Credit market concerns – especially about mortgage markets – took center stage, weighing on financials in particular. But record high oil prices also pushed down equities.

Recap of US Markets

STOCKS

The Dow in intraday trading fell below 11,000 this past week, hitting two-year lows before rallying back over the 11,000 mark but still falling further into bear territory. The S&P 500 also dropped into a bear market for the first time since 2002. Credit worries were the key culprits. The week started off with speculation that mortgage financiers Fannie Mae and Freddie Mac were going to be forced to raise capital. This continued throughout the week as their stocks fell sharply with stock holders not wanting to end up like those of Bear Stearns. Former St. Louis Fed President William Poole commented that the Fannie Mae and Freddie Mac were insolvent, adding to market concerns. Their stock value remained depressed despite supportive comments at a Congressional hearing on financial market regulation by Fed Chairman Bernanke and Treasury Secretary Paulson and a terse press release on Friday by Paulson that the administration is working to support the mortgage financiers. While credit market concerns especially weighed on financials, few sectors were spared being tugged down.  But on Friday, the Dow turned positive for all of about 30 seconds immediately after a report that the Fed would be letting Fannie Mae and Freddie Mac go to the discount window – a report that the Fed would not comment on.

Earnings did not inspire equities this past week.  Although Alcoa started the earnings season off with lower quarterly earnings, the numbers did top expectations. Meanwhile, GE also reported weaker earnings but met expectations. This coming week, however, could be quite touchy as key financial firms report quarterly earnings.

Oil prices hit record levels again last week, especially hurting transports and consumer sectors. Price swings for oil were extremely sharp and were partly responsible for some of the intraweek volatility in equities.

Fears of slowing economic growth were also a theme this past week. San Francisco Fed President Janet Yellen warned of softer economic growth and higher inflation for the second half of the year. Even signs of slowing economic growth in Europe are beginning to weigh on U.S. stocks.  Look for this Tuesday’s release of the newest Fed economic forecast to possibly move markets.

This past week, major indexes were mixed as follows: the Dow, down 1.7 percent; the S&P 500, down 1.9 percent; the Nasdaq, down 0.3 percent; and the Russell 2000, up 1.4 percent.

For the year-to-date, major indexes are down as follows: the Dow, down 16.3 percent; the S&P 500, down 15.6 percent; the Nasdaq, down 15.6 percent; and the Russell 2000, down 11.9 percent.

Markets at a Glance

Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.

BONDS

Except for a drop at the near end, Treasury yields ended this past week little changed despite a volatile week. Yields were under downward pressure the first three days of the week on flight to quality over concern about the solvency of Fannie Mae and Freddie Mac and also over what losses might still be lurking at other financial firms. Medium term notes came under moderately heavy buying particular on Wednesday after Merrill Lynch was downgraded by some analysts. Throughout the early part of the week, comments by Fed officials that the Fed is focusing on fighting inflation helped to ease rates somewhat. But rates completely reversed on Friday with double digit basis point gains (except for the 3-month T-bill) on speculation that the federal government will have to bail out Fannie Mae and Freddie Mac which would require massive amounts of government borrowing.

For this past week Treasury rates were mixed as follows: 3-month T-bill, down 24 basis points, the 2-year note, up 7 basis points; the 5-year note, unchanged; the 10-year bond, down 3 basis points; and the 30-year bond, down 2 basis points.

In recent weeks, the net trend for rates remains downward on flight to quality, a downgrading in forecasts for economic growth, and tougher anti-inflation talk by Fed officials.

OIL PRICES

Last week, oil prices were even more volatile than usual. Prices dropped more than $9 per barrel over the first two days of the week. A key factor was comments from an Iranian official indicating that his country is in talks with the West about its nuclear program. Comments that his country would not make an unprovoked attack on Israel also eased tensions and helped ease prices. Also, pulling down prices were reports from Germany and the U.K. that indicated a slowing of growth in Europe.  But in the latter part of the week, the Iranian government managed to undo all its favorable comments as this country test fired long-range missiles which many fear could be launched against Israel or against oil facilities in the Gulf. A $5 surge in crude oil prices during the last hour of trading on Thursday also triggered program trading which boosted prices further. On Friday a lower dollar and rumors that Israel is conducting practice raids planned for Iran boosted prices sharply. Throughout the week, oil also was seen as a safe haven for those wanting to get out of financial stocks. Oil prices rebounded just over $9 per barrel over Thursday and Friday.

Net for the week, spot prices for West Texas Intermediate edged down 21 cents per barrel to settle at $145.08.

The Economy

This past week was rather light on economic data with the highlights being international trade and import prices.  But the big stories were not about economic indicators but focused on issues addressed by Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson.

