STOCKS
Equities rebounded smartly last week - even though investors were somewhat schizophrenic regarding the economy. The markets liked the reassurance from favorable housing reports - which boosted interest rates - and then also liked the interpretation of the FOMC statement that the Fed would be cutting rates because of a view that the economy was too soft. Starting out the week, Monday saw broad gains due to a number of deals and rumors of deals for buyouts and also bargain hunters came out after the prior week's decline. Frequently, investors sit on the sidelines just before the FOMC announcement - but not last Tuesday. The favorable housing starts report boosted investor confidence - equity gains were broad-based. Even sub-prime stocks rose as some investors saw long-term opportunities with these lenders. After the release of the FOMC statement Wednesday afternoon, stocks jumped sharply with the Dow posting its largest one-day point gain since last July. Techs were especially strong on Wednesday, led by strong earnings by Oracle and Adobe. Thursday was basically flat as Wednesday afternoon's euphoria wore off and pundits reconsidered the Fed statement and decided that the Fed was merely signaling that no further hikes are pending but also that rate cuts are not likely without an improved inflation outlook. Techs did give back some of the sharp Wednesday gain - but not much. Friday was sluggish as the favorable report on existing home sales helped to offset some of the sobering up over the real meaning of the FOMC statement.

Last week, the Dow was up 3.1 percent; the S&P 500, up 3.5 percent; the Nasdaq, up 3.5 percent; and the Russell 2000, up, 3.9 percent.

Year-to-date, major indexes are now back in the green after being down the prior week. The Dow is up 0.1 percent; the S&P500, up 1.3 percent; the Nasdaq, up 1.7 percent; and the Russell 2000 is up 2.8 percent.

BONDS
Interest rates firmed last week net despite a dip on Wednesday provided by the markets' interpretation of the FOMC statement that the Fed was moving to a balanced policy posture. Starting out the week, rates drifted up on Monday mainly over money moving out of bonds and into equities as investors saw equities as oversold. Rates generally slipped on Tuesday despite the favorable housing starts report - largely out of anticipation of the FOMC announcement on Wednesday afternoon. Wednesday afternoon, rates fell notably for 2-year, 3-year, and 5-year notes as investors read into the FOMC announcement that the Fed would likely be easing sooner than later. Markets reconsidered that view on Thursday and largely concluded that the Fed is still focusing more on inflation and is not likely to ease during the first half of 2007. Friday's report on improved sales for existing homes nudged rates up further. Strong gains in oil prices also supported rate gains Wednesday through Thursday.

Net for the week the Treasury yield curve was up with the biggest rate gains in the longer maturities. Yields were up as follows: 3-month T-bill, up 3 basis points; 2-year Treasury note, up 2 basis points; 3-year, up 2 basis points; 5-year, up 4 basis points; the 10-year bond, up 6 basis points; and the 30-year bond, up 10 basis points.

Over the last three weeks, the longer maturities have been trending up, reflecting the view that the economy is not quite as weak as earlier believed. The 3-month T-bill has eased, still on the expectation of the Fed cutting rates in the second half of this year.

Markets at a Glance

The Economy
Last week the markets got two favorable housing reports to bolster confidence in the economy. One came before the FOMC statement and one after. Only during a brief period Wednesday afternoon after the release of the FOMC statement was there much attention to the belief that the economy was too soft as some pundits read into the FOMC statement that the Fed saw weakness in the economy. By Thursday, most had reconsidered, saw inflation as still a problem and the second housing report corroborated that recession is not in sight.

Housing starts rebound but permits slow
The first housing report out last week was for housing starts which rebounded in February. February housing starts jumped 9.0 percent to a 1.525 million annual rate. February's gain followed a 14.3 percent drop the prior month. For the latest month, single-family starts rose 10.3 percent while multifamily starts advanced 4.1 percent. For the latest month, single-family starts rose 10.3 percent while multifamily starts advanced 4.1 percent.

Starts can be affected by favorable (and unfavorable) weather and this may have been the case. Housing permits are less affected by the weather and permits declined 2.5 percent to a 1.532 million unit pace from 1.571 million units in January. So, the improvement in starts must be tempered by a dip in permits. Nonetheless, even permits seem to have leveled off - signaling either the end or near the end of the recent decline in housing.

Existing home sales continue to rise, easing fears over housing
Existing home sales posted a healthy 3.9 percent gain in February, following a 2.7 percent increase the prior month. Sales have risen for three consecutive months. Sales in February were strongest in the Northeast, which rebounded 14.2 percent. Sales in other regions were little changed. However, supply actually edged up to 6.7 months from 6.6 months in both January and December but supply should be considered as reasonably balanced.

