STOCKS
Equities cooled off last week - especially the Nasdaq and the tech stocks. Small caps also took a notable hit. Monday and Tuesday, stocks largely drifted sideways, waiting for major earnings announcements later in the week and key economic indicators. Wednesday's tone was largely set after close on Tuesday when Apple announced its earnings and guidance. Fourth quarter earnings and sales were way above estimates but guidance for 2007 was well below expectations. Apple and other tech stocks dropped sharply Wednesday. Intel and Cisco Systems also pulled down the techs. On Thursday, technology stocks were down even more, led by Lam Research, a semiconductor equipment company. Curiously, the stock market took the CPI report to heart more than the bond market. Equity investors were concerned more about the delay in interest rate cuts than they were relieved that housing and manufacturing are improving. Friday, except for the Dow which nudged down, equities were generally up modestly, coming off of being oversold earlier in the week.

For the week, the blue chips were mostly flat while the techs and small caps fell notably. Among the blue chip indexes, the Dow nudged up 0.1 percent while the S&P 500 slipped barely but rounded up to no change. The Nasdaq dropped 2.1 percent while the Russell 2000 fell 1.1 percent. Year-to-date, the Dow is up 0.8 percent; the S&P 500 up 0.9 percent; and the Nasdaq is up 1.5 percent. The Russell 2000 is down 0.3 percent since the end of 2006.

BONDS
Bonds ended last week little changed despite the strong economic data. Markets have interpreted the inflation numbers as benign once the effects from then-higher oil prices have been discounted. Nonetheless, the lack of upward drift in rates after last week's industrial production and housing starts numbers is a little surprising. After being closed Monday for the Martin Luther King holiday, rates dipped slightly on Tuesday due to a below expectations figure for the Empire State manufacturing survey. Rates were nudged back up on Wednesday as a result of the strong industrial production numbers and comments by San Francisco Fed President Janet Yellen that lower inflation numbers have not been sustained long enough. While Federal Reserve Chairman Ben Bernanke spoke before the Senate Finance Committee on Thursday, his comments focused only on the long term issue of federal deficits and had no impact on the market. Strong housing starts and a healthy Philly Fed number pushed rates up during the first half of Thursday but in the afternoon rates closed down slightly. On Friday, rates were little changed except for the bills and shorter notes which drifted up on the firming in oil prices and on hawkish Fed speak by Richmond Fed President Jeffrey Lacker and Kansas City Fed President Thomas Hoenig.

Net for the week the Treasury yield curve is up slightly except for the long bond which was unchanged. Yields are up as follows: 3-month Treasury bill, up 5 basis points; 2-year Treasury note, up 4 basis points; 3-year, up 2 basis points; 5-year, up 2 basis points; and the 10-year bond, up 1 basis point.

Rates have been trending upward over the last month or somewhat longer. Short-term rates have risen about 30 basis points since the end of November. Meanwhile, the long bond rate also has risen about 30 basis points but since mid-December.

Markets at a Glance

The Economy
Last week's economic data added another week into the score card on the strong side overall. Industrial production and housing starts were particularly strong. Price data were affected by oil at the headline level. Core figures were not disconcerting on the upside, but they also showed no progress toward the Fed's comfort zone.

Consumer prices up but not as much as headline but still too high
Last week, the CPI jumped but the markets largely took the CPI report as benign once the boost in oil-related components was discounted. Overall consumer prices jumped 0.5 percent in December, following no change in November. The core CPI came in at a more moderate 0.2 percent gain, following no change in November. Markets saw the 0.2 percent rise in the core rate as indication that inflation is still easing. But does more detailed analysis confirm this'

A key component has been the owners' equivalent rent subcomponent in housing. This subcomponent makes up 23.4 percent of the overall CPI. How did it fare in December' This important subcomponent maintained a 0.3 percent pace as in November. Also, rent rose 0.3 percent but was down from 0.4 percent in November. Most of the price pressure in housing was in the fuels & utilities subcomponent. What this means is that there was no worsening in the downwardly sticky rent components and actually some modest improvement. So, that was good news but the bottom line is that it has not eased below levels seen prior to last summer when the core rate spiked.

