Futures for oil prices are down somewhat over $1 per barrel for November and December 2006 contracts compared to the prior week. For contracts for 2007 and into 2008, futures were little changed, net for the week with crude sticking to a $62 to $67 per barrel range.

STOCKS
Stocks ended the week up significantly despite initial concerns over the report of a nuclear bomb test by North Korea over the prior weekend. Record close highs for the Dow were set consecutively Monday and Tuesday and then again Thursday. Despite an initial dip due to concerns over North Korea, stocks ended Monday on the upside and were led by technology companies. After the close, Google announced plans to buy YouTube and helped boost equities on Tuesday. Oil dipped below $59 per barrel, also helping boost stocks outside the energy sector on Tuesday. However, earnings season got off to a slow start as company earnings by a number of key companies such as Alcoa were coming in a little below expectations. Equities gave up Monday and Tuesday gains on Wednesday, pushed down by soft earnings reports, concerns over the crash of a small private plane into a New York high-rise apartment building, and the Fed's FOMC minutes which indicated greater concern over inflation than previously believed. On Thursday, earnings reports were much stronger and gave a sharp boost to equities. The widening of the U.S. trade gap was viewed by the markets as indicating a slowing in the economy. Equities continued to rise on Friday, setting another record close, despite hawkish remarks by Federal Reserve Bank of Chicago President Michael Moskow that the Fed still may need to raise interest rates. Healthy earnings reports carried the day.

BONDS
Interest rates ended the week up significantly due to strong economic data and the end of week firming in oil prices. Bond markets were closed on Monday due to the Columbus Day holiday. On Tuesday, bond traders began anticipating strong economic data later in the week by pushing prices down and rates up. Treasuries also declined due comments by Federal Reserve Bank of Dallas President Richard Fisher that the current rate of inflation is too high and that the decline in housing would not pull down the rest of the economy. Safe haven effects related to concerns over North Korea were minor and clearly were overwhelmed by downward pressure on bond prices. On Wednesday, the Fed released minutes of the September 20 FOMC meeting and were interpreted as hawkish - concern on inflation remains strong by Fed members. On Thursday, bonds were little changed. Friday's strong retail sales numbers and an increase in oil prices lifted interest rates notably. Federal Reserve Bank of Chicago President Michael Moskow also helped to nudge rates higher. The 10-year bond yield ended the week at a three-week high.

Net for the week the Treasury yield curve was up from 10 to 12 basis points with even the short end up sharply. The 3-month bill was up 12 basis points; 2-year Treasury note, up 12 basis points; 3-year, up 12 basis points; 5-year, up 12 basis points; 10-year bond, up 10 basis points; and 30-year bond, up 10 basis points.

Markets at a Glance

The Economy
Last week, some key economic data were pulled down by lower oil and gasoline prices. But the net effects were quite positive.

Retail sales robust despite negative headlines
Lower oil prices probably had their biggest impact on retail sales. Despite quirks with the headline numbers, lower gasoline prices clearly helped to fuel consumer spending in September. First, overall retail sales fell 0.4 percent in September, following a 0.1 percent increase in August. But the decline was almost entirely (not quite) due to a sharp drop in gasoline prices and gasoline dollar volume sales. Gasoline station sales fell a monthly 9.3 percent - record drop for this new version of the retail sales data going back to 1992. Excluding gas station sales, retail sales for September posted a 0.6 percent advance, following a 0.2 percent gain in August. Motor vehicle sales were flat in September and excluding both gas station and motor vehicles components, sales increased a robust 0.8 percent in September, following a 0.4 percent advance in August.

Sales gains were broad-based - indicating the consumers have been spending the added discretionary income from lower gasoline prices. Strong gains were seen in clothing, sporting goods, general merchandise, non-store retailers, miscellaneous stores, and even in building materials. By major category, the only declining components were the already noted gasoline sales and also food & beverage stores. Interestingly, despite the large drop in gasoline sale dollar volume, real sales were probably up as lower costs encouraged a little more liberal use of motor vehicles.

Year-on-year, overall sales are up 5.5 percent, down from 6.4 percent in August. Excluding motor vehicles, year-on-year sales slipped to 5.5 percent from 7.5 percent in August. Excluding motor vehicles and gas station sales, year-on-year sales rose to 7.3 percent from 7.1 percent in August.

