BONDS
The Federal Open Market Committee (FOMC) met on December 13 and voted unanimously to raise its target fed funds rate by 25 basis points to 4.25 percent. As we have seen in the past, Fed rate hikes don't always translate into higher market rates. Moderate economic growth coupled with friendly inflation news helped to keep down market rates. Treasury yields are lower this week than last week!

As we head into the final two weeks of the year - and holidays galore - markets are bound to be thin (unlike many waistlines after the Christmas cookies). If anything, we are likely to see deeper markets in the first half of the upcoming week since several market-moving indicators will be reported (such as housing starts and the PPI).

Markets at a Glance

The Economy
CONSUMER PRICE INDEX DROPS
The consumer price index fell 0.6 percent in November reversing at least some of the previous months' gains. According to the Bureau of Labor Statistics, this was the largest one-month drop since July 1949 when the CPI fell 0.9 percent. It posted a similar 0.6 percent drop in March 1986, also a period of falling energy prices. And indeed, energy prices plunged 8 percent in November. Gas & electricity prices did post a 2.1 percent gain (and were 20.1 percent higher than a year ago), but fuel oil dropped 4.3 percent and gasoline prices plummeted a whopping 16 percent in November after falling 4.5 percent in October. It does feel good to pay lower gas prices. I paid $1.999 per gallon the other day and was truly excited. But gas prices remain 16.1 percent above year ago levels. And to think we complained last year about high gas prices!

The core CPI (excluding food & energy prices) increased 0.2 percent in November, on par with the previous month but twice as much as the 0.1 percent gains posted in August and September. Lodging away from home (includes hotel and student dorms) costs continue to rise, up 1.3 percent in November after a 3.5 percent spurt in October. The costs of water, sewer & trash collection have accelerated in the past three months, as have medical care costs. Education costs are also on the upswing.

Market players are talking about the slight variation in the Fed's post-FOMC meeting statement and coming to the conclusion that the Fed will soon stop raising rates. It is indeed possible that the rate raising cycle will come to an end in 2006, but the Fed will need to keep a close watch on inflation. And while the core CPI moderated from its high, it remains above 2 percent (year-over-year) and this may be too much for the Fed. Granted, they monitor the PCE deflator, which tends to show a lower rate of inflation than the CPI, but it is based on the CPI.

The producer price index will be reported next week. There is not much in the CPI that can tell us about the PPI since the CPI is largely focused on prices in the service sector. However, the import price index for November posted a 1.7 percent drop, stemming from an 8 percent drop in petroleum import prices. Often, the petroleum import price index will move in tandem with the energy component of the PPI, and this bodes well for the November PPI.

RETAIL SALES: WEAKER THAN WALL STREET EXPECTED IN NOVEMBER
Retail sales inched up 0.3 percent in November, matching the gains of the two previous months. The auto group posted a moderate 2.6 percent hike after declining sharply in the past three months. Excluding autos, retail sales fell 0.3 percent. This appeared to cause a rending of garments among financial market players who were disappointed with the "weak" figure. (Although it should have delighted bond investors.) But this figure hides the underlying strength of November retail sales. Sales at gas stations fell 5.9 percent in November - but remember that gasoline prices plunged 16 percent during the month! This is truly a price phenomenon. That's why we like to exclude gas station sales along with auto sales to arrive at a "core" retail sales figure. Retail sales excluding autos and gas posted a healthy 0.5 percent during the month. Considering the heavy discounting going on at retailers, I wouldn't be surprised to see a stronger real (inflation-adjusted) growth rate for the month. Does this mean holiday sales will be robust - beyond expectations' Not likely based on the weekly indicators and anecdotal evidence. But the November figures should not be considered weak by any means.

INDUSTRIAL PRODUCTION POSTS SOLID GROWTH IN NOVEMBER
The index of industrial production increased 0.7 percent in November after an upward revised gain of 1.3 percent in October. Manufacturing production inched up only 0.3 percent after gaining 1.8 percent in October and utilities production also increased 0.3 percent after posting sharp declines in the two previous months. Production of mining surged 4.8 percent, recovering at least some of September's whopping 9.6 percent plunge. But mining production is still 6.1 percent weaker than a year ago.

