STOCKS
Equities continue to be soft this year for the most part. Most major indexes declined but with the Russell 2000 pulling out a gain for the week with a boost on Friday. Even technology stocks slipped after being the one area of strength this year. The week got off to a bad start with widespread declines on Monday. Downgraded expectations for Pfizer and Boeing helped pull stocks down on Monday. On Tuesday, an oil rally helped boost the energy and commodities sectors. Several Dow components reported better-than-expected earnings. On Wednesday, Yahoo! and Sun Microsystems helped the Nasdaq jump 1.4 percent for the day. A number of key firms reported healthy earnings, including AT&T's Cingular, Corning, and cell phone chip maker RF Micro Devices. President Bush's State of the Union speech the night before also was seen as a positive. By end of day on Wednesday, the Dow had set another record close. The big hit for the week was Thursday, with the Dow losing more than 100 points during the session. A run up in bond rates pushed down financials such as American Express. Higher rates led to broad weakness in all markets but with the Nasdaq down the most. Friday was mixed with most markets drifting downward ahead of the FOMC meeting on January 30-31.

For the week, weakness in stocks was widespread but with small caps being an exception with a moderate gain. The Dow, the S&P500, and the Nasdaq were each down 0.6 percent for the week. The Russell 2000 posted a 0.4 percent increase.

Year-to-date, the Dow is up 0.2 percent; the S&P500, up 0.3 percent; the Nasdaq, up 0.8 percent; and the Russell 2000 is up 0.1 percent.

BONDS
Bond rates ended last week up significantly as market psychology turned toward Fed think - that is, worrying about how long the Fed will put off cutting rates or even whether the Fed will raise rates a notch or two. Thursday saw the most damage to bonds. Poor auction results, concern about the global trend in rates, and concern about Friday's durables and new housing sales caused the big change in psychology. Actual news of a healthy boost in durables orders and in new home sales just padded the rate gains slightly. The near end was little changed over the week.

Net for the week the Treasury yield curve is up noticeably except for the 3-month T-bill which was unchanged. Yields are up as follows: 2-year Treasury note, up 5 basis points; 3-year, up 8 basis points; 5-year, up 9 basis points; the 10-year bond, up 10 basis points; and the 30-year bond, up 12 basis points.

Rates have been trending upward over the last month or somewhat longer. Short-term rates have risen about 30 to 35 basis points since the end of November. Meanwhile, the long bond rate has risen about 40 basis points but since mid-December.

Markets at a Glance

The Economy
We only had a limited amount of economic news last week but it generally was upbeat. Durables orders have put to rest fears of any recession in manufacturing while housing sales indicate that sector is bottoming out.

Manufacturing is rebounding as durables orders post broad-based increase
With the latest report on durables orders, talk of pending recession in manufacturing has all but disappeared. New factory orders for durable goods orders increased 3.1 percent in December, following a 2.2 percent rebound in November. The rebound was led by the transportation component but was still healthy in other components. Excluding the volatile transportation component, new orders advanced 2.3 percent, following a 1.0 percent dip in November.

Within transportation, a jump in orders for civilian aircraft more than offset a drop in orders for defense aircraft - both of which are volatile series. Importantly, we saw a boost in new orders for motor vehicles, which rose 6.8 percent in December, following a 2.3 percent increase in November. The auto industry was one of the two soft spots in the economy along with housing. Now both of the soft sectors are showing signs of strengthening.

Strength in orders in December was broad-based with gains seen in primary metals, fabricated metals, machinery, computers & electronics, transportation equipment, and in "other." Of major categories, only electrical equipment declined.

Year-on-year, new orders for durable goods rose to up 2.6 percent from up 0.4 percent in November. Unfilled durables orders firmed to up 20.6 percent year-on-year December from up 20.5 percent in November.

New home sales begin to pull housing out of recession
Housing has been the biggest drag on the economy - being in a sharp downturn since mid-2005. We now have seen new home sales up for two consecutive months as new home sales rose 4.8 percent in December, following a 7.4 percent jump in November. December's annualized sales pace of 1.120 million is still 11.1 percent below the December 2005 sales pace.

Importantly, supply declined to 5.9 months from 6.1 months in November. A decline in supply is needed before builders will push starts back up - not counting the weather-related quirks boosting starts temporarily in December. The combination of higher sales and declining stocks to sales indicates that the worst is over or almost over for housing.

For the year, new single-family home sales were down 17 percent for the nation as a whole. By region, weakness was most pronounced in the West followed by the Northeast and Midwest with declines of 25 percent, 21 percent, and 20 percent, respectively. These are the regions that had the highest earlier appreciation, also. The South saw only an 11 percent decline in sales last year.