Lower oil prices also helped strengthen the consumer sector as seen in last week's consumer sentiment numbers. The University of Michigan's consumer sentiment index jumped to 92.3 in mid-October from 85.4 in September. Lower oil prices are putting consumers in a better mood while at the same time adding to their spending power - a combination that certainly is making retailers a little more optimistic heading into the holiday season.

The U.S. trade gap widens but actually points to strong economy
The international trade data lag most other economic data for the U.S. economy, and last week we saw numbers for the August trade situation with oil prices playing a major role - only for this report prices were still rising. The U.S. trade gap set another record high at $69.9 billion in August, compared to the prior record of $68.0 billion in July. Much of this widening was due to higher oil prices. This is seen in the merchandise trade data. The merchandise trade gap widened to a record $73.9 billion from $72.0 billion in July. But excluding petroleum, the goods trade gap rose to $46.7 billion from $46.3 billion in July - a mere $400 million dollar widening compared to $1.9 billion for the trade gap overall.

Many in the markets took the widening trade gap to indicate a slowing economy. Certainly, net exports are currently a negative in the GDP calculations but just doing the GDP accounting does not explain the dynamics. Both exports and imports rose in August, up 2.3 percent and 2.4 percent, respectively. We have seen a resumption of the uptrend in exports and this is a positive for manufacturing. On the export side, merchandise gains were strong except in autos. Increases were seen in foods, feeds & beverages, industrial supplies, capital goods and in consumer goods.

On the import side, merchandise gains were, of course, led by industrial supplies - which includes crude oil imports. But there also were strong increases in capital goods and consumer goods. These categories would not be so robust if businesses were not planning expansion or expecting healthy consumer spending.

The bottom line is that contrary to the typical market view of last week's trade report, the data suggest a strong U.S. economy.

Oil prices pull down import prices
Declining oil prices pulled down overall import prices by 2.1 percent in September, following a 0.8 percent boost the month before. September's figure was the first decline in six months and the steepest in nearly 3-1/2 years. Petroleum prices fell 10.3 percent in September - the largest drop since 11.4 percent in December 2004. Even excluding petroleum, import prices slowed to a 0.1 percent increase from 0.5 percent in August. This deceleration was welcome in the markets after the surge in August raised inflation fears.

Most of the price pressure in non-petroleum import prices was for non-petroleum industrial supplies. Prices for consumer goods and for capital goods were actually soft. Import prices for consumer goods decelerated to 0.1 percent monthly gains in both August and September after a 0.6 percent spike in July. Prices for imported capital goods were flat in both August and September.

On a year-on-year basis, overall import price inflation dropped to 2.0 percent from 6.3 percent August. Petroleum import prices fell to a 2.9 percent year-on-year rate from 22.6 percent in August while non-petroleum import price inflation slipped to 2.0 percent from 2.9 percent the prior month.

The latest import price numbers indicate that import prices may actually start to help bring down both the overall CPI and also the core CPI.

Fed Minutes and Beige Book point to soft landing taking longer
Last week the Fed was again in the news with the release of FOMC minutes and the Beige Book. Both indicated a healthy economy outside of housing and autos. There were several items suggesting that the Fed still sees a relatively robust economy and still must consider additional interest rate hikes if necessary. In particular, it was noted that the consumer sector is strengthening, nonresidential construction continues to be robust, and manufacturing is rebounding.

The minutes of the September 20 FOMC meeting indicated that the Fed was more comfortable with its decision to not raise the fed funds rate. But it also was evident that many members of the FOMC remain concerned that inflation will remain unacceptably high despite some easing in inflation. What is new from the minutes is that the Fed is forecasting a rebound in housing in 2007 and is projecting lower potential growth for the economy. Both factors reduce the odds of a near-term reduction in interest rates.

More Fed officials are taking a hawkish tone. Last week Federal Reserve Bank of Chicago President Michael Moskow joined other members of the FOMC indicating that there could be additional interest rate increases needed to bring inflation down to an appropriate level. Other Fed official that recently have indicated that inflation may not come down enough with current interest rates include Fed Vice Chairman Donald Kohn and Federal Reserve regional bank presidents Lacker (Richmond), Fisher (Dallas), Plosser (Philadelphia), and Poole (St. Louis).

Last week's robust retail sales numbers clinched the view that the Fed is not likely to reduce interest rates soon.

In turn, the markets have sharply revised their opinions regarding near-term interest rate cuts. The fed funds futures market has sharply reduced the odds of any Fed rate cuts before June 2007.

