BONDS
Bond investors realize that the Fed will have to raise the federal funds rate in order to alleviate inflationary pressures. However, the plunge in the stock market over the course of the month and the less-than-stellar performance of economic activity are leading investors to rethink their views. Will the Fed be removing policy accommodation as rapidly as previously assumed' Notice that yields are down about 25 basis points from a month ago - except for the 3-month bill rate which is higher than last month. This reflects the belief that the fed funds rate is indeed headed higher. The Fed may raise rates as expected, but maybe they'll keep in place their "measured pace" terminology at Tuesday's meeting.

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

GDP growth moderates in Q1
Real GDP expanded at a moderate 3.1 percent rate in the first quarter after expanding at a more rapid 3.9 percent rate in the second half of 2004. Indeed the first half of 2004 also averaged a 3.9 percent rate of growth. As expected, real (inflation-adjusted) personal consumption expenditures increased at a 3.5 percent rate, a moderation from the 4.2 percent pace posted in the fourth quarter of 2004 and a 5.1 percent rate recorded in the third quarter of last year. The downward trend should not be surprising in light of the dramatic increases in gasoline prices which have been taking a healthy chunk out of consumers' pockets.

While the slowdown in consumer spending was moderate, it appears that the growth rate in real fixed business investment came to a relative standstill. Investment spending grew at healthy double-digit rates in the second, third and fourth quarters of 2004 (12.5, 13, 14.5 percent rates) and only grew at a 4.7 percent rate in the first quarter of 2005. Spending on structures declined and equipment spending grew at roughly one-third the previous quarter's pace. Given the recent pattern of soft growth in durable goods new orders and shipments, this is not altogether surprising.

Real net exports took a major bite out of GDP growth since exports increased at a 7 percent rate but imports surged at a whopping 14.7 percent rate. The widening trade gap yawned even further.

At the same time, inventory building accelerated in the first quarter, at almost double the fourth quarter pace. It is certainly possible that some of the imports that came to our shores during the quarter ended up as inventories. But the big inventory build-up coupled with slower growth in final sales don't bode well for the economy. Real final sales increased at a 1.9 percent rate in the first quarter after increasing at a 3.4 percent rate in the fourth quarter of 2004. In both quarters, the growth in final sales was less than the growth in GDP, reflecting inventory building. In a healthy economy, that isn't worrisome, but moderation in key sectors such as consumer spending and equipment investment is a concern.

Economists can say, until they are blue in the face, that gasoline prices really aren't that high in real terms. The fact remains that gasoline prices have doubled over the past year. Consumers don't spend inflation-adjusted dollars - they spend what they have in their pockets - and their pockets are much flatter & lighter these days.

The GDP deflator grew at a 3.2 percent rate in the first quarter, the fastest pace since last year's second quarter. After some moderation in crude oil prices in the middle of 2004, oil began to accelerate again - and this has carried over into this year. The Fed is less concerned with the GDP deflator than they are with the PCE deflator, which shows a lower inflation rate (2.2 percent in the first quarter) but a similar pattern (0.9 percent in the third quarter and 1.7 percent in the fourth quarter of 2004).

ECI moderates in Q1
The employment cost index increased 0.7 percent in March, the smallest quarterly rise since 1998! Wages and salaries increased 0.6 percent for the quarter, a tick higher than the 0.5 percent gain posted in the fourth quarter. In contrast, benefits rose 1.2 percent, a slower pace than the 1.6 percent gain recorded in the fourth quarter. This helped to keep a lid on total compensation costs. Consequently, the ECI rose 3.5 percent on a year-over-year basis, the smallest rise in two years.

The slower pace of growth in the ECI is often a double-edged sword. Slower gains in compensation costs bode well for corporations who face lower business costs. However, workers aren't always able to keep up with inflation when their compensation gains moderate.

Durable goods orders plunge
New orders for durable goods dropped 2.8 percent in March after declining in January and February as well. As a result, new orders fell for the quarter as well. In March new orders for transportation, machinery and electrical equipment fell sharply. After all was said and done, new orders were up only a small amount for primary metals and computers & electronics.

Nondefense capital goods orders are considered a leading indicator for capital spending. New orders fell 6.2 percent in March after a 0.7 percent drop in February. New orders for nondefense capital goods had been up sharply in December and moderately in January - and this helped to lift the category on a quarterly basis in the first quarter. But nonetheless, the gain was small. Notice that the quarterly pattern has shifted to a lower level in the past two quarters after posting healthier gains in 2003 and the first part of 2004. This could signal more weakness ahead.

Housing activity in Q1 moderates
New home sales jumped 12.2 percent in March after an 8.2 percent spurt in February. In contrast, existing home sales, which make up the lion's share of the market, rose 1 percent in March after remaining unchanged in February. But the monthly figures are easily impacted by unusual weather patterns, making it a good idea to look at three-month averages. As it turns out, home sales were nearly unchanged in the first quarter of 2005 from the fourth quarter pace. Indeed, it appears that housing activity has remained in a tight range since the second quarter of 2004. Steady growth in housing is not a surprise given that mortgage rates have remained at roughly 5.75 percent for the past two quarters.

