Even though prices rose on Friday, it was a down week for the bulk of the market. The Dow was the only major index to gain on the week and now stands 3.9 percent above year-end levels and is outperforming the S&P 500, which is up 3.3 percent from year-end. The Wilshire 5000, which encompasses the entire U.S. market, is up 4.4 percent. The Nasdaq composite is up 5.5 percent. The small cap sector is outperforming the rest of the market by a wide margin with the Russell 2000 up 11.6 percent from year-end levels despite the drop in the two most recent weeks.

BONDS
Robust retail sales led to a surge in bond yields on Friday, although yields were already on the rise over the course of the week. By Thursday, the 10-year note yield surpassed the 5 percent mark - a level not seen since June 2002. The 30-year bond had surpassed the 5 percent mark last week for the first time since September 2004. While the yield curve remained relatively flat, it is no longer inverted. Higher yields on Treasury securities will be driving up mortgage rates - and this should hamper housing activity as well as consumer borrowing.

Markets at a Glance

The Economy
Q1 RETAIL SALES STRONGEST SINCE Q4:2001
Retail sales increased 0.6 percent in March, not quite reversing February's 0.8 percent decline. But it isn't worth fretting because January's 3 percent spurt was sufficient to carry the quarter. Excluding autos, retail sales increased 0.4 percent in March, reversing February's 0.3 percent gain. Nonauto retail sales had jumped 2.7 percent in January.

In the past couple of years, we have pointed out that it is important to also exclude gas station sales to look at underlying retail spending because sharp fluctuations in gas prices can obscure core retail spending trends. In fact, retail sales excluding autos and gas stations rose 0.4 percent in March after dipping 0.1 percent in February and surging 2.5 percent in January. As a result, the quarterly growth rate was still strongest for total retail sales because auto sales helped boost spending in January. Nonetheless, the majority of retail sales components posted healthy gains over the entire quarter.

Which components grew fastest in the first quarter' From strongest to weakest: sales at building materials, supplies & garden equipment stores posted the largest gains, followed by motor vehicles sales, furniture & home furnishing stores, miscellaneous stores, sporting goods stores, and electronic & appliances stores. These all grew at double-digit rates - in excess of the total pace. Stores that posted the slowest growth (from weakest to strongest) included gas station sales, food & beverage stores, health & personal care stores, clothing and accessory stores and general merchandise stores. Each of the stores in this latter group grew at a more moderate pace and less than the total gain in retail sales.

Undoubtedly, consumer spending will grow at a healthy pace in the first quarter, as economists have been predicting over the past several months. Keep in mind, though, that some of the rise in January auto sales stemmed from fleet sales, and these will be counted in the capital spending portion of GDP. Now that we have seen the first quarter, the next question is: will this torrid pace continue' The Fed has increased interest rates twice already in the first quarter. With a fed funds rate target of 4.75 percent, it means that the best consumers can do is get home equity loans tied to the prime rate of 7.75. This is a far cry from the rates we had seen a couple of years ago. And the Fed stands poised to raise the fed funds rate target to 5 percent in May, and perhaps even 5.25 percent in June. Consumer borrowing will continue to get more expensive.

Anecdotal evidence: My husband and I are bombarded daily with credit card offers that offer zero interest. However, reading the fine print, one learns that the offers are no longer really zero percent on the balance transfer since one must pay a transfer fee. In addition to the transfer fee, the periods for which the balance can run at a zero interest has shortened. The 0-interest deal is simply not as good as it used to be - and that's because credit card companies are facing the higher rate market. Higher interest costs will crimp borrowing - and consumer spending - eventually.

REFINANCING TO CASH OUT BECOMES MORE EXPENSIVE
In addition to utilizing generous credit card offers, many homeowners have refinanced and cashed out some of their home equity. But this trend has also been declining as fewer and fewer homeowners are left with high mortgage rates. Even though homes have appreciated sharply in value over the past two years, and some owners may have additional equity to tap into, mortgage rates are higher than they were in 2004. Lately, I've been getting letters from mortgage companies who claim that I can refinance my loan and reduce by mortgage payment. In fact with a 5.5 percent fixed rate mortgage, the only way to reduce my monthly payment is to switch to a 1-year ARM - an irrational choice since the rate would jump up in subsequent years and the total cost would outweigh any short term benefit. As mortgage loans rates continue to rise, refinancing activity will obviously slow further.

INTERNATIONAL TRADE DEFICIT NARROWS IN FEBRUARY
The international trade deficit narrowed in February to $65.7 billion after posting a $68.6 billion shortfall in January. Both imports and exports declined in February, but the drop in imports was larger than the drop in exports. Notice that the trade deficit has remained in a relatively narrow range since September 2005. The worsening deficit coincides with higher crude oil trends.

Imports and exports have been growing nearly at the same rate on a year-over-year basis after a significant gap in 2004 when imports grew much more rapidly than exports. In recent months, imports have grown more rapidly than exports primarily because of higher energy prices. Imports of consumer good have been roughly level over the past couple months, as have imports of capital goods. On the export side, aircraft shipments are rising, but otherwise exports of capital goods remain roughly unchanged. Exports of consumer goods have remained roughly level as well.

