was up, a positive sign that could mean stronger growth in coming months.

With all the focus on inflation, another very high reading for prices paid, at 76.5, is a matter of concern because it signals pervasive month-to-month cost increases for raw materials, largely but not exclusively based on energy. The ISM prices paid index reading was the first key inflation indicator of the week. Combined with Wednesday's boost in oil prices and Friday's jump in wages, the ISM prices paid index came to weigh on market players even more by the end of the week.

Separately, BLS's payroll survey showed an increase in manufacturing production hours in June of 0.4 percent, following no change in May. The June figure suggests moderate strength in manufacturing for June.

Construction slips but relative strengths and weaknesses remain
Construction spending fell 0.4 percent in May following a revised 0.2 percent decline in April. May's figure was the largest decline since September 2004. Residential construction fell 0.8 percent with single-family homes down 1.7 percent. In contrast to recent months, nonresidential construction spending slipped 0.3 percent in May but followed healthy gains of 1.6 percent and 2.4 percent for April and March, respectively. Nonresidential weakness for May was in commercial and manufacturing construction. Nonetheless, nonresidential outlays have been on a strong uptrend and are up 12.7 percent from a year ago. The latest construction outlays numbers still point to strong numbers for second quarter business investment in structures within real GDP. However, residential investment numbers will probably be nudged down after last Monday's figures.

The Bottom Line
On balance, last week's economic news portrayed an economy that is in the process of slowing. Consumer sector fundamentals were mixed as payroll jobs slowed but wages jumped. Manufacturing showed mixed signals with the ISM survey softer but with payroll manufacturing production hours up. Relative strengths and weaknesses are progressing much as expected in housing (edging down) and in nonresidential construction (gaining strength). June's strong wage numbers are certainly giving the Fed some material to mull over along with the strength in household employment. As a whole, incoming economic data certainly indicate that the Fed is near the end of the current tightening cycle. Fed officials have been very open about their belief that rates are close to where they should be - the question "simply" appears to be "are we there yet?"

Additionally, the jury is still out on whether the economy has slowed so much as to put the economy in a mild period of stagflation. But if the payroll numbers hold true and reflect sluggish economic growth, then as indicated by CPI numbers - and lesser by wage data - the economy may be headed toward at least a mild and temporary period of stagflation.

Nonetheless, there is still moderate momentum in the economy. By historical standards, the Fed has not tightened dramatically. At worst, interest rates are only slightly above a neutral policy stance - even with one more 25 basis point increase in fed funds in August. As of mid-Friday afternoon and according to fed funds futures prices, odds were well above 50 percent for an additional 25 basis point increase in fed funds.

Looking Ahead: Week of July 10 to July 14

Monday
Consumer credit jumped $10.6 billion in April reflecting a $7.6 billion spike in nonrevolving credit, a category dominated by auto loans. But revolving credit also rose, up $3.0 billion. Though only one month's data, the surge could reflect the negative savings rate and the slowdown in home refinancing. Consumers have fewer options and may be turning to traditional loans and their credit cards. Vehicle sales were soft in May and in June, which may limit the total in the next two reports.

Consumer credit Consensus Forecast for May 06: +$2.5 billion
Range: +$1.3 billion to +$5.0 billion

Wednesday
The international trade deficit on goods and services widened in April to $63.4 billion, compared to a $61.9 billion gap in March. Oil prices had softened in May and should lead to some nominal improvement in the trade gap - albeit temporary given recent oil price hikes. Will robust economic growth overseas continue to nudge U.S. exports higher and keep U.S. manufacturing from softening too much? Most believe that aircraft exports and weaker oil imports will reduce the deficit in May.

International trade balance Consensus Forecast for May 06: -$64.6 billion
Range: -$67.0 billion to -$62.0 billion

Thursday
New jobless claims edged down 2,000 in the week ended July 1 to 313,000, and the 4-week moving average nudged up to 308,500. Continuing claims remain near a multi-year low. Will claims begin a moderate rise in response to lagged effects of higher interest rates - or is the economy still on the strong side as suggested by household employment? With the continuing divergence between the payroll and household surveys, weekly jobless numbers may take on greater significance. The consensus, however, expects a modest weakening in the labor market based on an expected rise in initial claims.

Jobless Claims Consensus Forecast for 7/8/06: 320,000
Range: 308,000 to 330,000

The U.S. Treasury will release the monthly budget report for June, which typically shows a moderate surplus for the month. Over the past 10 years, the average surplus for the month of June has been $37 billion. Revenues for fiscal 2006 are running ahead of the Administration's earlier projections and if this trend continues may have an impact on making Bush's tax cuts permanent.

Treasury Statement Consensus Forecast for June 06: +$23.5 billion
Range: +$18.0 billion to +$30.0 billion

Friday
Retail sales rose 0.1 percent in May, following a 0.8 percent jump in April. Excluding gas station sales which have been boosted nominally by high gas prices, retail sales for May slipped 0.1 percent compared to a 0.3 percent rise in April. We will need to see some improvement in retail sales to keep the consumer sector healthy and to keep job growth from slipping further. Auto sales edged up in June and provide a little support for June retail sales.

Retail sales Consensus Forecast for June 06: +0.4 percent
Range: +0.2 to +0.6 percent

Retail sales excluding motor vehicles Consensus Forecast for June: +0.3 percent
Range: +0.2 to +0.6 percent

Import prices rose 1.6 percent in May, a jump that follows a 2.1 percent spike in April. A sudden jump in non-fuel import prices may even be a bigger concern, up 0.7 percent in the month and a shift that raises questions whether energy prices have finally begun to bleed through. Non-oil import price increases have kept up with core inflation - a sharp contrast to when non-oil import price inflation was below core CPI inflation in the late-1990s. Will non-oil import prices weaken and help the Fed achieve slower growth in core inflation? Without help from softening in import prices, lower core inflation is going to be hard to get. The consensus expects a modest increase in import prices.

Import prices Consensus Forecast for June 06: +0.3 percent
Range: -0.2 to +1.0 percent

The University of Michigan's consumer sentiment index edged up to 82.4 in the first two weeks of June from the very low 79.1 reading in May. How will consumer sentiment hold up with the more recent rebound in oil prices and with additional interest rate increases? The markets are betting that the recent, mild uptrend in consumer sentiment will continue.

Consumer sentiment Consensus Forecast for July 06: 86.0
Range: 84.0 to 86.0

Business inventories rose 0.4 percent in April, held down by a 0.2 percent decline in retailer inventories. Inventory change is the tail that wags the dog of production. Are manufacturers anticipating slower growth and keeping inventory growth in line with demand? Inventory growth might be a little too strong given current domestic demand if the consensus figure of 0.4 percent holds true.

Business inventories Consensus Forecast for May 06: +0.4 percent
Range: +0.2 to +0.6 percent