BONDS
Interest rates fell significantly in the week except on the short end. Throughout the week, the bond market essentially operated on the belief that the Fed's tightening cycle is over. The markets were a little nervous about St. Louis Fed President Poole's comments on the odds of another tightening but chose to see San Francisco Fed President Yellen's comments as less hawkish. Bond markets for the week focused almost entirely on weak economic indicators and paid little attention to strong inflation indicators such as prices paid indexes in the ISM surveys and in the Chicago-NAPM survey along with the core PCE deflator and hourly earnings. The soft employment numbers pushed long and intermediate rates down sharply on Friday with all but the front end being under 5 percent. The 30-year bond had not closed under 5 percent since April 6 of this year.

Net for the week the yield curve was down significantly except on the short end. For the 2-year note through the 30-year bond, rates fell from 7 to 9 basis points. The 3-month bill edged up 2 basis points.

Markets at a Glance

The Economy
Employment growth softens but earnings remain strong
Friday's employment report came in on the soft side as many had wished so as to hopefully preclude another Fed interest rate hike. Non-farm payrolls posted a weak 113,000 gain in July, following modest revised gains of 124,000 in June and 100,000 in May. Most of the gains were in service-providing industries, up 115,000. Manufacturing jobs actually fell 15,000 but construction hiring was up, rising a modest 6,000. Importantly, payroll employment has clearly been on a moderate downtrend.

The three-month average for payroll gains is down to 112,000 from a recent high of 218,000 this past January. Also, payroll employment is up 1.3 percent on a year-on-year basis, down from 1.4 percent in June and from this cycle's high of 1.7 percent in February 2005.

What the markets seem to ignore is the continued strength in hourly earnings. Hourly earnings posted a robust 0.4 percent gain in July, following a 0.4 percent boost the prior month. Average hourly earnings are up 3.8 percent on a year-on-year basis, down marginally from 3.9 the month before. While inflation has not yet been wage driven due to the restraining factor of strong productivity, this may not continue. Slower real growth could result in weakening productivity and higher unit labor costs.

The markets also took solace in an uptick in the unemployment rate. The unemployment rate rose to 4.8 percent in July from 4.6 percent in June. However, labor markets remain tight - especially in selected occupations. The employment-to-population ratio and labor force participation rate remain high.

Personal income remains strong
With economic growth slowing, it is important that the consumer sector remain moderately healthy since it makes up about two-thirds of the U.S. economy. Fortunately, personal income rose notably June with a 0.6 percent jump. The wages and salaries component also rebounded 0.6 percent in June, following no change in May. Wages and salaries make up about 60 percent of overall personal income. Overall personal income was up 6.5 percent on a year-on-year basis in June, while the wages and salaries component was up 6.9 percent.

The consumer still continues to be willing to spend. Personal consumption continued strong with a 0.4 percent boost for June, following a 0.6 percent jump in May. However, some of the gains have been price related due to the effects of higher gasoline prices.

Overall personal income was up 6.5 percent on a year-on-year basis in June, while the wages and salaries component was up 6.9 percent.

The core PCE deflator raises inflation concerns
The first key indicators for inflation out last week were the PCE deflator and core PCE deflator. The core PCE deflator is the Fed's preferred inflation measure since it focuses on the consumer sector and has broader coverage than the core CPI. The overall PCE deflator rose a moderate 0.2 percent with the core PCE also up 0.2 percent. The recent numbers are a little tamer than earlier in the year. However, even a 0.2 percent monthly increase translates to a 2.7 percent annualized boost - above the Fed's target band. Year-on-year rates continued to rise - up one tenth to 3.5 percent for the overall PCE deflator, with the core rate up two tenths to 2.4 percent. The core's year-on-year rate is the highest since September 2002.

Manufacturing still healthy but costs rising
Manufacturing remained moderately positive this week with both the Chicago NAPM and the ISM manufacturing indexes edging up. The Chicago index rose to 58.2 in July from 57.2 in June while the ISM index rose to 54.7 from 53.8 in June. But there may be some signs of slowing as both surveys showed notable declines in backlogs.

But the key story is that both surveys showed continuing high prices paid indexes. The Chicago NAPM survey had prices paid at 86.8 in July while the ISM survey put prices paid at 78.5. Raw materials prices are creating some price pressure for manufacturers, but some believe that currently high profit margins will help reduce the need to pass price increases along. Nonetheless, the prices paid indexes will be part of the Fed's policy debate.

Residential spending slows, nonresidential strong
Construction outlays were up 0.3 percent in June, following no change in May. Continuing the recent pattern in housing starts, private residential construction fell 1.0 percent, led by single-family homes which declined 2.1 percent. Private residential outlays are down 0.1 percent year-on-year.

Economists are counting on business investment to keep economic growth healthy in coming quarters, and nonresidential structures continue to do their part. Nonresidential construction spending jumped 2.7 percent in June, following a 1.6 percent rise in May. Monthly nonresidential outlays for June were up in all major categories.

Overall construction outlays are up 6.8 percent on a year-on-year basis. Private residential outlays are down 0.1 percent year-on-year while nonresidential outlays are up a robust 21.6 percent. Public construction is up 9.7 percent year-on-year.

Fed funds futures imply low odds for any additional rate hikes in near term
Following the weak employment report, implied fed funds futures rates fell significantly. The market puts odds for a 25 basis point increase in Fed funds on Tuesday as a little under 20 percent and with odds lower for contracts further out. Implied rates have fallen but remain above 5-1/4 since the implied essentially is a weighted average of those expecting no change from 5-1/4 percent and those expecting an increase to 5-1/2 percent.