Bernanke and Paulson weigh in on credit markets and regulation

While Fannie Mae and Freddie Mac dominated the news in the financial markets this past week, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson made some very important comments that have both short-term and long-term importance.

Paulson’s comments at the end of the week on Fannie Mae and Freddie Mac got the most attention. As stock prices for the two mortgage agencies plummeted on speculation that they were insolvent, Treasury Secretary Paulson issued a brief press release supporting these two government-sponsored agencies (GSEs).

"Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission.

"We appreciate Congress' important efforts to complete legislation that will help promote confidence in these companies. We are maintaining a dialogue with regulators and with the companies. OFHEO will continue to work with the companies as they take the steps necessary to allow them to continue to perform their important public mission."

While the press release did help boost the agencies’ stock prices a little above rock bottom, Paulson’s statement actually appeared to hurt shares of other financial firms and also boosted Treasury interest rates.

Markets concluded that some kind of government intervention is likely and will require some type of capital infusion. Some fear that the long-term consequences of the problems with these agencies are a rise in mortgage rates and higher taxes from paying for bailing them out. The two companies either own or back more than half of the nation's $12 trillion in mortgages.

Earlier in the week both Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified before the House Financial Services Committee on reforming regulation of the financial system. Both echoed recent comments by Fed and Treasury officials that the financial system can be strengthened by rationalizing and expanding regulatory authority and called on Congress to consider such legislation. Bernanke called the current system a "patchwork" while Paulson sees it as "outdated." Bernanke pointed to other central banks with more explicit oversight authority and asked Congress to consider giving more oversight authority to the Federal Reserve.

But what is of long-term importance is that both explicitly endorsed a policy in which large financial institutions are allowed to fail when insolvent. While it is good that Paulson agreed, it is even more important that the Fed is backing such a policy. Many have been critical that Fed bailouts of investment firms create a moral hazard that encourages risk taking at taxpayer expense. Bernanke is now saying that investment firms should be cautious because the Fed believes a “too big to fail” policy is not in the public’s interest. But Bernanke and Paulson stated that procedures need to be put in place that would ensure, according to Bernanke, "an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy." Bernanke cited the current FDIC process for dealing with insolvent commercial banks as a model for managing the liquidation of insolvent securities firms, indicating that keeping the costs to taxpayers low would be a priority.

The bottom line is that the Fed and Treasury still see financial markets as somewhat fragile but are working on ways to preclude future "Bear Stearns" and to help ensure that investment firms do not engage in excessive risk taking.

International trade unexpectedly improves

Consumers are responding to the soft economy and high oil prices, reflected in at least a temporary dip in the trade gap. The U.S. trade deficit in May surprisingly narrowed despite a huge run up in oil prices as exports outpaced imports. The overall U.S. trade gap narrowed to $59.8 billion from a revised $60.5 billion deficit in April and came in smaller than the market forecast for a $62.1 billion deficit. In May, exports continued upward with a healthy 0.9 percent gain while imports rose a moderate 0.3 percent. The oil gap actually shrank to $33.2 billion in May from $34.8 billion in the prior month, while the nonoil deficit widened to $38.0 billion from $35.8 billion in April. Not surprisingly, the average price of imported oil set another record high, reaching $106.21 per barrel in May from $96.81 per barrel in April. Strength in exports was led by industrial supplies. Import growth was slowed by a decline in automotive and in industrial supplies (which includes oil). 

The May report on international trade report contained several themes. First, export growth remains healthy due to both a lower dollar and relatively strong economic growth abroad. On the import side, U.S. consumers have responded to higher oil prices by trying to cut back on gasoline purchases.  But given further spikes in oil prices, the dollar value of oil imports is likely to rise in June and July. As already noted, oil prices traded at record highs this past Friday. Also, on imports, U.S. consumers appear to be cutting back on motor vehicle purchases as they choose between buying more gasoline efficient vehicles and not buying at all for now. The non-oil gap may shrink in coming months if consumers cut back on spending after the income tax rebate checks run out.  But the oil gap will almost certainly widen despite cut backs in driving by consumers as price gains outpace any drop in volume.

Import price inflation touches record highs

The lower dollar and higher oil prices are boosting imported inflation pressures for consumers and businesses. Readings across the import price report are near or at record highs. Import prices spiked a monthly 2.6 percent in June – the same as in May. The year-on-year pace has soared to 20.5 percent. Most of June’s surge was oil-related as prices for petroleum spiked 7.4 percent, just on the low end of similar gains in prior months with the year-on-year rate up 78.6 percent.

