BONDS
For the week, interest rates took a brief roller-coaster ride. Monday was basically a day for sitting on the sidelines - waiting on Bernanke's testimony before Congress. However, the strong IP report did make the bond markets a little nervous. Tuesday, rates jumped sharply on news of strong gains in the PPI. Wednesday, bond prices rallied sharply and rates fell as Bernanke's comments were seen as suggesting the Fed might pause and not raise fed funds at the August meeting.

Net for the week the yield curve was down marginally, 1 to 4 basis points except on the short end. The 3-month T-bill rate was up 2 basis points for the week. Over the past two months, there has been a notable increase in rates on the short end and decrease on the long end, partially the result of the latest Fed tightening and a belief by some that at least one more is in the works.

Markets at a Glance

The Economy
Last week's economic data focused on output in manufacturing and housing and on prices - all in the context of where Fed monetary policy stands and is headed.

While housing finally appears to be moderating, the direction of manufacturing is still uncertain with manufacturing indicators giving divergent signals. Industrial production for June jumped 0.8 percent, following a 0.1 percent increase in May. Over the last five months, industrial production has averaged monthly gains of 0.5 percent - not really slowing. In contrast, last week's releases for the N.Y. Fed's and the Philadelphia Fed's manufacturing indexes showed notable deceleration in the manufacturing sector.

According to the industrial production index, manufacturing continues to post healthy gains - probably too high even with the need for manufacturing to support the economy as housing slowly declines and the consumer sector moderates. However, new durables orders and regional Fed manufacturing indexes suggest some pending moderation.

Year-on-year gains for industrial production are the highest in almost two years. Except for mining, capacity utilization remains at moderate levels. Industrial production numbers need to moderate somewhat in coming months.

The Philadelphia Fed and New York Fed manufacturing indexes weakened in July, suggesting future moderation in industrial production. Additionally, we are starting to see a slowing in new durables orders. Although the evidence is mixed, manufacturing is likely to moderate in coming months from recently high monthly increases. The markets have noted that prices paid indexes have been on the high side in the manufacturing surveys - raising some concern about whether inflation is coming down.

Housing starts continued to moderate in June as higher mortgage rates are starting to take a bite out of affordability. Housing starts declined 5.3 percent in June, following a 6.6 percent jump in May. Starts are now a moderate 11.0 percent below June 2005 levels. Further moderation is expected based on industry data on mortgage applications and on current and expected traffic.

Both single-family and multifamily units have shown a little volatility but both remain on a moderate downtrend.

Inflation numbers were a key focus of the markets last week with data coming out for both the PPI and CPI.

The producer price index for June came in with a very high headline figure of 0.5 percent following a 0.2 percent increase in May with energy and food playing key roles in the overall June price hike. Core PPI met expectations with a 0.2 percent increase in June. Essentially, the unexpected high overall figure raised fears that rising energy costs are feeding through to core inflation more than previously believed.

The year-on-year core rate, a closely watched barometer for underlying inflation, rose to 1.9 percent from 1.5 percent in May.

The consumer price index rattled the markets last Wednesday morning just before Fed Chairman Bernanke's Congressional testimony. The CPI showed a pattern in reverse of the latest month's PPI with the core CPI exceeding the overall CPI increase. June's overall CPI came in at 0.2 percent with declining energy costs providing some of the basis for the modest gain. The core CPI rose 0.3 percent in June, exceeding expectations of a 0.2 percent rise.

While the overall CPI has seen much volatility recently due to oil price effects, the core CPI has risen 0.3 percent in each of the last four months. For core CPI inflation to ease to the perceived Fed target of annualized 1.5 to 2.0 percent inflation, we need to see occasional increases in the core CPI of only 0.1 percent along with mostly 0.2 percent gains and only with rare 0.3 percent gains. Within the core CPI, rent continued strong with a 0.4 percent boost. Core prices were also supported by medical costs, education, tobacco, and some entertainment costs.

The CPI and core CPI continue to trend upward based on year-on-year percent changes, with the CPI at 4.3 percent and core CPI at 2.6 percent. However, on a 3-month-ago, annualized basis, the core CPI is running at over a 3 percent annualized pace.

The Fed focuses more on the core PCE deflator than on the core CPI figure because the deflator has broader coverage and has less of an upward bias. However, the CPI is released sooner than the PCE deflator and the pattern between the two suggests a strong June figure for the PCE deflator - and ammunition for an August rate hike by the Fed.

Fed Chairman Ben Bernanke testified before Congress in his semi-annual Monetary Policy Report to the Congress . From the testimony and report, the Fed believes the economy is moderating but also sees inflation as unexpectedly high. The markets took the Fed's semi-annual forecast for the economy to show that core inflation will be coming down in 2007. However, the latest Fed outlook for inflation is slightly higher than projected in February. Additionally, it is important to remember that the Fed forecast is "conditional" - conditional upon the required assumption by Board governors and regional Fed presidents to assume that an appropriate monetary policy occurs during the forecast period. We do not know what monetary policy assumptions are made but the assumptions could as easily include 25 to 75 basis point increases in Fed funds in coming months.

If one compares Fed policy during the late 1990s with current policy, it is quite clear that Fed funds less core CPI is much lower now than during the 1999-2000 period. Additionally, looking at the core CPI on a more marginal basis than year-on-year (such as a 3-month-ago, annualized percent change), the core CPI has been rising sharply in recent months. Chairman Bernanke also specifically noted that the rise in core inflation is not limited only to the rent component.

There has been much discussion regarding the impact of sharply rising oil prices on inflation numbers and on inflation expectations. How has the Fed reacted to sharp oil price increases' In the 1970s, the Fed largely assumed the oil price hikes would have a temporary effect on inflation and ignored or missed the impact on inflation expectations - and inflation continued out of control for some time. In the late 1990s, the Fed took the opposite approach and continued to boost interest rates as oil prices continued to rise. Of course, there is the possibility that the Fed overreacted as the U.S. economy experienced a mild recession - whether it was due to Fed action or other factors. The Fed may aim for some middle ground in reacting to higher oil prices. Nonetheless, the Fed is sharply behind the rise in core CPI gains compared to the most recent tightening phase in 1999-2000.

The Bottom Line
The equities and bond markets were calmed to some degree by Bernanke's testimony to Congress last week. Bonds clearly reacted more favorably than equities as Fed policy uncertainty and weak earnings were concerns in the equity markets. We really do not have clear information on the strength of the manufacturing sector but the evidence may slightly weigh in favor of moderation over excessive strength. Housing appears to be on a controlled downtrend, in line with Fed projections. However, inflation at the PPI and CPI levels is clearly on the high side for the Fed.

Last week, the markets decided that Bernanke's comments significantly lowered the odds of an August interest rate hike with the odds falling marginally below 50 percent. Should the Fed pause now and not raise fed funds in August, the policy stance will be significantly less restrictive than in 1999 and 2000 - suggesting that interest rate increases will have to resume not long down the road.

Looking Ahead: Week of July 24 to July 28