By volume, the South still outpaces the other Census regions significantly. This region includes the large Florida and Texas home-building areas.

Existing home sales slip but inventories drop further
Existing home sales slipped 0.8 percent in December to a 6.22 million annual rate. In its report, the National Association of Realtors described the latest figure as a "bottoming out" in sales. Sales, indeed, have been essentially flat for four months, showing no notable continuation of a downtrend. Nonetheless, December sales were down 7.9 percent on a year-ago basis.

But fewer homes went on the market and the stocks to sales figure eased in December to 6.8 months from a very high 7.3 months in November. The drop in stocks will add to homebuilders ability to build new homes as existing homes compete with new homes.

For all of 2006, existing home sales were down 8.4 percent - the largest yearly decline in 17 years.

Home prices stabilize
Good news for the consumer is that home prices have stabilized and do not appear to be declining. New home prices were up 1.2 percent in December, following a 7.9 percent increase in October and a 5.1 percent dip in November. Existing home prices were up 2.3 percent in November, following a decline of 0.9 percent in both October and November. But the bottom line is that as of December prices appear to have leveled off. This is good for consumer confidence and for homebuilders.

While the year-on-year trend is soft, prices have firmed in recent months with prices essentially on a flat trend instead of declining. Existing home prices are up 0.2 percent year-on-year in December while new home prices are down 1.5 percent.

The bottom line
For most of January, economic data have clearly been coming in positive but not overly robust. Housing and manufacturing are turning around. While some are disappointed that the Fed will not likely be easing soon, the bottom line is that the economy is still near a soft landing. At worst, only a modest mid-course correction is needed by the Fed.

Based upon the January 25 market close, the federal funds futures contract for the February 2007 expiration is currently pricing in only a 2 percent probability that the FOMC will decrease the target rate by at least 25 basis points from 5-1/4 percent at the FOMC meeting on January 31. The markets see a 98 percent probability of no change in the fed funds target.

Over the last month, market expectations for a cut in the fed funds rate have steadily declined. That is the same as the fed funds futures rate drifting back up to a no change position as seen below. The fed funds futures markets see no odds on chance (greater than 50 percent probability) of a rate cut before December 2007.

Looking Ahead: Week of January 29 through February 2
Looking ahead, the Fed has a two-day FOMC meeting on Tuesday and Wednesday with the policy statement being released Wednesday afternoon. But the Fed will get a chance to review a boat load of important economic data beforehand on Tuesday and Wednesday mornings - including the first peek at fourth quarter GDP and employment costs. And, of course, we start Friday off with the all important employment situation report.

Tuesday
The Conference Board's consumer confidence index is finally responding to improvements in the economy. The Conference Board's index rose to 109.0 in December from 105.3 in November and is even up notably from 103.8 in December last year. Importantly, confidence in both the present situation and in the future outlook both showed gains, indicating that the consumer will continue to be willing to spend and contribute to economic growth. But 12-month inflation expectations rose to 4.8 percent from 4.6 percent. The Fed certainly will be watching for the inflation-expectation numbers as the FOMC's two-day meeting starts the same day the Conference Board's report is released.

Consumer confidence Consensus Forecast for January 06: 110.0
Range: 107.5 to 111.0

Wednesday
Third quarter real GDP growth was revised down slightly to 2.0 percent annualized growth from the prior estimate of 2.2 percent. Wednesday we get our first look at fourth quarter GDP and the Fed will checking to see if the economy is running below the general estimate of 3 percent for long-term potential and to see if there is any improvement in the core PCE deflator. The consensus believes GDP will come in a little above trend with a 3.1 percent gain. The core deflator for PCEs rose 2.2 percent in the third quarter, following a 2.7 percent increase in the second quarter. The overall GDP price index rose only 1.9 percent in the third quarter due to some assistance from declining oil prices. The third quarter GDP price index had posted gains of 3.3 percent in each of the prior four quarters.

Real GDP Consensus Forecast for advance Q4 06: 3.1 percent annual rate
Range: 2.8 to 3.6 percent annual rate

GDP price index Consensus Forecast for advance Q4 06: 1.5 percent annual rate
Range: 0.5 to 2.0 percent annual rate

The employment cost index for civilian workers rose a quarter-to-quarter 1.0 percent in the third quarter, up a little over the 0.9 percent rise in the second quarter and the fastest rise in more than two years. Rising labor costs have been a key concern for the Fed.

Employment cost index Consensus Forecast for Q4 06: 1.0 percent simple quarterly rate
Range: 0.9 to 1.5 percent simple quarterly rate

The NAPM-Chicago purchasing managers' index posted a moderate rise to 52.4 in December from 49.9 in November. This rebound was key to the markets revising their view that manufacturing might be headed for recession.

