BONDS
It has been an exciting week for the bond market. President Bush nominated Ben Bernanke, current Chairman of the Council of Economic Advisors and former Fed governor, as Chairman of the Federal Reserve to replace Alan Greenspan on February 1, 2006. Ninety-nine percent of the economists who were asked have given rave reviews to this appointment. Dr. Bernanke is considered the foremost expert on monetary economics. And while he has indeed spent the majority of his career as a college professor, he did serve on the Fed board for three years - giving him more Fed experience than Alan Greenspan had in 1987.

Despite Ben Bernanke's penchant for inflation-targeting, which one might consider to be hawkish with respect to inflation matters, bond investors remember Bernanke's fear of deflation back in 2003 and 2004 and he has somehow developed a reputation in the bond market as an inflation dove. These fears are clearly overblown, but bond investors pushed up yields after his announcement. But perhaps bond investors were only using that as an excuse.

The FOMC is meeting next week, on Tuesday, and markets are looking for another 25 basis point rate hike. It has become common to see yields rise in advance of the meeting and then dip a bit afterwards. The consensus among economists working for primary dealers is unanimous: the Fed will raise the fed funds rate target by 25 basis points to 4 percent. The majority is looking for a 25 basis point rate hike in December as well, but at least three economists are looking for a December pause.

Markets at a Glance

The Economy
THIRD QUARTER GDP GROWTH ACCELERATES FROM SECOND QUARTER PACE
The Commerce Department's advance estimate revealed that real GDP expanded at a 3.8 percent rate in the third quarter, matching the first quarter's pace and stronger than the second quarter's 3.3 percent hike. It is important to remember that the Commerce Department's advance estimate for GDP always is missing a few variables and includes assumptions for the final month of the quarter. In this case, the assumptions for the month of September include a period with severe hurricane damage and may therefore see more revisions than usual when complete figures are reported next month.

In any case, real GDP benefited by a 3.9 percent gain in personal consumption expenditures - which were boosted by durable goods spending. Keep in mind that the major part of that spending took place early in the quarter - motor vehicle sales were pretty miserable in August and September. Spending on nondurable goods moderated for the second straight quarter, growing at a 2.6 percent rate - about half the pace registered in the first quarter this year. It remains to be seen whether fourth quarter consumption expenditures will match the third quarter pace. The weakness in motor vehicle sales in August and September means that they will have to climb out of a hole to help boost durable goods in the fourth quarter. While gasoline prices have been falling at the pump in recent weeks, they remain relatively high and consumers will be facing much higher heating bills to boot. This does not bode well for extravagant spending this holiday season.

Business fixed investment grew at a solid 6.2 percent rate, but this was down from the previous quarter's pace. After rising in the second quarter, investment in nonresidential structures decreased again in the third quarter. Capital spending on equipment and software posted a healthy 8.9 percent gain during the quarter, but this too was weaker than in the second quarter. No doubt, the strike by Boeing machinists played a role in holding down capital spending. And of course, hurricanes Katrina and Rita played a major role in dampening industrial production in the third quarter.

Residential investment spending grew only half as much in the third quarter as in the second quarter. Even though new home sales and housing starts remained at high level in the third quarter, they did not accelerate their pace of growth. Consequently, this may keep residential investment humming, but not accelerating.

Government spending played a major role in boosting economic activity in the third quarter (contributing a full 0.6 percentage points to that 3.8 percent rate). National defense expenditures surged at a 10.2 percent rate, the fastest quarterly growth rate since the first quarter of 2004 when military outlays increased at a whopping 13.8 percent rate. Government spending certainly contributes to our GDP growth - but the third quarter would not have been as strong without it. In the first half of this year, the government's contribution to growth was much less significant.

Net exports and business inventories are the two sectors that include Commerce Department assumptions for business activity in September. These two components always see the largest revisions when more complete data become available. The advance estimates show a small rise in exports coupled with no growth in imports and implies a slight positive contribution to GDP growth. Business inventories were a drag on GDP, although the advance estimate shows a smaller decline in inventories in the third quarter than in the second quarter. It remains to be seen how this will truly play out when September figures become available.

In the meantime, the advance report shows that real final sales grew at a 4.4 percent rate in the third quarter, a moderation from the 5.6 percent rate posted in the second quarter, but certainly a solid rate of growth. Often, when real GDP grows less rapidly than final sales, and inventories are declining, it suggests that there is momentum in the economy and future GDP growth may accelerate, as producers want to replenish inventories.

The GDP deflator increased at a 3.1 percent rate in the third quarter, accelerating from the second quarter rate, but in line with the gain in the first quarter this year. Notice that the GDP deflator has generally posted much larger increases in the past six quarters than in the previous six quarters. To a large extent, this reflects higher energy prices. The personal consumption expenditure deflator increased at a 3.7 percent rate in the July to September period - the largest quarterly gain since the second quarter of 2004 when the PCE deflator increased at a 3.8 percent rate. Excluding food and energy prices, the PCE deflator moderated to show a 1.3 percent hike compared with a 1.7 percent gain in the previous quarter.