Also showing some modest improvement was the median price for an existing home sale, which rose 0.9 percent in February to $212,800. This is still well below last July's peak at $230,200 - down 7.6 percent. On a year-on-year basis, prices are down 2.6 percent, compared to down 3.5 percent in January. This bottoming in home prices is welcome news for supporting the consumer sector. Home equity refinancing is not likely to pick up due to sharp appreciation as in recent years but neither is the consumer going to be undermined by further declines in home values.

The Fed hints at pending rate cuts - or does it'
Last week revolved around the Fed's policy meeting and Wednesday release of the FOMC statement. As expected, the Federal Open Market Committee voted to keep the target for the federal funds rate unchanged at 5-1/4 percent. The vote was unanimous - 10 to 0. The Fed continued to emphasize its concern about inflation remaining too high but acknowledged that economic data have been mixed. The key controversy from the markets' perspectives is regarding the change in wording in the statement.

The FOMC statement no longer included a specific reference to "any additional firming" for potential policy moves but instead had more balanced wording - "Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information." Both the bond and equity markets were off and running with the view that the Fed would be cutting rates before August. The key part of the statement that the markets generally ignored on Wednesday was the Fed's wording on inflation. The Fed was clear to emphasize "the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected."

The important fact for the initial reaction by the markets is that the removing of "any additional firming" was in "the directive" portion of the statement. The "directive" portion of the statement is basically an instruction from the FOMC to the Fed's trading desk for open market operations at the New York Fed. This deletion in the directive was seen as moving from an anti-inflation bias to a balanced policy stance - upside risks are evenly balanced by downside risks as seen by the Fed. This is a traditional Fed watcher's view of the statement. In times past, the directive was more important since the trading desk had more responsibility for implementing policy in between FOMC meetings. The directive really carries no more weight today than the overall context of the full statement. The FOMC members are in more frequent contact and the Fed is focusing on short-term interest rates more than the more nebulous monetary growth rates as during the early 1980s.

Taken in full context, the statement clearly retains an anti-inflation bias and this is what the less traditional Fed watchers finally convinced everyone else to see.

Rounding out the anti-inflation concerns were explicit statements on that issue. "[T]he Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected." The FOMC also noted the continuing "the high level of resource utilization" - most likely focusing on tight labor markets.

Until the Fed changes the overall wording of the statement to reflect evenly balanced downside and upside risks, we will likely remain at least two FOMC meetings away from the first rate cut.

Volatility is back not just for equities but also for fed funds futures. Last week saw sharp daily movement in implied fed funds future rates - especially before and after the FOMC statement on Wednesday afternoon. Implied rates fell significantly Wednesday afternoon but rebounded Thursday and into Friday. Implied fed funds rates at Friday close were almost back to exactly where they were Tuesday before the FOMC statement and were actually higher than the prior week. The fed funds futures market is still calling for a cut in rates starting with the August FOMC meeting with a quarter point cut and then another by December.

The bottom line
First, fears about a housing recession appear to been overblown as starts and existing home sales have improved modestly. The Fed has signaled that it is not likely to raise rates but also indicated that inflation remains a key concern. In turn, the Fed also is not likely to lower rates soon. Essentially, we are still on the moderate, slightly below potential growth path for which the Fed has been aiming. We are still waiting for inflation to ease and that is one of the sticking points indicating that the economy is likely to be on a 2 to 2-1/2 percent growth path for a while.

Looking Ahead: Week of March 26 through March 30
Looking ahead, we get additional information on housing sales and on durable goods orders. While housing has begun to level off, manufacturing has been on the iffy side and durables orders will get more attention than usual. We also get an update on fourth quarter GDP and new information on the consumer sector with the February personal income report - with the core PCE deflator giving a new reading on the Fed's favorite inflation indicator.

Monday
New home sales fell a sharp 16.6 percent in January to an annual rate of 937,000 units -- the lowest rate in four years. Sales declined in all regions especially in the West where sales hit a 12-year low. Damping the prospects for any immediate improvement in housing construction, supply rose sharply to 6.8 months from 5.7 months in December. Weather may have cut sales in January with severe weather in parts of the U.S. at month-end, indicating that sales are not as soft as the numbers at face value. But more recently existing home sales for February continued to rise with a 3.9 percent rise in February. Markets will be watching to see if this carries over to new homes.

New home sales Consensus Forecast for February 06: 0.980 million-unit rate
Range: 0.900 million to 1.030 million-unit rate

Tuesday
The Conference Board's consumer confidence index strengthened further in February, rising to 112.5 from 110.2 in January. February's level is the highest since August 2001. Importantly, inflation expectations edged down one-tenth of a percentage point in February, providing some solace to Fed officials concerned over inflation remaining too high. Given the weakness in housing, it is important that consumer spending remain moderately healthy to keep the forward momentum in the economy. March should give some indication whether all of the heightened chatter in the financial markets regarding subprime lending problems has been given much attention by consumers.