Over a longer-term view, sometimes the core rate has led owners' equivalent rent and other times it was the reverse. But the core rate has never stayed down without the owners' equivalent rent subcomponent also staying down.

Is the CPI on track for easing into the Fed's comfort zone of between 1 percent and 2 percent inflation' Year-on-year core inflation growth was unchanged from at 2.6 percent in November. By that measure we have a way to go. But on the margin, core numbers have been a little better.

Using a three-month ago percent change annualized, the core rate actually has fallen to 1.4 percent in December, annualized. This is because of the two very low numbers in October and November. The underlying trend is likely somewhere between the year-on-year number and the three-months-ago annualized figure. A core number of a monthly gain of 0.2 percent would cause the marginal trend to spike back up. The Fed is well aware that these, short marginal trends are very volatile as seen below and prefers to wait for a clearer trend.

Producer prices up on oil - old news and not so relevant now
Producer prices increased 0.9 percent in December, following a 2.0 percent jump in November. Most of the rise was in both food and energy. The core rate was more subdued with a sharp deceleration to a 0.2 percent rise, following a 1.3 percent rebound in November.

For the overall PPI, gains were primarily in food and energy. For the latest month, finished consumer food prices increased 1.7 percent while finished consumer goods excluding food rose 1.0 percent. Energy rose 2.5 percent in December, following a 6.1 percent rebound in November. December's increase was led by gasoline which increased 0.7 percent in December and by heating oil, up 4.0 percent.

Given that oil prices have fallen since this report, the energy spike is old news. However, food price pressure is likely to be a problem given the recent freeze in California's agricultural areas.

Housing jumps - but likely weather related
Housing is rebounding sooner than expected--perhaps helped by unseasonably warm weather. Housing starts jumped 4.5 percent in December, following a 6.4 percent rebound in November. Starts in December rose to an annualized pace of 1.642 million units from the revised 1.572 million units for November. On a year-on-year basis, starts are down 24.7 percent in December, compared to down 28.6 percent in November.

Housing permits rebounded 5.5 percent in December after a 2.6 percent decline in November. Permits stood at a 1.596 million unit pace in December, compared to1.513 million units in December. Permits are down 24.3 percent year-on-year in December, versus down 30.9 percent in December.

But the December jump in starts is likely related to unseasonably warm weather. The fact that there was a surge in multifamily starts in the Northeast corroborates that view. December is not typically when there is a jump in multifamily in the Northeast. If starts are atypically strong during winter months, then the seasonal factors exaggerate the gains.

The Census Bureau applies seasonal factors at a somewhat detailed level (by region and by type of start) and then seasonally adjusted components are added together for the seasonally adjusted total. But one can get an idea of the magnitude of this effect by comparing the ratio of seasonally adjusted total starts to not seasonally adjusted total starts. This would be an implicit seasonal adjustment ratio as seen below for each of the twelve months in 2006. During spring and summer the ratios are below "1" since those are the months that starts are typically high. During winter, starts are low due to cold and precipitation and this is seen with the seasonal adjustment ratios being significantly above "1." When unseasonably favorable weather boosts unadjusted starts, the impact on seasonally adjusted starts is greatest during winter months because the seasonal adjustment factors are the largest during those months. And that is a large part of the boost in starts in December. We can expect a technical softening in starts by spring when the seasonal adjustment factor is in the opposite direction.

Manufacturing picks up steam
Overall industrial production rebounded 0.4 percent in December, following a 0.1 percent decline in November. By sectors, manufacturing output jumped 0.7 percent in December, following no change in November. Mining output rebounded 0.8 percent in December after a 0.4 percent drop the prior month. Utilities output fell 2.6 percent, following a 0.2 percent rise in November. Most of the strength in manufacturing was in durables and was broad based.

Regional manufacturing surveys show factories in positive territory
Two regional surveys by Federal Reserve banks indicated that manufacturing is still healthy in January. The Philadelphia Federal Reserve's business activity index rose to a respectable 8.3 in January from a contractionary -2.3 in December. This index had been weak and had been a cause of concern by the markets that manufacturing was going into recession.