Among the major market groups, production of consumer goods fell 0.8 percent (primarily due to a drop in auto & truck assemblies), while production of business equipment increased 1 percent and nonindustrial supplies increased 0.7 percent while materials rose 1.8 percent. Production in the high tech industry appears relatively sluggish these days at 26 percent (year-over-year) compared to the booming days of five years ago. But high tech production is significantly stronger than just about any other category. The next strongest category is aerospace with an 11.3 percent yearly gain. It should come as no surprise to see the sluggish activity in motor vehicles.

The outlook for December may be positive. Both the Philadelphia Fed's business outlook survey and the Empire State Manufacturing survey showed improvement in December figures. This may not point to accelerating production growth, but it does point to gains instead of declines.

The Fed's post-meeting statement mentioned resource utilization as a potential issue for them. Resource utilization can refer to the labor market as well as the capacity utilization rate in the industrial sector. In November, the capacity utilization rate increased to 80.2 percent, nearly reaching the pre-Katrina level. In the manufacturing sector, the operating rate is lower, remaining at 79.4 percent in November. Historically, the capacity utilization rate signaled impending inflationary pressures when it surpassed 80 percent - but usually much closer to 85 percent. It is important to keep in mind, though, that we are a global economy and global capacity constraints matter more than just domestic ones.

INTERNATIONAL TRADE DEFICIT WIDENS IN OCTOBER, BUT 3Q CURRENT ACCOUNT IMPROVES
The international trade deficit on goods and services widened again in October with a $68.9 billion shortfall. Notice the sharp two-month deterioration relative to the August trade deficit. Exports fell in September and the October rise was not sufficient to bring the level of exports back to August levels. Consequently, exports are posting smaller and smaller year-over-year gains. In contrast, the yearly gains in imports have been on the rise in the past few months. Of course, some of this is due to higher crude oil prices over a year ago. We are also importing more nonauto capital goods lately. This is partly good news since capital goods spending improves our productive capacity and one can't say that about increases in consumer goods (these are also higher lately).

The sharp deterioration in the international trade deficit on goods was evident in the third quarter's current account balance. However, the balance on services managed to post a slightly larger surplus than in the second quarter. Also, the balance on investment income was slightly positive, reversing from the deficit in the second quarter. And hurricanes Katrina and Rita led to insurance payments from abroad. Consequently, our unilateral transfers narrowed significantly in the third quarter, helping to lead to a slight narrowing of the current account balance. However, this small narrowing of the current account balance is due to "special factors," not inherent improvement in the U.S. trade position. This does not help the foreign exchange value of the dollar at all!

The Bottom Line
Economic indicators showed a fairly healthy economic picture for November with moderately healthy industrial production and retail sales and an improvement in inflation. While market players and the Fed would also like to see the core CPI show improvement, consumers spend a good deal of their income on gasoline - and the sharp drop in prices in the past month is surely promising. Despite a Fed rate hike, market rates once again declined. Consumers won't necessarily benefit from the lower market rates since their home equity loans and credit cards are tied to banks' prime rate, now at 7.25 percent.

Several market moving indicators will be closely monitored this upcoming week - particularly the producer price index and housing starts. Durable goods orders will be important for those who don't take off next Friday! But markets are bound to be thin in the final two weeks of the year.

Looking Ahead: Week of December 19 to 23
Tuesday
The producer price index increased 0.7 percent in October due primarily to a 4.1 percent jump in energy prices. Excluding energy and food, the PPI fell 0.3 during the month. Petroleum import prices plunged 8 percent in November and this bodes well for the energy component of the PPI since the two often move in tandem.

PPI Consensus Forecast for Nov 05: -0.5 percent
Range: -1.1 to 0.2 percent

PPI ex food & energy Consensus Forecast for Nov 05: 0.2 percent
Range: 0.1 to 0.4 percent

Housing starts decreased 5.6 percent in October to a 2.014 million-unit rate with declines in both single-family and multi-family construction. While housing activity should moderate, housing starts do jump around from one month to the next, so it is important to look at the 6-month moving average, the period that the Census Bureau claims it takes to establish a trend.

