STOCKS
Most stock indexes ended the week down with the Nasdaq being the exception and ending the week up moderately. Stocks made an initial optimistic surge through most of Wednesday - the opening day for last week. Equity markets in the U.S. were closed on Monday for the New Year's Day holiday and on Tuesday for the funeral of former president Gerald Ford. The Dow had broad support with triple digit gains at midday with a positive ISM manufacturing report providing some of the boost. However, when the FOMC minutes for the December 12 policy meeting were released at 2:00 p.m. Wednesday, stock indexes rapidly retreated back to around opening levels - with the Nasdaq being the exception. The FOMC minutes stated continuing concern by the Fed over inflation remaining too high but now with some FOMC members worrying about too weak economic growth. This combination was seen as the worst combination for stocks. Big news for the day also included the announcement of the resignation of Home Depot's Chief Executive Officer Robert Nardelli - which sharply boosted Home Depot stocks. On Thursday, most equities moved sideways with the markets waiting on Friday's employment report. However, the Nasdaq posted a strong 1.2 percent gain on Thursday, led by technology stocks. All major indexes fell sharply on Friday as the strong employment report caused the markets to push back when they expect the Fed to cut interest rates.

For the week, all major indexes were down except for the Nasdaq which was up. Declining indexes included: the Dow, down 0.5 percent; the S&P 500, down 0.6 percent; and the Russell 2000, down 1.5 percent. The Nasdaq was up 0.8 percent.

BONDS
The bond market whipsawed last week. Rates fell sharply over Wednesday and Thursday due to worries over too weak economic growth. The Fed's FOMC minutes released on Wednesday indicated, for the first time this monetary policy cycle, official discussion by some members that the risks of too weak growth had become notable. Also, on Thursday a jump in initial jobless claims pushed rates down even further. By close on Thursday, interest rates had dropped across the yield curve except on the near end. Rates had fallen 10 to 11 basis points. On Friday, however, the stronger-than-expect payroll employment gains and wage increases pushed rates back up almost to where they had been just before the release of the FOMC minutes.

Net for the week the Treasury yield curve is down only marginally but with the front end up incrementally. Otherwise, yields were down net 4 to 7 basis points. Yields were down as follows: 2-year Treasury note, down 5 basis points; 3-year, down 5 basis points; 5-year, down 4 basis points; the 10-year bond, down 5 basis points, and the 30-year bond, down 7 basis points. The 3-month Treasury bill was up 3 basis points.

Despite last week's volatility, longer rates remain lower than recent highs set in June and July of last year. The 10-year Treasury bond closed at 5.28 percent on June 28 and closed last week at 4.65 percent.

Markets at a Glance

The Economy
Last week showed some improvement in manufacturing and a boost in employment and wages. The Fed's FOMC minutes also came out and the markets probably overreacted to wording that some FOMC members were concerned about downside risks to economic growth.

Employment and wages surprise on the upside
Friday's employment report for December had a major impact on both the equity and bond markets due to unexpected strength in employment and in wages. Nonfarm payroll employment rose 167,000 in December, following a revised 154,000 gain in November and 86,000 increase in October. The December boost was significantly more than the consensus expectation for a 100,000 increase. Also, the gain in December payrolls was a sharp contrast to the ADP employment projection that called for 40,000 drop in private employment for the month. The weak ADP figure probably helped contribute to the sharp market reaction to Friday's report due to setting up such a significant contrast.

Within the payroll survey, gains were strong in services while goods producing jobs were weak. Overall service-providing industries were up 178,000, following a 195,000 increase in November. Goods-producing jobs fell 11,000 with construction down 3,000 and manufacturing down 12,000. Natural resources & mining rose by 4,000.

The household survey indicated that labor markets remain notably tight - something that has been a key concern for the Fed. The civilian unemployment rate was unchanged from 4.5 percent in November. Household employment jumped 303,000 in December, following a 286,000 boost in November. Once again, household employment has been stronger than payroll employment. Household survey job growth was 71 percent stronger than payroll growth during 2006. Monthly gains for household survey jobs averaged 262,000 while payroll increases averaged 153 during last year. This still suggests that the economy is stronger than indicated by the more popularly watched payroll survey.

