BONDS
For the week, interest rates were mostly flat through Thursday and then dipped Friday after the release of the moderate 2.5 percent rise in second quarter GDP. Traders almost seemed intent on sending a message to the Fed about where they believe rates should be. Except for the 30-year, all notes and bonds rates closed below 5.00 percent.

Net for the week the yield curve was down - and notably so except for the end points. For the 2-year note through the 10-year bond, rates fell from 5 to 10 basis points. The 3-month bill edged down 2 basis points while the 30-year bond declined 3 basis points.

Markets at a Glance

The Economy
GDP cools but inflation stays high
Markets were relieved at week's end to see a slowing in GDP growth. GDP posted a moderate 2.5 percent annualized rise, following a revised 5.6 percent increase in the first quarter. Component analysis points to some forward looking issues. Final sales decelerated to a 2.1 percent pace from 5.6 percent in the first quarter. In turn, inventory investment rose to $52.6 billion from $41.2 billion in the first quarter. While a large part of inventories is supported by imports, certainly a big chunk is based on domestic manufacturing. Hence, we may see a mild slowing in manufacturing in coming months despite the currently strong durables orders data. Either final sales need to pick back up or new factory orders and imports will slow.

The consumer sector has slowed. Overall strength for the quarter was led by services PCEs (up 3.5 percent) but durables PCEs fell an annualized 0.5 percent in the second quarter while nondurables PCEs rose only 1.7 percent. Business fixed investment was mixed with structures up 12.7 percent but with equipment & software down 1.0 percent. Quite a bit was made of the slowing in equipment investment in Friday's markets. However, there is every reason to believe that healthy underlying momentum remains. The second quarter dip followed a 15.6 percent spike in the first quarter and may merely have been a technical slowing. Businesses generally continue to have healthy profits and interest rates are not restrictive of further investment. There is the possibility that business inventories may be accumulating a little too fast - but not dramatically. This could help real growth remain at moderate growth rates as industrial production may have to slow somewhat.

Inflation figures in the GDP report are a concern, however. The core deflator for PCEs jumped to 2.9 percent annualized, following a 2.1 percent rise in the first quarter. The 2.9 percent figure is well above the Fed's perceived target of 1-1/2 to 2 percent core PCE inflation. Additionally, the overall GDP deflator stood at 3.3 percent - the same as in the first quarter. While there was no acceleration in the GDP deflator, the 3 percent plus figure is quite high. The GDP deflator has been in excess of 3 percent for the last four quarters and in eight of the last 10 quarters - and it is showing no signs of slowing.

The markets also took note that annual revisions to GDP resulted in slightly lower growth over the last three years. The average growth rate for 2003 through 2005 is now at 3.2 percent vs. the earlier 3.5 percent. GDP inflation, however, was revised up a little and is averaging 3.0 percent over the 2003 through 2005 period, compared to 2.8 previously.

Durables orders point to continued healthy industrial production
Many are counting on a strong manufacturing sector to keep the economy from becoming too soft. Evidence is mixed on this issue as new and unfilled durables orders continue to rise but so do inventories. Durable goods orders jumped a sharp 3.1 percent in June, after a revised 0.3 percent increase in May. We have seen a lot of volatility in the transportation component with ups and downs in new orders for civilian aircraft. Nonetheless, even excluding transportation, new orders were up 1.0 percent in June, following a 1.5 percent boost in May. Durables orders excluding transportation have risen in nine of the last 11 months.

But the question mark in the latest report is the uptrend in durables inventories. The June increase of 0.6 percent was the fifth gain in six months. Overall shipments edged up 0.1 percent in June while unfilled orders rose 1.7 percent. It is an important issue of whether inventories are up merely to meet expected future shipments or whether the gains are unplanned. At this point, there does not seem to be notable unplanned accumulation but this is an issue that bears watching.

The continued strong gains in unfilled orders for durable goods suggest that much of the moderate inventory build up is planned. Unfilled durables orders are up 19.4 percent on a year-on-year basis. But if the economy weakens too much, some businesses will have to cancel pending orders.

Housing eases back - no cliff for now
Both new and existing home sales slipped in June. Higher mortgage rates have been expected to slow the housing market and they are finally having some impact. Mortgage rates are up roughly 125 basis points since this time last year. In June new home sales edged down 3.0 percent to an annual rate of 1.131 million. New home sales are now down 11.1 percent on a year-on-year basis.

Supply is now starting to weigh on the housing market. In June, supply rose to 6.1 months from 5.9 months in May. The latest supply figure is a little below the recent high of 6.4 reached this February but significantly higher than the cycle low of 3.5 in August 2003. We are likely to see continued moderation in starts and in residential construction outlays as a result.

Existing home sales also have slowed with supplies also rising. Existing home sales edged down 1.3 percent in June. Existing home sales are down 8.9 percent on a year-on-year basis. Supply is even more of an issue for existing homes than new homes. Supply jumped in June to 6.8 months from 6.4 in May. June's supply figure set a 9-year high.

Employment costs add to inflation worries
In the euphoria over a moderate second-quarter GDP figure, the markets completely ignored the employment cost report on Friday. The overall employment cost index rose a quarterly 0.9 percent in the second quarter, following 0.6 percent in the first quarter. This rise in total compensation costs might be written off as merely a technical rebound from the first quarter's slowing from 0.8 percent in the fourth quarter. However, wage costs have been steadily rising since the third quarter of last year. Wage costs were up 0.9 percent in the second quarter, following a 0.7 percent rise in the first quarter. On a year-on-year basis, wage costs are up 2.9 percent, compared to 2.5 percent in the first quarter and the recent low of 2.3 percent in the third quarter of last year. Certainly productivity gains have kept wages from pushing hard on retail prices but with the economy slowing, productivity also is likely to slip.