Confidence falls
Regular readers of this weekly wrap-up know that we are not big fans of consumer confidence surveys as predictors of monthly changes in consumer spending. However, the confidence surveys can suggest that spending is likely to trend one way or another depending on consumers' attitudes. In fact, both the University of Michigan's consumer sentiment index and The Conference Board's consumer confidence index dropped sharply in April. It is no surprise that consumers, who have to pay twice as much to fill up their gas tanks, are not feeling optimistic about current conditions. Economists like to exclude energy prices when they look at inflation in order to smooth out monthly fluctuations, but nowadays excluding energy prices misses the point! Unless gas prices fall and unless labor market conditions improve dramatically (this is the other major determinant to consumer attitudes), confidence surveys will correctly predict that consumer spending is likely to moderate in the next few months.

The Bottom Line
The FOMC is meeting on Tuesday and just about every economist on Wall Street is predicting that they will raise the federal funds rate target by 25 basis points to 3 percent. We last saw a 3 percent fed funds rate target in September 2001 when the Fed was in a rate-cutting mode. The Fed will be concerned about current economic conditions - slower GDP growth, decreasing consumer optimism, falling new orders - but they will have no choice but to raise the fed funds rate target since the current rate remains accommodative. And the Fed can't allow rising energy prices to lead to accelerating inflationary pressures across the board. As everyone knows only the Fed, through its monetary policy, has the ability to prevent inflationary expectations from percolating.

Economists and financial market players will eagerly await the Fed's post-FOMC statement. Will the Fed give a hint at their thoughts beyond their usual statement of "removing policy accommodation at a measured pace"' There is no question that the fly on the wall at this current meeting will hear some interesting comments. No doubt, market players will relish the release of the FOMC minutes on May 24.

In addition to the FOMC meeting on Tuesday, market players will have plenty of economic indicators to monitor - such as the ISM surveys and the employment situation.

Looking Ahead: Week of May 2 to May 6

Monday
The ISM manufacturing index was virtually unchanged in March at 55.2. In April, the business barometer from the NAPM-Chicago decreased 3.6 percentage points to 65.6. This index tends to rise and fall more sharply than the ISM. Also, remember that the Chicago index includes all business activity, not just the manufacturing sector.

ISM manufacturing index Consensus Forecast for April 05: 54.8
Range: 53.5 to 57.5

Construction spending rose 0.4 percent in February. Housing starts improved in the past three months and this could help boost construction expenditures in upcoming months. In addition, we could see increases in nonresidential spending as well.

Construction spending Consensus Forecast for Mar 05: 0.3 percent
Range: -1.0 to 0.7 percent

Motor vehicle sales increased 3.8 percent in March to a 13.5 million-unit rate with sales rising for both light trucks and autos. Autos sold at a 5.5 million-unit rate while light trucks sold at an 8 million-unit rate for the month. With high gasoline prices, one would expect improved sales gains for cars and fewer purchases of gas-guzzling SUVs.

Auto sales Consensus Forecast for Apr 05: 5.3 million-unit rate
Range: 5.3 to 5.6 million-unit rate

Light truck sales Consensus Forecast for Apr 05: 7.9 million-unit rate
Range: 7.8 to 7.9 million-unit rate

Tuesday
Factory orders rose only 0.2 percent in February but are likely to post a sharp decline in March given the 2.8 percent in durable goods orders. Orders may show improvement in April or May given a spurt in Boeing orders for those months.

Factory orders Consensus Forecast for Mar 05: -1.1 percent
Range: -2.1 to 0.4 percent

The FOMC meeting is likely to bring a widely anticipated result of a 25-basis-point increase in the federal funds rate target. Market players will be more interested in the post-meeting statement. Will the word "measured" be deleted from the statement' Such a change could wreak havoc in the financial markets.

Federal funds rate target Consensus Forecast for May 3 05: 3.0 percent (+0.25 percent)
Range: None

Wednesday
The business activity index from the ISM non-manufacturing survey jumped 3.3 percentage points in March to 63.1. With the drop in the NAPM-Chicago, which incorporates non-manufacturing activity, it could signal a drop in the business activity index too.

Business activity index Consensus Forecast for Apr 05: 61.5
Range: 59 to 64

Thursday
New jobless claims jumped 21,000 in the week ended April 23 to 320,000, after falling in the three past weeks. Jobless claims have been showing a lot of fluctuation lately.

Jobless Claims Consensus Forecast for 4/30/05: 320,000 (unch)
Range: 300,000 to 340,000

Nonfarm productivity rose at a 2.1 percent rate in the fourth quarter, slightly faster than in the third quarter. The more moderate GDP growth in the first quarter could point to a productivity slowdown. In the fourth quarter, unit labor costs increased at a 1.3 percent rate, but usually a slowdown in productivity growth is accompanied by faster growth in unit labor costs.

Nonfarm productivity Consensus Forecast for Q4 04: 2 percent rate
Range: 1.0 to 2.8 percent rate

Unit labor costs Consensus Forecast for Q4 04: 2.0 percent rate
Range: 0.5 to 3.1 percent rate

Friday
Nonfarm payroll employment increased 110,000 in March, less than expected and slow for this stage of the cycle. The civilian unemployment rate decreased 0.2 percentage points in March, bringing the level back to 5.2 percent.

Nonfarm payrolls Consensus Forecast for Apr 05: 160,000
Range: 140,000 to 225,000

Unemployment rate Consensus Forecast for Apr 05: 5.2 percent
Range: 5.1 to 5.3 percent

Average workweek Consensus Forecast for Apr 05: 33.7 hours
Range: 33.6 to 33.8 hours

Average hourly earnings Consensus Forecast for Apr 05: 0.2 percent
Range: 0.1 to 0.3 percent

Consumer installment credit expanded only $5.5 billion in February after an $11.7 billion surge in January. The rise in motor vehicle sales in March could point to a rise in credit.