But price pressures have not been limited to oil. Excluding petroleum, import prices spiked 0.9 percent in June, following a 0.7 percent boost the month before. Year-on-year, the ex-petroleum index has risen to 7.3 percent. What is especially important to remember is the contrast with the 2002 period when import prices were actually declining – overall by almost 10 percent and non-petroleum by over 5 percent. Import prices have a long way to soften before helping overall U.S. inflation to ease – and that will not happen until oil prices stabilize and the dollar strengthens.

The latest import price numbers also indicate that U.S. businesses are in a price squeeze with input prices rising and consumers resisting pass through. Here are some of the year-on-year numbers by import category: food, feeds & beverages up 20.5 percent, industrial supplies (which include oil) up 50.1 percent, consumer goods excluding autos up 3.7 percent; capital goods up 2.1 percent; and automotive vehicles, parts & engines up 3.1 percent.

Once again, the key point is that import prices are now adding to inflation pressures by all major components – instead of helping to restrain inflation as was the case earlier in this decade.

Consumer sentiment bumps along bottom

Consumers clearly do not feel good about the economy. Consumer spirits remain severely depressed while consumer expectations for inflation remain extremely elevated. Although the Reuters/University of Michigan's consumer sentiment index inched higher in July to 56.6 from 56.4 in June, it remains very low. The latest numbers are barely above the series low of 51.7 set for May 1980. Consumers are not expecting much out of the economy in coming months as June’s expectations component fell 7 tenths to 48.3 while the current conditions component rose 8 tenths to 69.5. The Fed must be concerned about consumers building in higher prices into their outlook as one-year inflation expectations jumped 2 tenths in the month to 5.3 percent with 5-year expectations unchanged at 3.4 percent.

The bottom line

The limited data out this past week showed a continuation of many recent trends, including a troubled consumer sector, healthy exports, and rising inflation pressures. The mix still points to moderate stagflation in the near term.

Looking Ahead: Week of July 14 through July 18

This coming week certainly makes up for last week’s sparse numbers. Market moving indicators this week include the producer price index, retail sales, the consumer price index, industrial production, and housing starts. Also, the Fed releases its semiannual Monetary Report to Congress on Tuesday with minutes of the June 24-25 FOMC meeting released on Wednesday.  Both reports will include the latest Fed forecast for the economic growth, inflation, and unemployment.

Tuesday

The Fed’s semiannual Monetary Report to Congress is released this morning as Fed Chairman Ben Bernanke testifies before Congress Tuesday and Wednesday. Given that Fed officials have been indicating that they have downgraded their growth forecasts and upgraded inflation forecasts, markets will be paying close attention to the Fed’s forecast tables in this report.  Markets could move well before Bernanke actually speaks based on the new numbers.

The producer price index in May surged at the headline level while the core rate remained moderate. The overall PPI jumped a red hot 1.4 percent, following a modest 0.2 percent rise in April. Meanwhile, the core PPI rate grew a more moderate 0.2 percent, following a 0.4 percent boost in April. The surge in headline inflation was largely due to higher energy costs as
gasoline spiked 9.3 percent for the month and home heating oil increased 8.0 percent. Markets will be watching to see if higher energy costs will spill into the core rate. Certainly some core components are feeling upward pressure from higher energy bills, but the soft economy is also keeping some components weak with car prices down 1.0 percent in the latest month and light truck prices down 0.9 percent.

PPI Consensus Forecast for June 08: +1.4 percent

Range: +0.8 to +2.4 percent

PPI ex food & energy Consensus Forecast for June 08: +0.3 percent

Range: +0.1 to +0.3 percent

Retail sales have been surprisingly strong – perhaps due to government rebate checks. The question is whether consumer spending will continue on this path or start to sag in line with the labor market. Overall retail sales surged 1.0 percent in May, following a 0.4 percent gain in April. Excluding motor vehicles, retail sales continued strong with a 1.2 percent surge in April, after gaining 1.0 percent the month before. When excluding both motor vehicles and gasoline, sales posted a 1.0 percent increase, after rising 1.1 percent in April. Clearly, gasoline sales were strong due to higher prices, but sizeable sales gains were also seen in building materials & garden equipment and in general merchandise. Other increases were widespread as the only major component to decline was miscellaneous store retailers. The second round of rebate checks went out in June and a spike in the May personal saving rate suggests that not all of the rebate checks were spent that month.  So, we may see another strong month of sales for June.

