Stock prices did surge this week, but let's keep in mind how downtrodden they had gotten. The chart below shows key market indexes relative to year-end. All the key indexes are still below levels posted on December 31. The Nasdaq composite and the Russell 2000 remain are fighting for third. The Dow and the S&P 500 are back and forth, but mostly showing the same trends.

BONDS
While there is no question that the Treasury market saw some fluctuations this week, market activity was relatively subdued when one compares today's market close with last Friday's. Inflation news was relatively friendly this week - at least the core CPI was tamer than expected by most market players. However, stock prices posted healthy gains this week - and this took some of the bloom off the bond market's rose.

The chart below depicts trends in the 2-year note and the 10-year note over the past year. Notice that 2-year note yields have generally risen - as one would expect in an environment in which the Fed was removing policy accommodation. In contrast, the 10-year note yield is lower today than it was a year ago. The conundrum continues.

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.

The Economy

PPI jumps
The producer price index increased 0.6 percent in April after a slightly larger 0.7 percent spurt in March. Energy prices posted a 2.1 percent spurt, somewhat less than March's 3.3 percent hike. April energy prices are 15.9 percent higher than a year ago. Excluding the volatile food and energy components, the core PPI increased 0.3 percent, faster than the gains of the past two months. Key components (cars & light trucks, tobacco products, pharmaceuticals) were largely responsible for the acceleration. These categories are those that do spike from time to time.

Market players and economists also look at price changes for the producer price index at earlier stages of processing. The intermediate goods index increased 0.8 percent while the crude materials index jumped 2.7 percent. Obviously these indexes are also being boosted by energy prices. Excluding food and energy, the intermediate goods index inched up 0.2 percent, less then last month's 0.3 percent gain; and the crude materials index rose 0.8 percent, less than the previous month's 1 percent hike. On a year-over-year basis, the intermediate goods index is 6.6 percent higher than last April while the crude goods index is 8.3 percent higher.

It is likely that cost increases are not entirely being passed along to finished goods producers, since the finished goods index (excluding food and energy) was only 2.6 percent higher than a year ago. This means that costs are rising for producers, but the economy is not quite strong enough to allow all the costs to be passed on. This is hurting company profit margins.

CPI jumps - but core components are subdued
The consumer price index jumped 0.5 percent in April, only a tad less than March's 0.6 percent spurt. This pushed the year-over-year gain in the CPI back up to 3.5 percent. It had been on a slight retreat the last few months. Energy prices jumped 4.5 percent in April, faster than March's 4 percent hike and twice as large as February's 2 percent gain. This should come as no surprise to consumers filling up their tanks at the gas pump.

Excluding food and energy, the CPI was unchanged in April, a much better showing than March's 0.4 percent hike. A 0.6 percent drop in apparel prices helped to keep a lid on core inflation, as did a moderation in health care costs (0.2 percent in April vs. 0.4 percent in March). Most likely, the March gain was overstated - and the April figures were understated. It is always best to smooth out these data by looking at a three-month average, and it suggests that the core CPI has not fluctuated very much lately. In fact, the core CPI is up 2.2 percent from a year ago, a slight improvement over the two previous months - in line with the better year-over-year gains seen in November & December 2004 as well as January 2005.

Housing comes back
It is no wonder that the Census Bureau recommends that analysts look at a five-month moving average for housing starts before determining a change in trend. Housing starts plunged 17.6 percent in March, but jumped 11 percent in April. This brought housing starts back to a 2.04 million-unit rate. Single family starts increased 6.3 percent to a 1.64 million-unit rate, not quite returning to February's stunning 1.8 million-unit rate but still a fairly strong showing. It appears that relatively low mortgage rates continue to spur housing activity. The chart below shows the 5-month moving average of housing starts, which smoothes out the sharp monthly fluctuations that obscure the underlying trends.

Industrial production moderates
The index of industrial production dipped 0.2 percent in April after posing a meager 0.1 percent hike in March and a stronger 0.5 percent gain in February. Undoubtedly, a 2.3 percent drop in utilities output helped dampen the index, but even manufacturing activity was unchanged for the month. Among major market groups, production of consumer goods plunged 0.9 percent - mostly due to a drop in motor vehicle assemblies. Production of business equipment recorded a healthy 0.8 percent gain for the month. In April, consumer goods production was only 1.4 percent higher than a year ago, but business equipment output was 8.4 percent higher. Economists have been predicting that a moderation in the consumer sector would come with an acceleration in capital spending. Since consumer spending accounts for roughly 70 percent of GDP, a moderation could dampen overall economic growth.