In contrast, the Empire State Index fell back sharply in January to 9.1 from 22.2 in December. This still was a positive number, however, indicating moderate growth.

Fed Speak - San Francisco's Yellen Says It All
Chairman Ben Bernanke and several others within the Fed System spoke last week. Bernanke focused on the long-term issue of federal deficits but said nothing about current conditions. On the other hand, early in the week San Francisco Fed President Janet Yellen gave her view on the economy and outlook. She hinted that the economy may be growing more than GDP indicates. She pointed to the strong growth in income as the reason for that suspicion. She also noted that unemployment remains tight. What stood out, however, was her comment that the October and November softness in the core CPI "has yet to show up in the data on any sort of a sustained basis." This was before the Thursday CPI report and her comments turned out to be prophetic. The core rate jumped from flat in November to 0.2 percent in December. And she and the other Fed members are well aware that a monthly 0.2 rate is over 2.4 percent annualized - above their comfort zone.

A the end of the week, Richmond Fed President Lacker and Kansas City Fed President Hoenig chimed in with similar concerns about inflation coming down too slowly. Hoenig used almost similar language as Yellen, saying that he wanted to see an easing in core inflation that was "not just temporary, but sustainable." The bottom line is that the latest industrial production, housing, and CPI numbers have put the Fed even more firmly in the wait and see mode rather than in a rate cutting mood.

Last week, fed funds futures rates rose further - especially for late in 2007. Currently, odds for a 25 basis point cut in the fed funds target are not greater than 50 percent until October.

The bottom line
We now have had two weeks with solid economic data and with little real improvement in inflation. Basically, the economy is near trend. There do not appear to be strong upside risks to economic growth, but it looks like its going to take longer for inflation to ease to a sustained pace within the Fed's comfort zone. With this scenario, one should bank on a healthy consumer sector and eventually a healthy housing sector. Manufacturing will remain moderate due to exports and healthy consumer spending. But financial sectors should not count on lower interest rates for some time.

Looking Ahead: Week of January 22 through January 26

Monday
The Conference Board's index of leading indicators rose 0.1 percent in November for a second month. More recently, we have had good news for a number of components, including housing starts and jobless claims.

Leading indicators Consensus Forecast for December 06: +0.3 percent
Range: +0.1 to +0.5 percent

Thursday
Initial jobless claims in the January 13 week fell 8,000 to an 11-month low of 290,000 with the four-week average down 6,500 to a 3-month low of 308,000. While there can be significant seasonal adjustment problems during holiday weeks such as with the MLK holiday shortened week, that does not appear to be the case. The labor market is the key area of concern for the Fed and markets will continue to focus on measures of how tight conditions are.

Jobless Claims Consensus Forecast for 1/20/07: 310,000
Range: 285,000 to 330,000

Existing home sales rose 0.6 percent in November to 6.280 million units. Gains were led by the condos component but the single-family category did show a modest gain. Currently, the key indicator that everyone is watching in housing is the supply number. Supply did edge down 1 tenth to 7.3 months in November but supply still needs to come down further before starts really pick up.

Existing home sales Consensus Forecast for December 06: 6.25 million-unit rate
Range: 6.05 to 6.35 million-unit rate

Friday
Durable goods orders increased 1.6 percent in November, following an 8.1 percent drop in October. Most of the November gain was due to a jump in aircraft orders. Excluding transportation (which includes aircraft), durables orders declined 0.5 percent in November, following a 0.9 drop in October. With conditions being positive in some of the regional manufacturing surveys, it is important to start getting some corroboration in national data. Also, the latest durables numbers will affect how the markets view the latest strong industrial production numbers - as part of a strengthening trend or just a one month up tick.

New orders for durable goods Consensus Forecast for December 06: +3.0 percent
Range: +1.1 percent to +8.7 percent

New home sales rose 3.4 percent in November to an annual rate of 1.047 million units. As with existing home sales, supply did ease, falling to 6.3 months vs. 6.7 months in October. A further decline in supply would be good for new construction but even holding steady would likely be seen as a positive given the significant decline in November.

New home sales Consensus Forecast for December 06: 1.05 million-unit rate
Range: 1.02 million to 1.10 million-unit rate