EMPLOYMENT COST INDEX MODERATES FURTHER IN Q3
The employment cost index is widely followed by economists and Fed officials because it reflects total compensation costs faced by employers and can signal potential inflationary pressures. The third quarter ECI edged down by a minuscule amount in the third quarter from the second quarter, but in light of the accelerating rate of inflation due to higher energy prices, it should be viewed in a favorable light. If compensation costs don't increase, then businesses will have less reason to increase product prices - the inflationary wage-price spiral doesn't begin.

The employment cost index increased 0.8 percent in September and was 3.1 percent higher than a year ago. Wages and salaries, which account for the lion's share of the index, rose 0.6 percent and were 2.3 percent higher than a year ago. Benefits costs jumped 1.3 percent but were still 5.1 percent higher than a year ago, showing no increase from the year-over-year gain in June. If businesses can contain labor costs, the Fed will have an easier time containing overall inflationary pressures.

Looking at the flip side, though, reveals that consumers' wages are not keeping up with inflation and their purchasing power is eroding because of escalating energy costs. This suggests that consumers will have less discretionary income to spend during the holiday season.

DURABLE GOODS ORDERS PERFORM THEIR MONTHLY FLIP-FLOP
New orders for durable goods fell 2.1 percent in September, reversing part of August's 3.8 percent gain. Excluding transportation, new orders fell only 1 percent in September after gaining a healthy 5.1 percent in August. While several industry components posted declines during the month (fabricated metals, computers & electronics, electrical equipment and transportation equipment) at least a few (primary metals and machinery) posted monthly gains. And looking at the bigger picture, new orders for nondefense capital goods excluding aircraft still fell 1.2 percent after gaining 4 percent in the previous month.

Since durable goods are so floppy from one month to the next, it's good to keep a running average of new orders. In the first nine months of this year, new orders averaged monthly gains of only 0.3 percent - this is much slower than last year's 0.6 percent average and the 1.3 percent monthly average posted in 2003. But the year is not over, and it is certainly possible that new orders could strengthen in the final months of the year. Manufacturing surveys have shown that activity is still expanding. But at least thus far, durable goods have underperformed this year.

HOME SALES MODERATE IN SEPTEMBER
Home sales inched up only 0.3 percent in September basically reversing the previous month's drop. Most of the stories I saw on the home sales figures were quite chirpy about a 2.1 percent increase in new home sales and the unchanged figure for existing home sales. Actually, the behavior of home sales over the past few months suggests to me that the housing sales bubble may be coming to an end. New home sales were revised down in both July and August. And in fact, the report last month saw similar revisions. In the booming home sales period, revisions to previous months were upward in nature, not downward. Existing home sales are not typically revised very much, but August figures were revised down marginally. Total home sales appeared to have peaked in June - when mortgage rates (30-year fixed) were at their lows for the year at 5.58 percent. Mortgage rates dipped a few basis points in September, but rose 30 basis points in October to 6.07 percent, the highest rate since June 2004.

At current rates, mortgage rates are not high enough to totally deflate the housing bubble. But if rates continue to edge higher - and with Treasury yields generally running higher lately - we could see a moderation in housing activity in coming months. If we're lucky, home sales will decline at a moderate rate - and not plunge.

The Bottom Line
The most negative news of the week was the durable goods report. But given that new orders move in a seesaw pattern, the September drop could easily be followed by an October gain. We know that the Boeing strike is over and the hurricane season is coming to an end (soon, anyway). The University of Michigan's consumer sentiment index showed that the final October figure was revised down from the mid-month reading. This consistent pessimism among consumers can't be good going into the holiday season.

Third quarter GDP growth was pretty healthy despite the fact that business activity was held down by hurricanes and strikes. Final sales grew faster than GDP for two straight quarters and this often (though not always) suggests that producers may eventually try to accelerate inventory building. While hurricanes devastated the financial well-being of many many households, the fiscal stimulus promised by the administration and Congress should help alleviate at least some suffering and help to boost economic growth in coming months (and years).

The housing figures were not at all bad, but the signs are certainly more prevalent that we have reached a peak. More likely than not, we should see moderation in this market even if rebuilding after the hurricanes helps boost housing in the damaged areas.

Inflation news was good and bad. The GDP deflator showed acceleration - primarily stemming from the energy sector. The employment cost index continued to moderate in the third quarter when comparing year-over-year figures. If inflationary expectations don't enter the psyche of the wage earner, it will make the Fed's job easier to alleviate inflationary pressures. On the flip side, wage earners are not keeping up with inflation and are seeing their purchasing power erode. That will hurt retail sales.