Housing starts Consensus Forecast for Nov 05: 2.00 million-unit rate
Range: 1.95 to 2.12 million-unit rate

Wednesday
Last month, the Commerce Department estimated that real GDP expanded at a 4.3 percent rate in the third quarter of 2005 with healthy gains in consumption expenditures and investment spending. By the third release of these quarterly figures, revisions are usually small since only small segments of the report are missing.

Real GDP Consensus Forecast for Q3 05: 4.3 percent annual rate
Range: 4.0 to 4.5 percent annual rate

GDP deflator Consensus Forecast for Q3 05: 3.0 percent annual rate
Range: none

Thursday
New jobless claims inched up 1,000 in the week ended December 10 to 329,000, bringing up the 4-week moving average level to 328,750. The number of new claims attributed to Hurricanes Katrina, Rita and Wilma were 2,500 in the week but the total has been diminishing rapidly.

Jobless Claims Consensus Forecast for 12/17/05: 325,000
Range: 315,000 to 334,000

Personal income increased 0.4 percent in October, in line with recent average monthly gains. Look for similar gains in November based on the employment situation. Personal consumption expenditures inched up 0.2 percent in October due to declines in durable goods. Consumption expenditures will look depressed in November, but some of this is price related and the real (inflation-adjusted) figures may look better than the data in current dollars. Market players are also interested in the core PCE deflator which is expected to rise about 0.2 percent for the month.

Personal income Consensus Forecast for Nov 05: 0.3 percent
Range: 0.2 to 0.6 percent

Personal consumption expenditures Consensus Forecast for Nov 05: 0.4 percent
Range: 0.2 to 0.7 percent

Some components of the index of leading indicators were positive in November: stock prices, consumer expectations and jobless claims. Some components posted declines: the factory workweek and vendor performance.

Leading indicators Consensus Forecast for Nov 05: 0.4 percent
Range: 0.2 to 0.6 percent

Friday
New orders for durable goods jumped 3.4 percent in October with substantial gains in the volatile transportation sector. Orders were not so healthy otherwise, with declines in key components such as primary metals, computers, and electrical equipment.

Durable goods orders Consensus Forecast for Nov 05: 1.0 percent
Range: -1.0 to +2.7 percent

New single-family home sales surged 13 percent in October after some weakness in August and September. The MBA purchase index was up in November even though interest rates were on the rise.

New home sales Consensus Forecast for Nov 05: 1,300,000 unit rate
Range: 1,250,000 to 1,415,000-unit rate

At the mid-December reading, the University of Michigan's consumer sentiment index increased about seven points, rising to 88.7. No doubt, consumers are feeling more optimistic now that gasoline prices have declined from their highs.

Consumer sentiment Consensus Forecast for Dec 05: 89.5
Range: 88.7 to 92

Looking Ahead: Week of December 26 to 30
Monday
Several Holidays Observed today

Wednesday
The Conference Board's consumer confidence index jumped 13.7 percentage points in November to 98.9. At least two other confidence measures have increased in December and this bodes well for the report. Labor market conditions are improving and gasoline prices are falling from their highs.

Consumer confidence Consensus Forecast for Dec 05: 100.5
Range: 99 to 105

Thursday
New jobless claims are remaining in a tight range in recent weeks, even as claims related to hurricanes Katrina, Rita and Wilma have diminished. Continuing claims have come down from their highs but have not reached new lows yet this year.

Jobless Claims Consensus Forecast for 12/24/05: 323,000
Range: 320,000 to 325,000

Existing home sales declined 2.7 percent in October to a 7,090,000-unit rate. Existing home sales tends to lag new home sales by a month since they are based on closings rather than contract signings. Following the new home sales pattern, existing home sales could post a rise in November.

Existing home sales Consensus Forecast for Nov 05: 7.02 million-unit rate
Range: 6.80 to 7.10 million-unit rate

Friday
The NAPM-Chicago's business barometer fell back to 61.7 in November. This index, which measures both manufacturing and non-manufacturing activity in the Chicago region, is often considered a leading indicator for the ISM manufacturing index. The Fed surveys were mixed in December with the New York area showing faster growth then the Philadelphia region.

NAPM-Chicago Consensus Forecast for Dec 05: 60
Range: 58 to 61.5