The country balance figures show a large improvement in the trade deficit in February relative to December and January, but these figures are not adjusted for seasonal fluctuation. So, while the U.S. showed improvement on a bilateral basis with many foreign countries in February, this is somewhat misleading. It is more appropriate to look at the year-to-date figure, which would be just January and February, and compare this to last year's two-month performance. The U.S. trade deficit is growing most rapidly with our neighbor to the south (Mexico) with a 42.4 percent gain over a year ago and our neighbor to the north (Canada) with a 34.5 percent gain. Both are oil producers and this may be playing a role in the widening deficit. Our bilateral deficit with the European Union (25 countries) is up 9 percent from last year, the same as the increase with the U.S. bilateral deficit with China. Our deficit with Japan is up only 3.7 percent from a year ago and our deficit with NICs (newly industrialized countries) is down 5.2 percent from last year.

MARCH IMPORT PRICES FALL
The import price index fell 0.4 percent in March after decreasing 0.5 percent in February - and this nearly offsets January's 1.2 percent gain. In February and March, both petroleum and non-petroleum import prices decreased. The chart below depicts year-over-year changes in the import price index relative to the producer price index for finished goods. Notice how the two generally move in tandem, although not necessarily by the same magnitude. Both are driven by oil prices. With the March decline in import prices, it is possible that some of this will translate into weaker energy prices in the PPI. However, keep in mind that the PPI is adjusted for seasonal variation, while the import price index is not adjusted.

The Bottom Line
Retail sales were robust in the first quarter and this will help boost first quarter GDP since consumer spending drives the economy. Economists have generally been predicting that the first quarter will be a sharp improvement over the fourth quarter's growth rate of 1.7 percent. It remains to be seen whether the narrower trade deficit in February will also help GDP growth. As it stands now, the average trade deficit in January and February is significantly higher than the October to December average. Without further improvement in March (and no one is predicting that at this stage), it appears that net exports will act as a drag on GDP growth yet again.

Inflation data will dominate the news next week, although market players will also closely monitor housing starts and the Fed manufacturing surveys.

Looking Ahead: Week of April 17 to April 21

Monday
The Empire State manufacturing index jumped 10 points in March after remaining roughly unchanged in February. At 31.2 in March, the general business conditions index was twice as strong as posted for October 2005 - just six months earlier - suggesting that this region's manufacturing activity has improved.

Empire State index Consensus Forecast for Apr 06: 23.8
Range: 22 to 25

Tuesday
The producer price index dropped 1.4 percent in February as energy prices declined 4.7 percent during the month. Excluding energy and food, the PPI rose 0.3 in February. Increases in the core PPI were generally moderate in the second half of 2005, but 2006 began on a stronger note.

PPI Consensus Forecast for Mar 06: 0.5 percent
Range: -0.2 to 1.0 percent

PPI ex food & energy Consensus Forecast for Mar 06: 0.2 percent
Range: 0.0 to 0.3 percent

Housing starts declined 7.9 percent in February to a 2.12 million-unit rate with moderate declines in single-family construction and larger ones in the multi-family sector. The February drop in construction was not unexpected. The more interesting question is what happens in the spring'

Housing starts Consensus Forecast for Mar 06: 2.05 million-unit rate
Range: 1.90 to 2.12 million-unit rate

Ever since the Federal Reserve decided to release the FOMC minutes with a shorter lag (3 weeks instead of 6) market players have become even more mesmerized by the report. The minutes of the March 27- 28 meeting will be particularly interesting since this was the first meeting chaired by Ben Bernanke.

Wednesday
The consumer price index inched up only 0.1 percent in February dampened by a 1.2 percent drop in energy prices. Excluding food and energy, the CPI rose 0.1 percent for the month, with lower prices across the board - except medical care. Crude oil prices were up in March and the EIA has been reporting higher average gasoline pump prices over the course of the month.

CPI Consensus Forecast for Mar 06: 0.4 percent
Range: 0.2 to 0.5 percent

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

Thursday
New jobless claims rose 12,000 in the week ended April 8 to 313,000, but the 4-week moving average decreased nonetheless to 307,500. The weekly increase in new claims follows three straight declines. On the whole, claims were higher in March than in February.

Jobless Claims Consensus Forecast for 4/15/06: 310,000
Range: 290,000 to 320,000

A few components of the index of leading indicators were positive in March: stock prices, consumer expectations, vendor performance and the interest rate spread. New jobless claims were higher during the month and this counts as a negative factor. The factory workweek was unchanged for the month and building permits were down. Information is still not available on new orders for consumer goods and capital goods.

Leading indicators Consensus Forecast for Mar 06: 0.1 percent
Range: -0.1 to 0.3 percent

The general business conditions component of the Philadelphia Fed's business outlook survey decreased to 12.3 in March from a level of 15.4 in February. While the overall levels are somewhat lower than the Empire State manufacturing survey, any level above zero represents growth in manufacturing activity.

Philadelphia Fed survey Consensus Forecast for Apr 06: 15
Range: 12.5 to 25