The bottom line
The economy still appears to be on a soft landing. Lower oil prices clearly are helping but the economy seems stronger than what either the markets or the Fed had been projecting just a few weeks ago. For now, the Fed seems cautiously content to see if current interest rates will achieve the soft landing. Certainly, the Fed is not leaning to cut rates immediately but the current strength in the economy leaves room for further gains in equities even without immediately pending rate cuts.

Looking Ahead: Week of October 16 to October 20

Monday
Empire State manufacturing index edged higher in September to 13.84 vs. 11.04 in August. However, last month we saw moderation in new orders from the New York survey - suggesting future slowing. Separately, the Beige Book more recently indicated a pick up in manufacturing and we could see a rise in both the overall Empire State index as well as orders.

Empire State Manufacturing Survey Consensus Forecast for October 06: 11.0
Range: 6.0 to 15.0

Tuesday
The producer price index rose only 0.1 percent in August, following a 0.1 percent increase in July. The core rate actually fell 0.4 percent, following a 0.3 percent decline in June. We have since seen oil prices drop sharply and import prices come in weak. We can expect a notable decline in the overall PPI from oil prices. However, a repeat of the decline in the core rate is unlikely.

PPI Consensus Forecast for September 06: -0.7 percent
Range: -1.2 to -0.1 percent

PPI ex food & energy Consensus Forecast for September 06: +0.2 percent
Range: 0.0 (no change) to +0.3 percent

Industrial production edged down 0.1 percent in August, following an increase of 0.4 percent in July. We have had conflicting information on the direction of output in September. Aggregate manufacturing production worker hours fell 0.7 percent in September while the Fed's Beige Book reported gains in manufacturing. Manufacturing "may" be strengthening on the margin but the production worker hours data weigh heavily in initial estimates for industrial production. The markets think these two effects will offset with the forecast for no change but the aggregate hours are more likely to prevail.

Industrial production Consensus Forecast for September: 0.0 percent (no change)
Range: -0.5 to +0.3 percent

Capacity utilization Consensus Forecast for August 06: 82.2 percent
Range: 81.3 to 82.6 percent

Wednesday
The consumer price index rose 0.2 percent in August, following a 0.4 percent jump in July. As with the PPI we should see a weak headline number due to declining oil-related prices - such as gasoline and heating oil in the CPI. With consumer spending remaining robust - except for auto sales - will there be any softening in the core rate' Autos will probably help but we need to see a softening in housing rents for notable progress and we may not yet see that despite the weakening in the housing market. High interest rates actually keep apartment demand high.

CPI Consensus Forecast for September 06: -0.3 percent
Range: -0.4 to -0.1 percent

CPI ex food & energy Consensus Forecast for September 06: +0.2 percent
Range: +0.2 to +0.3 percent

Housing starts fell sharply in August, dropping 6.0 percent following a revised 3.3 percent drop in July. The Fed's Beige Book has reported pull backs by builders and we are likely to see another decline in starts in September. This is almost a given since new and existing home inventories remain high.

Housing starts Consensus Forecast for September 06: 1.64 million-unit rate
Range: 1.58 million to 1.68 million-unit rate

Thursday
Initial jobless claims continue to show a reasonably healthy labor market. Initial jobless claims edged up "only" 4,000 in the October 6 week despite expectations of a higher bounce back from the 15,000 drop the prior week.

Jobless Claims Consensus Forecast for 10/14/06 : 310,000
Range: +298,000 to +315,000

The Conference Board's index of leading indicators fell 0.2 percent in August - the second drop in a row of this size. A third decline in a row would meet the traditional definition of a recession warning. Components that are already known are mixed - such as starts down and the stock market up. The market consensus expects a rebound, however. Even if we get a third consecutive decline recession claims probably should be ignored given the small magnitudes of the declines and the rebound in consumer confidence.

Leading indicators Consensus Forecast for September 06: +0.3 percent
Range: +0.1 to +0.4 percent

The general business conditions component of the Philadelphia Fed's business outlook survey index dropped to minus 0.4 in September from 18.5 in August. Weakness was widespread among components with various indexes at 3-1/2 year lows. Was the September decline just a sharp quirk in the data' The consensus thinks so to some degree and is calling for a moderate rebound.

Philadelphia Fed survey Consensus Forecast for October 06: 7.0
Range: 3.0 to 10.0