The Bottom Line
The real economy is showing clear signs of moderating - notably in employment and in residential construction. Manufacturing remains healthy as does consumer spending at this point. However, inflation indicators are notably higher than had been expected just a few weeks ago. Last week's data on the core PCE deflator, prices paid indexes, and hourly earnings clearly are a concern to the Fed.

The markets have moved from a first quarter psychology reflecting excessive economic growth with rising interest rates to a second quarter mentality of slowing economic growth with the Fed on standby. Earnings have been a little better on average than expected in the second quarter. But markets have not moved forward to incorporate a realistic view of coming quarters. The economy may be in a slower growth phase, but it is also in a higher inflation environment than believed a few weeks ago. The Fed will either have to raise rates further or maintain current levels longer or both to bring inflation to the Fed's preferred pace. A realistic forward looking view of the combination of modest real growth, continuing high interest rates, and only slowly declining inflation will likely result in a lowering of estimates for earnings in the near term.

Looking Ahead: Week of August 7 to August 11

Monday
Consumer credit rose $4.4 billion in May with revolving credit jumping $6.6 billion. Nonrevolving credit fell $2.2 billion, reflecting weak motor vehicle sales.

Consumer credit Consensus Forecast for June 06: +$4.0 billion
Range: +$3.0 billion to +$6.0 billion

Tuesday
Nonfarm productivity in the first quarter was revised up to a 3.7 percent annualized boost from the initial estimate of a 3.2 percent increase. With the economy slowing and with CPI and PCE inflation remaining high along with wage inflation, productivity and unit labor cost numbers will start getting more attention in the markets. As several Fed officials have noted, productivity gains have kept wage inflation from pushing up overall inflation. If that trend reverses, then there will be concern that recently strong wage numbers will lead to further Fed tightening. The first quarter's healthy productivity number was largely due to strong GDP growth. However, real GDP slowed from 5.6 percent annualized in the first quarter to 2.5 percent in the second quarter and should lead to weaker productivity in the second quarter. The key question is whether this will impact unit labor costs.

Nonfarm Productivity Consensus Forecast for Q2 06: 0.9 percent
Range: 0.3 to 1.9 percent

Unit Labor Costs Consensus Forecast for Q2 06: 3.8 percent rate
Range: 2.5 to 4.4 percent rate

FOMC Announcement
At the end of June, the Fed raised the fed funds rate with a 17th consecutive increase to 5-1/4 percent. After last week's employment report, the fed funds futures market indicated that the markets believed that there is less than a 20 percent chance of an increase in Fed funds to 5-1/2 percent at the August 8 FOMC meeting.

Thursday
Weekly jobless claims rose 14,000 in the July 29 week, following declines of 4,000 for the July 22 week and 29,000 for the July 15 week. With the softness in the July employment report, the markets will be watching to see if labor market conditions firm or continue to weaken.

Jobless Claims Consensus Forecast for 8/3/06: 315,000
Range: 310,000 to 318,000

The monthly international trade deficit widened slightly in May to $63.8 billion from a $63.3 billion gap in April. Imports were up 1.8 percent while exports jumped 2.4 percent in May. For real GDP to remain moderately healthy, some help will need to come from the trade sector. However, higher oil prices are keeping the nominal deficit high while creating pressure to narrow the real trade deficit. Higher oil prices increase the dollar value of oil imports while reducing demand for real oil imports. We will probably see a continuing high monthly nominal deficit with the continuation of high oil prices. But will exports continue their recently healthy gains?

International trade balance Consensus Forecast for June 06: -$64.5 billion
Range: -$65.9 billion to -$63.8 billion

The U.S. Treasury will release the monthly budget report for July, which typically shows a moderate deficit for the month. Over the past 10 years, the average surplus for the month of July has been $30 billion.

Treasury Statement Consensus Forecast for July 06: -$42.0 billion
Range: -$47.5 billion to -$38.0 billion

Friday
Retail sales have been soft over the last couple of months, edging down 0.1 percent in June following a 0.1 percent rise in May. As usual, we will have to sort out the impact of volatile changes in gasoline prices as well as volatility in motor vehicle sales. The consumer was almost flat in the second quarter as noted in both retail sales and personal consumption expenditures in GDP. In fact, the second quarter probably was a little too weak, and we need to see monthly retail sales gains at least between 0.2 and 0.3 percent. The July employment report was mixed on underlying fundamentals for the consumer - employment was soft but earnings were strong.

Retail sales Consensus Forecast for July 06: +0.8 percent
Range: -0.1 to +1.2 percent

Retail sales excluding motor vehicles Consensus Forecast for July: +0.5 percent
Range: 0.0 to +0.8 percent

Import prices overall slowed in June with a modest 0.1 percent rise. But lower oil prices were responsible, and non-oil import prices showed higher inflation pressure in June. Non-oil import prices were boosted by metals and other input prices. The Fed certainly is watching the impact of non-oil import prices on the economy - given that CPI, PCE, and wage inflation have been strong in recent months.

Import prices Consensus Forecast for July 06: +0.8 percent
Range: +0.4 to +1.0 percent

Business inventories rose 0.8 percent in May but business sales rose an even more rapid 1.4 percent. Both will likely decelerate with the softening in consumer spending. Inventories are a key equilibrating mechanism in the economy. If inventories are overbuilt we could see a sharp deceleration in manufacturing. At this point, inventory overhang is not an issue but it always bears watching.

Business inventories Consensus Forecast for June 06: +0.6 percent
Range: +0.4 to +0.8 percent