Looking Ahead: Week of October 31 to November 4

Monday
Personal income decreased 0.1 percent in August stemming from more weakness in the employment data for the month; September figures were not weak outside of hurricane-related activity, but this should nonetheless affect personal income for the month. Personal consumption expenditures declined 0.5 percent in August due to a drop in durable goods spending. Motor vehicle sales fell again in September, but by a smaller magnitude; otherwise retail sales were relatively healthy in September.

Personal income Consensus Forecast for Sept 05: 0.3 percent
Range: 0.1 to 1.0 percent

Personal consumption expenditures Consensus Forecast for Sept 05: 0.5 percent
Range: -0.1 to 0.7 percent

The NAPM-Chicago's business barometer surged to 60.5 in September after plunging to its lowest level in over two years in August. 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 Fed surveys were mixed in October with the New York area showing slower growth and the Philadelphia region more rapid growth.

NAPM-Chicago Consensus Forecast for Oct 05: 57
Range: 55 to 60

Tuesday
The ISM manufacturing index increased almost 6 points to 59.4 in September despite, or because of, hurricanes Katrina and Rita. The Philadelphia Fed's business outlook survey showed improvement in October, although the New York Fed's survey did not.

ISM manufacturing index Consensus Forecast for Oct 05: 57
Range: 54.2 to 59.0

Construction spending inched up in August. The high level of housing starts in September suggests that residential spending should boost overall construction spending, although nonresidential construction spending may not be as buoyant.

Construction spending Consensus Forecast for Sept 05: 0.5 percent
Range: -0.5 to 1.1 percent

There does not appear to be any disagreement over the course of monetary policy these days - market players are expecting that the FOMC will indeed vote to raise the federal funds rate target by 25 basis points to 4 percent at the November 1 meeting. After seeing the minutes of the September meeting, market players will be looking for changes in the post-meeting statement.

Federal funds rate target Consensus Forecast for Nov 1 05: 4 percent (+0.25 percent)
Range: None

Domestic motor vehicle sales dropped 2.3 percent in September to a 13 million-unit rate as automakers face a payback on their incentive-boosted sales from this summer. Domestic cars were sold at a 5.6 million-unit rate and light trucks were sold at a 7.3 million-unit rate in September.

Domestic vehicle sales Consensus Forecast for Oct 05: 12.6 million-unit rate
Range: 11.3 to 12.8 million-unit rate

Thursday
New jobless claims fell 28,000 in the week ended October 22 to 328,000. Fewer and fewer claims are related to hurricanes Katrina and Rita each week. This latest week's level of claims is similar to that seen in the week ended September 3.

Jobless Claims Consensus Forecast for 10/29/05: 330,000 (2,000)
Range: 315,000 to 348,000

Nonfarm productivity rose at a 1.8 percent rate in the second quarter, slower than the first quarter's 3.2 percent rate. At the same time, unit labor costs increased at a 2.5 percent rate, slightly faster than in the first quarter but significantly lower than in the second half of 2004.

Nonfarm productivity Consensus Forecast for Q3 05: 2.7 percent rate
Range: 2 to 3.3 percent rate

Unit labor costs Consensus Forecast for Q3 05: 1.6 percent rate
Range: 0.8 to 3.0 percent rate

The business activity index from the ISM non-manufacturing declined nearly 12 points in September to 53.3. Until now, the non-manufacturing survey had shown more strength than the manufacturing survey. Hurricane activity was not as damaging in October as in September and this could help the business activity index in October.

Business activity index Consensus Forecast for Oct 05: 57
Range: 54 to 60

Factory orders rose 2.5 percent in August, boosted by a gain in durable goods orders. Given the 2.1 percent drop in durable goods orders in September, total orders will decrease as well, although to a lesser degree.

Factory orders Consensus Forecast for Sept 05: -1.0 percent
Range: 0.0 to -3.0 percent

Friday
Nonfarm payroll employment declined 35,000 in September. The initial estimate was actually stronger than estimated as employment growth outside Katrina-ravaged areas was showing healthy momentum. Nonetheless, one should not discount the lost jobs. The civilian unemployment rate increased 0.2 percentage points to 5.1 percent in September largely due to the negative impact of hurricane Katrina.

Nonfarm payrolls Consensus Forecast for Oct 05: 110,000
Range: -25,000 to 300,000

Unemployment rate Consensus Forecast for Oct 05: 5.1 percent
Range: 5 to 5.2 percent

Average workweek Consensus Forecast for Oct 05: 33.7 hours
Range: 33.7 to 33.8 hours

Average hourly earnings Consensus Forecast for Oct 05: 0.2 percent
Range: 0.2 to 0.4 percent