Importantly, the payroll data go through a number of revisions since the initial payroll data on based on business establishments in the Labor Department's sample. During the first year of estimates, the Labor Department has no actual data on births of new firms and has to estimate growth rates for new firms. Sometimes those forecasts miss significantly and that may have been happening over 2006 since there is such a wide difference between the payroll numbers and the household job gains. Of course, the household numbers also pick up the self-employed while the payroll figures do not. The household employment figures are based on a smaller sample but have no forecast portion in the initial year.

On a year-on-year basis, nonfarm payroll employment is up 1.4 percent for December - unchanged from November. Meanwhile, household employment is up 2.2 percent for December - up slightly from 2.1 percent in November.

The other portion of the employment report that really got the markets' attention was the wage data. Average hourly earnings jumped 0.5 percent in December, following a 0.3 percent rise in November. Average hourly earnings are up 4.2 percent on a year-on-year basis in December, the same as for November. Average hourly earnings have been on a steady uptrend since early 2004. Thus far, productivity gains have kept wage costs from pushing up inflation but wage costs remain a concern for the Fed.

Other measures of labor availability indicate that labor markets remain tight. The employment-to-population ratio came in at 63.4 percent, up slightly from 63.3 percent in November. Also the labor force participation rate edged up to 66.4 percent from 66.3 percent in November.

ISM reports indicate that manufacturing is not weakening further while non-manufacturing holds steady
The manufacturing sector has become an area of recent concern given that in recent months some manufacturing surveys had slipped just marginally into negative territory and new factory orders showed recent weakness outside of the aircraft industry. But the Institute for Supply Management report on manufacturing was modestly positive for December. The ISM's index rose back above the break even mark of 50, rising to 51.4 in December from 49.5 in November. Additionally, new orders improved, indicating that the gain in the composite index has a broad base. New orders rose to 52.1 from 48.7 in November.

The ISM's non-manufacturing index remained at a healthy level despite marginal slippage to 57.1 from 58.9 in November. New orders, however, edged down a little more in this survey compared to manufacturing, declining to 54.4 in December from 57.1 the prior month.

Prices paid were mixed for the two ISM surveys. For the manufacturing survey, prices paid fell to 47.5 in December from 53.5 the prior month. Manufacturing demand for raw materials has weakened notably as is the case for energy goods such as oil. However, prices paid from the non-manufacturing survey rose to 59.1 from 55.6 in November.

Fed minutes rattle equities as markets forget déjà vu
The markets seemed schizophrenic last week - much more than usual. First, stocks bounded up on opening Wednesday (the opening day for equities last week) with extreme optimism that the Goldilock's economy was firmly in place. Economic growth was moderate, inflation is coming down, and the Fed is expected to cut interest rates early this year well before the end of the first half. But Wednesday afternoon, the Fed's minutes indicated concern over a combination of inflation that is too high AND economic growth that is too weak. Goldilocks was nowhere to be found as equities and bond prices tumbled.

What was it that was in the FOMC minutes that rattled the markets' First, it was noted that all members remained concerned that inflation would remain too high under the current monetary stance. Second, for the first time during this tightening cycle, some FOMC members specifically stated that the risk of too weak economic growth had grown significantly. But bear in mind, the FOMC minutes reflected views based on data that were available only up through December 12. This included weak jobs reports for October and November, a firming in oil prices, a drop in industrial production and in manufacturing survey indexes, and core inflation numbers that were still high on a year-on-year basis.

But the markets oddly forgot that the FOMC minutes were reflecting Fed views based on data that are now old. Much has happened since December 12. The markets had already seen the data reflected in the FOMC minutes. Why did the markets not think déjà vu' Other than some members expressing concern over weak economic growth, there really was nothing new. The markets already had seen the data the FOMC members were discussing in the December 12 minutes, and the data had already been digested.