The Bottom Line
The economy clearly slowed in the second quarter and that probably is good news to the Fed. Housing is on a slow glide path while manufacturing is healthy. However, inflation is unacceptably high at the consumer level and for overall GDP, and we are starting to see a rise in wage costs. This is the week's bad news which the markets seemed to choose to ignore. At week's end, equities jumped on the belief that there will be no additional interest rate increases to key into the profits equations for at least the near term. However, what we are seeing is a slowing in growth with upwardly sticky inflation. If the Fed does not raise rates further, then it certainly will take longer for current interest rates to bring core inflation down from an unexpectedly higher level. Markets clearly have not taken that scenario into account - a more protracted period of current interest rates - with still the possibility of the Fed tightening further. Friday's run-up in equities clearly was not consistent with those fundamentals.

This week, there is a slew of key indicators covering manufacturing and construction as well as personal income and the all important core PCE deflator tracked by the Fed. The week ends with the employment report - just before the August FOMC meeting next week.

Looking Ahead: Week of July 31 to August 4

Monday
The Chicago NAPM purchasing index dropped to 56.5 in June from to 61.5 in May but remained in positive territory. The softening was led by new orders. In contrast, the prices paid index soared to 89.0 from 76.9. This regional index continues to be softer on the output side than national industrial production and on the high side for prices paid.

NAPM-Chicago Consensus Forecast for July 06: 55.5
Range: 53.4 to 57.0

Tuesday
Personal income moderated somewhat in May with a 0.4 percent increase, following a 0.7 percent boost in April. The slowing was primarily due to flat wages and salaries. Personal consumption also decelerated with a 0.4 percent rise in May, following a 0.7 percent increase in April. On the inflation front, the overall PCE deflator rose a strong 0.4 percent with the core PCE up a more moderate 0.2 percent. After last week's moderate GDP report, markets will be watching to see if wages and salaries and consumer spending stay in a moderate but healthy range to help bring down the core PCE deflator. Markets expect a rebound in personal income but call for core PCE inflation to remain moderate.

Personal income Consensus Forecast for June 06: +0.6 percent
Range: +0.4 to +0.8 percent

Personal consumption expenditures Consensus Forecast for June 06: +0.4 percent
Range: +0.2 to +0.6 percent

Construction spending has been on a dual track as construction spending fell 0.4 percent in May following a revised 0.2 percent decline in April. Residential construction fell 0.8 percent in the latest month. Nonresidential construction spending also slipped 0.3 percent in May but followed healthy gains of 1.6 percent and 2.4 percent for April and March, respectively. The recent trend in housing starts suggests further moderate softening in the residential outlays component.

Construction spending Consensus Forecast for June 06: +0.2 percent
Range: -0.5 to +0.7 percent

The ISM manufacturing index continues to be a little softer than national industrial production data as have other manufacturing surveys. The Institute for Supply Management's manufacturing index edged down in June to 53.8 from 54.4 in May. However, the prices paid index stood at a very high 76.5 - nearly equal to the recent high of 77.0 in May. The moderation in output is welcome as long as the softening is not too great. However, we still need to see softening in the prices paid index to keep prices from feeding through to the consumer.

ISM manufacturing index Consensus Forecast for July 06: 53.8
Range: 51.0 to 55.0

Motor vehicle sales edged up to 12.5 million annual rate in June, compared to a 12.2 million unit pace in May. Sales have been on the soft side since January. With consumers having little room to tap home equity further, auto dealers are likely to face softer prices and more incentives to get sales up again.

Auto sales Consensus Forecast for July 06: 13.0 million-unit rate
Range: 12.5 to 13.6 million-unit rate

Thursday
New jobless claims fell 7,000 in the July 22 week to a total of 298,000. Continuing claims also fell during the week. The latest numbers suggest a stronger labor market than indicated by official payroll numbers. Markets will be watching this early indicator for employment to see whether the consumer sector is moderating sufficiently.

Jobless Claims Consensus Forecast for 7/29/06: 305,000
Range: 300,000 to 310,000

The business activity index from the ISM non-manufacturing survey edged down to 57.0 in June from 60.1 in May. New orders also slipped, indicated a moderation in future activity.

Business activity index Consensus Forecast for July 06: 56.5
Range: 54.5 to 59.0

Factory orders jumped 0.7 percent in May - primarily due to a large and temporary boost in non-durables orders related to May's high oil and coal prices. We already have a strong advance figure for the durables component for June which jumped 3.1 percent and any retreat in the non-durables components is not likely to offset the large boost in durables orders.

Factory orders Consensus Forecast for June 06: 1.8 percent
Range: +0.8 to +2.4 percent

Friday
Nonfarm payroll employment was mixed in June with payroll gains soft at a gain of only 121,000. However, hourly earnings jumped 0.5 percent and household employment rose by 387,000. Which employment figure is giving the true picture and will earnings moderate or remain high, reflecting some tightness in labor markets? The markets expect only a modest rise in payrolls but with earnings still only a little off June's figure.

Nonfarm payrolls Consensus Forecast for July 06: 150,000
Range: 100,000 to 225,000

Unemployment rate Consensus Forecast for July 06: 4.6 percent
Range: 4.5 to 4.6 percent

Average workweek Consensus Forecast for July 06: 33.9 hours
Range: 33.8 to 33.9 hours

Average hourly earnings Consensus Forecast for July 06: +0.3 percent
Range: +0.2 to +0.4 percent