Consumer confidence Consensus Forecast for March 07: 107.0
Range: 100.0 to 112.5

Wednesday
Durable goods orders fell a sharp 8.7 percent in January, following a 3.5 percent gain the prior month. January was led downward largely by lower aircraft orders for Boeing. Nonetheless, excluding transportation, durables were down 4.0 percent, compared to up 3.2 percent in December. Recent surveys on the manufacturing sector have been mixed for February and March and the February durables data will give the first comprehensive forward looking numbers for manufacturing.

New orders for durable goods Consensus Forecast for February 07: +3.4 percent
Range: +0.5 percent to +4.6 percent

Thursday
Fourth quarter real GDP was revised down last month to an annualized 2.2 percent from the initial estimate of 3.5 percent. The 1.3 percentage point revision was an atypically large revision and was mainly due to downward revisions to inventory investment and business fixed investment. The markets are not expecting much change in the GDP figure for the second revision. The main point is that real growth is moderately below the 3 percent estimate for long-term potential growth - and the Fed wants the economy a little below potential to bring inflation down. As long as GDP is not revised much up or down, the markets likely will not care and will then focus on Friday's personal income report which has much more current data on the consumer sector and on inflation.

Real GDP Consensus Forecast for final Q4 06: +2.2 percent annual rate
Range: +2.0 to +2.3 percent annual rate

GDP price index Consensus Forecast for final Q4 06: +1.7 percent annual rate
Range: +1.6 to +1.8 percent annual rate

Initial jobless claims recently have shown a firming in the labor market. First-time jobless claims fell 4,000 in the week ending March 17 to 316,000. The four-week average fell 3,750 to 326,000, a slightly elevated level but still under February levels near 340,000. Maintaining current claims levels or even posting only modest increases in the next week will strengthen the argument that employment may pick up in March from sluggish payrolls gains in January and February. The tight labor market is one of the Fed's continuing concerns and it is a tough balancing act between easing in the labor market versus losing too much momentum in the consumer sector from slower job and income growth.

Jobless Claims Consensus Forecast for 3/24/07: 320,000
Range: 310,000 to 324,000

Friday
Personal income jumped in January due partly to first-of-the-year increases in government salaries, private sector bonuses, and the exercise of stock options. Personal income jumped 1.0 percent in January, following a 0.5 percent boost in December. However, the special factors for January are not likely to be repeated in February. Sluggish employment gains for the month suggest modest gains in wages & salaries, leaving overall personal income soft.

Personal consumption expenditures advanced 0.5 percent in January, following a 0.7 percent increase in December.

With the Fed continuing to focus more on inflation than on soft economic growth, markets will be watching data on the core PCE price index - the Fed's favorite inflation indicator. The core PCE price index firmed in January with a 0.3 percent increase, following a 0.1 percent rise in December. The core CPI provides input for the bulk of the core PCE deflator and the core CPI index came in at 0.2 percent in February - 0.2411 percent unrounded. Markets have finally caught on to the fact that a monthly percent change rounded to one decimal place does not give enough detail on the trend - so pay attention to the monthly percent change to more decimal places. The unrounded percent change for the core PCE price index was 0.25401 percent for January, compared to 0.12672 percent in December.

Personal income Consensus Forecast for February 07: +0.3 percent
Range: -0.2 to +0.5 percent

Personal consumption expenditures Consensus Forecast for February 07: +0.3 percent
Range: +0.2 to +0.4 percent

Core PCE deflator Consensus Forecast for February 07: +0.2 percent
Range: +0.2 to +0.3 percent

The NAPM-Chicago purchasing managers' index fell to 47.9 in February from 48.8 in January, remaining below the break even level of 50. The Chicago index has been one of the softer regional indexes and is likely to remain that way for March. The February report showed new orders and backlogs slightly in negative territory (below 50) while inventories rose - all of which point to weak future activity.

NAPM-Chicago Consensus Forecast for March 07: 49.0
Range: 47.0 to 51.3

Construction spending fell 0.8 percent in January, following a 0.6 percent increase in December. January's figure was weaker than in recent months due to a flattening in nonresidential construction which has been on a moderate uptrend. Residential outlays remained on a decline as expected, while public outlays rose.

Construction spending Consensus Forecast for February 07: -1.0 percent
Range: -1.5 to -0.1 percent

The University of Michigan's Consumer sentiment index slipped in the preliminary report for March, falling 2.5 points to 88.8 - the lowest reading since September. However, the labor market and stock market have been improving and some of this might be rubbing off on consumers.

Consumer sentiment Consensus Forecast for final March 07: 88.8
Range: 87.0 to 89.8