NAPM-Chicago Consensus Forecast for January 07: 52.0
Range: 50.9 to 54.0

Construction spending slipped 0.2 percent in November, following a 0.3 percent dip in October. November's decline was led by private residential construction as both private nonresidential and public outlays posted gains. More recently, we have seen a pick up in housing starts and that may translate into a boost in residential outlay - which would lead to a sizeable increase in overall outlays if nonresidential and public outlays hold up. However, any boost in residential outlays would essentially be a weather-related event tied to an unseasonably warm and dry winter thus far.

Construction spending Consensus Forecast for December 06: 0.1 percent
Range: -0.4 to +1.2 percent

The FOMC announcement for the January 30-31 FOMC policy meeting is expected to leave the Fed funds target unchanged at 5-1/4 percent.

FOMC Consensus Forecast for 1/31/07 policy vote on fed funds target: unchanged at 5-1/4 percent
Range: Ninety-eight percent probability for no change based on the Fed funds futures close, January 25, 2007

Thursday
Initial jobless claims jumped 36,000 in the week ending January 20 to a much higher-than-expected and disappointing level of 325,000. But the week included Martin Luther King Day Jr. Day which may have skewed the results. So, the markets are expecting a large drop in initial claims but if that happens much of it will merely be a technical improvement - that is, unless they fall more than 36,000.

Jobless Claims Consensus Forecast for 1/27/07: 315,000
Range: 310,000 to 325,000

Personal income rose 0.3 percent in November - the same as in October. While income growth remained moderately healthy, inflation numbers looked very good with overall numbers still soft due to lower oil prices. The overall PCE deflator firmed to 0.0 percent (no change) in November, following a 0.2 percent drop in October. The core PCE deflator fell to 0.0 percent (no change) in November, following a 0.2 percent gain in October. However, the consumer price index rebounded in December to 0.5 percent from no change in November and the core CPI firmed back to 0.2 percent in December, also up from no change in November. The Fed will be watching the core PCE deflator number closely even though the FOMC meeting will have ended the day before this release.

Personal income Consensus Forecast for December 06: +0.5 percent
Range: +0.5 to +0.8 percent

Personal consumption expenditures Consensus Forecast for December 06: +0.7 percent
Range: +0.5 to +0.8 percent

Core PCE deflator Consensus Forecast for December 06: +0.2 percent
Range: +0.1 to +0.2 percent

The Institute for Supply Management's manufacturing index rebounded back into positive territory in December to 51.4, up from a 49.5 reading in November. After last week's strong durables orders report for December, this will be the first comprehensive look at manufacturing in January.

ISM manufacturing index Consensus Forecast for January 07: 52.0
Range: 50.4 to 53.0

Motor vehicle sales have surprised many with recently strong numbers as sales jumped to a 12.7 million annual rate in December from 12.1 million in November. Strong sales recently have translated into healthy orders and production numbers and another healthy month of sales will be seen as giving manufacturing a solid boost.

Motor vehicle sales Consensus Forecast for January 07: 12.9 million-unit rate
Range: 12.7 to 13.1 million-unit rate

Friday
Nonfarm payroll employment was on the strong side in December with a 167,000 boost in December, following a revised 154,000 gain in November. These recent gains are likely too strong to ease tightness in the labor markets and to help ease wage inflation. In fact, average hourly earnings posted a sharp 0.5 percent increase in December, following a 0.3 percent rise in November. And the civilian unemployment rate remains low at 4.5 percent in December.

Nonfarm payrolls Consensus Forecast for January 07: 160,000
Range: 20,000 to 200,000

Unemployment rate Consensus Forecast for January 07: 4.5 percent
Range: 4.4 to 4.6 percent

Average workweek Consensus Forecast for January 07: 33.9 hours
Range: 33.9 to 40.0 hours

Average hourly earnings Consensus Forecast for January 07: +0.3 percent
Range: +0.2 to +0.4 percent

The University of Michigan's consumer sentiment index jumped sharply to 98.0 at mid-month from 91.7 in December. Gains were centered in the expectations component. Friday's report will provide an update on December with more complete numbers for the month.

Consumer sentiment index Consensus Forecast for final December 06: 98.0
Range: 94.0 to 98.0

Factory orders rebounded 0.9 percent in November, led by a surge in durables. However, last week's advance report on durables showed a 3.1 percent in December and should boost overall factory orders for the month. With the firming in oil prices during December, the nondurables component will also likely be positive.

Factory orders Consensus Forecast for December 06: +1.9 percent
Range: +1.0 to +3.5 percent