Retail sales Consensus Forecast for June 08: +0.5 percent

Range: 0.0 to +1.1 percent

Retail sales excluding motor vehicles Consensus Forecast for June 08: +1.0 percent

Range: +0.4 to +1.6 percent

The Empire State manufacturing index has shown slippage in growth but acceleration in prices. The headline index fell in June to minus 8.7 from minus 3.2 the month before. Growth prospects are not good as the new orders index for June came in at minus 6.7 while unfilled orders stood at minus 12.1. But inflation pressures have risen. The prices received index spiked more than 11 points in June to a 26.5 level that is highly elevated. Prices paid remained steady but high at 65.1.

Empire State Manufacturing Survey Consensus Forecast for July 08: -7.0

Range: -15.0 to -2.0

Business inventories are signaling a pickup in demand as inventories posted a 0.5 percent gain in April. Retailer inventories rose 0.4 percent, nearly reversing a 0.6 decline in March. Retailer inventories may have to climb further given strong retail sales in both April and May. But it is a tough balancing act for businesses as the outlook for consumer demand is so uncertain – consumers may retrench after the income tax rebate checks run out.

Business inventories Consensus Forecast for May 08: +0.4 percent

Range: +0.4 to +0.6 percent

Wednesday

The consumer price index turned red hot at the headline level in May due to a surge in energy costs. In May, the CPI spurted 0.6 percent based on oil-related price increases, following a 0.2 percent increase the month before. The core rate also firmed but not as much with a 0.2 percent boost after a 0.1 percent uptick in April. Fed officials will be parsing the numbers closely after indicating increased concern that food and energy inflation could be bleeding into the core rate. A soft economy has kept key portions of the core weak – notably for motor vehicles and apparel and the Fed is likely hoping for more of the same in coming months.

CPI Consensus Forecast for June 08: +0.8 percent

Range: +0.5 to +1.1 percent

CPI ex food & energy Consensus Forecast for June 08: +0.2 percent

Range: +0.1 to +0.3 percent

Industrial production in May unexpectedly fell but the decline was primarily due to a drop in utilities output. But the bottom line still is that the manufacturing sector is flat. Overall industrial production fell 0.2 percent in May, following a 0.7 percent decline in April. However, the manufacturing component was not was weak, coming in flat after falling 0.9 percent in April. Utilities output dropped 1.8 percent in the latest month while mining output edged up 0.1 percent. But recent data suggest that at least the manufacturing component will fall in June as most regional manufacturing surveys have been in the negative range and the June aggregate manufacturing hours index from the employment report slipped 0.2 percent. On a final note, overall capacity utilization in May slipped to 79.4 percent from 79.6 percent the prior month.

Industrial production Consensus Forecast for June: 0.0 percent

Range: -0.4 to +0.5 percent

Capacity utilization Consensus Forecast for June 08: 79.3 percent

Range: 79.0 to 79.7 percent

The Minutes of the June 24-25 FOMC meeting are scheduled for release at 2:15 p.m. ET.  Markets will be parsing the minutes for signs of what might trigger the Fed to actually raise rates in coming months.

Thursday

Housing starts continue to be weighed down by inventory overhang of unsold homes and by tighter credit standards as starts fell 3.3 percent in May to an annualized pace of 0.975 million units, following a 2.0 percent rebound in April. The May pace was down 32.1 percent year-on-year. The May decline was led by an 8.0 percent drop in multifamily starts as single-family starts fell another 1.0 percent. May’s overall level was the lowest since 0.921 million units in March 1991.

Housing starts Consensus Forecast for June 08: 0.960 million-unit rate

Range: 0.935 million to 0.990 million-unit rate

Initial jobless claims were surprisingly strong in the latest report but the labor picture is definitely mixed as continuing claims rose sharply. Initial jobless claims fell 58,000 in the week ending July 5 to a 346,000 level that's the lowest since mid-April. The reporting week is of course a holiday week which typically makes for large swings and puts special emphasis on the four-week average which came in at 380,500 for a 10,000 decline. But continuing claims, in data for the week ending June 28, jumped 91,000 to 3.202 million for the highest reading in five years. Though from an employer’s perspective the economy is sluggish, good workers are still hard to find, resulting in a reluctance to either lay off existing workers or hire new workers.

Jobless Claims Consensus Forecast for 7/12/08: 378,000

Range: 365,000 to 390,000

The general business conditions component of the Philadelphia Fed's business outlook survey index fell another point-and-a-half into negative territory, to minus 17.1 for the June reading. The outlook is not good as new orders worsened to minus 12.4 from minus 3.7 in May. Meanwhile, inflation pressures have been building as the prices paid index jumped more than 15 points to 69.3, while prices received remains unusually high at 29.7. In recent months, the Philly Fed report has been pointing toward stagflation.

Philadelphia Fed survey Consensus Forecast for July 08: -17.0

Range: -22.0 to -9.0

Econoday Senior Writer Mark Pender contributed to this article.