Even as manufacturing activity moderates on a year-over-year basis, the high tech sector remains stable - posting a year-over-year gain of 20.3 percent in April. The chart below shows that high tech spending has been stable since early 2003, while overall manufacturing activity has fluctuated over this period.

Can Fed surveys tell us anything about May manufacturing activity'
Two key Fed surveys showed marked deterioration in manufacturing activity in May. The Empire State manufacturing index fell to -11.1 from an already low level of 2.0 in April. This is a sharp deterioration given that the index stood at 20.2 in March. The Philadelphia Fed's business outlook survey didn't turn negative, but the general business conditions index fell back to 7.3 from a level of 25.3 in April. This index has been quite choppy the past few months, but the overall trend is down if one looks at averages over the past year.

We have found that the Philadelphia Fed survey does a pretty good job of predicting trends in industrial production - and this slow pace of activity in May could be pointing to continued anemic activity in the index of industrial production as well for the month of May.

The Bottom Line
Market players focused on the friendly CPI news this week since higher prices were due to a surge in energy costs, rather than higher prices in the core components. While core inflation has not accelerated in the past couple of months, there is no question that consumers are still paying higher costs for an important portion of their budget. And if consumers adjust to higher gasoline prices, it does mean that spending on other goods and services may eventually suffer.

The housing market appears to have more than nine lives as it continues to post healthy growth. More and more pundits are talking about housing bubbles (Fed Chairman Alan Greenspan said Friday he doesn't believe there's a housing bubble though he did point to a little "froth" and said the level of activity was unsustainable). While we believe that housing activity is very location-specific, there is no question that home appreciation may have accelerated too rapidly on the whole. Should the bubble burst, those consumers holding interest-only adjustable rate loans, will suffer the most. This may not be a problem today or tomorrow, but it is a trend that needs to be monitored.

Looking Ahead: Week of May 23 to May 27

Wednesday
New orders for durable goods fell 2.3 percent in March, the third straight monthly decline. Boeing orders have risen in recent months, but non-transportation orders have also been sluggish. For instance, machinery orders fell 7.2 percent for the month. Sluggish new orders dampen industrial activity.

Durable goods orders Consensus Forecast for Apr 05: 1.5 percent
Range: -1.0 to +3.5 percent

New single-family home sales jumped 12.2 percent to a 1,431,000-unit rate. Mortgage rates have inched up a bit, but remain relatively low and this continues to help the housing market. A strong level of new single-family housing starts in April suggests that new home sales gains have some legs.

New home sales Consensus Forecast for Apr 05: 1,350,000
Range: 1,200,000 to 1,500,000-unit rate

Existing home sales inched up in March to a 6.89 million-unit rate. Sales of existing homes are counted at closing, while sales of new homes are counted when a contract is signed. New home sales increased in March and this could point to a rise in existing home sales in April.

Existing home sales Consensus Forecast for Apr 05: 6.91 million-unit rate
Range: 6.50 to 7.10 million-unit rate

Thursday
New jobless claims fell 20,000 in the week ended May 147 to 321,000, posting their first drop after three straight gains. After falling sharply in mid-April, claims are higher in May.

Jobless Claims Consensus Forecast for 5/21/05: 325,000 (4,000)
Range: 316,000 to 335,000

The Commerce Department initially estimated that real GDP expanded at a 3.1 percent rate in the first quarter of 2005. Consumer spending moderated, although business fixed investment slowed down even more dramatically. Economists are looking for an upward revision since the international trade deficit was lower than expected for March.

Real GDP Consensus Forecast for Q1 05: 3.7 percent annual rate
Range: 3.4 to 3.9 percent annual rate

GDP deflator Consensus Forecast for Q1 05: 3.2 percent annual rate
Range: 3.1 to 3.4 percent annual rate

Friday
Personal income increased 0.5 percent in March. April gains could be healthy since nonfarm payrolls jumped, hourly earnings grew, and the average workweek increased as well. Personal consumption expenditures grew 0.6 percent in March. Retail sales jumped in April - and this points to faster growth in personal consumption expenditures as well.

Personal income Consensus Forecast for Apr 05: 0.7 percent
Range: 0.6 to 1.2 percent

Personal consumption expenditures Consensus Forecast for Apr 05: 0.8 percent
Range: 0.5 to 1.0 percent

At mid-month, the University of Michigan's consumer sentiment survey fell from the final April level to 85.3. Given that higher gasoline prices were probably a factor in making consumers more pessimistic, it is likely that the full month reading won't show much improvement (gas prices are still high!)