What's new since December 12' Importantly, later in December, the November report for the core CPI number came in at flat following a 0.1 percent increase in October. A good downward trend in core inflation has been established since December 12. What about the health of the economy' Retail sales have since been released showing a robust 1.0 percent in November and anecdotal information indicates that spending is still holding up well. This includes a rebound in motor vehicle sales in December. For manufacturing, various surveys including the ISM show improvement. Finally, the just released report on the employment situation shows a generally healthy labor sector. Basically, the markets just whiffed interpreting or discounting the December 12 FOMC minutes.

What about the downside on the data' The downside includes a still tight labor market. But the labor market - including wages - is a lagging indicator. Wage pressures really do not lead changes in inflation. The main points are that the Fed's soft landing is intact but labor market concerns remain. Also, the markets likely overreacted to the FOMC minutes as well as to the healthy employment report.

Indeed, core inflation has come down more since the December 12 FOMC meeting.

Following last Friday's employment report, the odds of a Fed cut in interest rates during the first half of 2007 went down notably compared to just prior to the report - according to the fed funds futures market, but still remain a little greater than 50 percent.

The bottom line
Last week's data do not indicate that the soft landing is at much risk despite sharp changes in market perceptions about the strength of the economy. The FOMC minutes for December 12 were clearly an out-of-date indicator. The concerns about too weak economic growth have been surpassed by a number of healthy reports since the FOMC meeting. These reports include last week's employment numbers but also softer CPI numbers. The bottom line is that economic growth remains moderately healthy and we are likely still headed toward a slow easing in longer-term inflation numbers. But this easing is not happening as fast as some would like. Nonetheless, there is still room for healthy profits for corporations and further gains in equities. However, bond rates may be a little slow in coming down.

Looking Ahead: Week of January 8 through January 12

Wednesday
The U.S. international trade gap shrank to $58.9 billion in October - thanks in large part to a decline in oil prices as imports fell and exports edged up. Oil prices will likely have the opposite effect for November. With manufacturing softening, continued growth in exports is important for support in this sector.

International trade balance Consensus Forecast for November 06: -$60.0 billion
Range: -$63.5 billion to -$57.0 billion

Thursday
Initial jobless claims rose 10,000 in the Dec. 30 week to 329,000. There were no special factors in the latest week but seasonal adjustment is difficult on a weekly basis for the holiday season.

Jobless Claims Consensus Forecast for 1/6/07: 320,000
Range: 300,000 to 340,000

The U.S. Treasury monthly budget posted a deficit of $75.6 billion in November. Looking ahead, the month of December typically shows a moderate surplus for the month. Over the past 10 years, the average surplus for the month of December has been $11.5 billion.

Treasury Statement Consensus Forecast for December 06: -$25.0 billion
Range: -$28.0 billion to -$20.0 billion.

Friday
Import prices rose 0.2 percent in November - largely on a spike in natural gas prices. Excluding all fuels, import prices posted a modest 0.1 percent increase, following a 0.1 percent decline in October.

Import prices Consensus Forecast for December 06: +0.5 percent
Range: +0.3 to +1.0 percent

Retail Sales jumped 1.0 percent in November, following a 0.1 percent dip in October. Excluding motor vehicles, retail sales rebounded 1.1 percent in November, following a 0.3 percent drop in October. Government retail sales numbers have been running higher than private surveys and markets will be watching to see if this is the case for December. Even so, chain store sales have been improving slightly and portend moderately healthy sales. However, warm weather has dampened seasonal sales somewhat and that effect may show up in the clothing portion of retail sales.

Retail sales Consensus Forecast for December 06: +0.6 percent
Range: +0.3 to +1.1 percent

Retail sales excluding motor vehicles Consensus Forecast for December: +0.5 percent
Range: +0.2 to +0.7 percent

Business inventories rose 0.4 percent in October though business sales fell 0.2 percent. This boosted the stock-to-sales ratio to 1.31 vs. 1.30 in September and compared to 1.27 as recently as August. However, retail numbers were strong in November and we should see moderation in inventory growth and possibly a drop in the stock-to-sales ratio.

Business inventories Consensus Forecast for November 06: +0.4 percent
Range: +0.0 (flat) to +0.5 percent