While last week's stock price action was negative, this week was generally positive. Furthermore, all key indexes are up from year end. In fact, the Dow Jones industrials are up 1.9 percent from year-end, slightly higher than the S&P 500 gain of 1.5 percent. The Nasdaq composite index is up 2.6 percent while the Russell 2000 continues to outpace them all at 6.5 percent.

BONDS
The Treasury market saw some excitement this week in the form of a quarterly refunding that featured the return of the 30-year bond! The quarterly refunding is always important to the Treasury market because market players want to see strong demand in the auctions. This week, market players were on pins and needles when the U.S. Treasury auctioned a 30-year bond for the first time since August 2001. Indeed, results were even better than expected as the high yield came in at 4.53 percent, about five basis points lower than expectations. Despite the friendly auction results, yields across the maturity spectrum (except for the 30-year bond) still ended the week higher than last Friday.

The yield curve, though, has almost completely inverted since the FOMC announced the most recent rate hike on January 31. Some analysts were saying that the spread between the 2-year and 10-year note was less important than the spread between the 3-month bill and the 10-year note. Well, now the 3-month bill is only 5 basis points lower than the 10-year note yield, and it is only 2 basis point lower than the 30-year bond yield. We don't have far to go here.

Markets at a Glance

The Economy
INTERNATIONAL TRADE
The international trade deficit widened in December to show a $65.7 billion shortfall after narrowing moderately in November. Exports managed to post a 2.1 percent gain, but imports increased 1.9 percent. Given that imports outnumber exports by 1.5 to 1, it led to a wider trade deficit. In 2005, the trade deficit widened to $725.8 billion. Total merchandise exports (on a Census basis) increased 10.4 percent in 2005. Exports of industrial supplies & materials jumped 13.6 percent during the year while exports of nonauto consumer goods surged 12.1 percent. Nonauto capital goods also posted a healthy gain of 9.2 percent while foods, feeds and beverages only rose 3.9 percent. Exports of autos & parts posted a solid 9.5 percent gain. "Other" exports jumped 12.2 percent. The export market was healthy.

But the U.S. economy continues to grow faster than many of its major trading partners. Consequently, merchandise trade imports (on a Census basis) grew 13.7 percent in 2005. The largest gain, not surprisingly, came from industrial supplies & materials, which jumped a whopping 26.1 percent. Keep in mind that this category includes oil, and price certainly played a major role in boosting this sector. Imports of nonauto capital goods rose 10.5 percent while imports of nonauto consumer goods increased 9.1 percent. Since we hope to increase our output capacity, it is always better to see larger gains in the capital goods component than in the consumer goods sector. Imports of autos & parts rose 5.1 percent. However, don't worry about the health of foreign transplant manufacturers here in the U.S. - since their output is not counted as imports. Imports of foods, feeds and beverages jumped 9.6 percent and "other" imports surged 11 percent. Incidentally, until the late 1990s, we exported more foods, feeds and beverages than we imported. Since 2000, the trend shifted and now we import more than we export in this category.

The bilateral trade deficits show unsurprising trends. Our deficit widened with our major trading partners including Canada, Mexico, the European Union, Japan and of course, China. Our deficit with Asian NICs (newly industrialized countries) narrowed, but that was more than offset by the sharply higher deficit with China. Notice how the deficit with China has grown by leaps and bounds over the past three years. Our deficit with Japan is small in comparison.

The Commerce Department anticipated that the net export balance for goods would widen by roughly $20 billion (at an annualized rate) in December. In fact, the net export balance deteriorated by a smaller margin of roughly $12 billion. This should lead the Commerce Department to reduce the net export deficit slightly for fourth quarter GDP and could help lift the initial 1.1 percent growth estimate.

CONSUMER CREDIT
Consumer installment credit expanded by $3.3 billion in December after growing at a slower pace in November. Revolving credit declined by $1 billion during the month, while nonrevolving credit (which includes auto loans) grew by $4.3 billion during the month after decreasing in the previous month. The drop in revolving credit reflects the mediocre pace of December retail sales.

Note that annual growth in consumer installment credit (interchangeable with installment debt) has moderated for five straight years and posted the smallest annual gain since 1992. The debt-to-income ratio also dipped for the second straight year after reaching a peak in 2003. It would be good (for the economy) to say that the drop in annual debt growth, along with the drop in the debt-to-income ratio, is due to less credit card usage. In fact consumers, many of whom happen to be homeowners, have used their home equity like cash machines and have refinanced their mortgages at what is really an alarming rate. It is true that home equity loans are tax-advantaged, so that borrowing against your home might have a lower interest rate than credit card borrowing - or even getting an auto loan. But these loans have disadvantages too.

Home equity loans are typically tied to banks' prime rate - and this is tied to the fed funds rate. Over the past couple of years, homeowners have seen their home equity loan rates increase dramatically from 4 percent in 2004 to 7.5 percent today. But it is true that these rates are typically lower than credit card rates.

Some homeowners simply refinanced their mortgage loans and rolled over their consumer credit loans into their mortgage. This means that loans on nondurable consumer goods get tied in a mortgage that is often amortized over 30 years. So, the mortgage interest might be tax deductible, but the mortgage interest becomes ever larger and you are paying interest on goods long forgotten.

There are still consumers who don't have the advantage of using their home mortgage like a cash machine (which could be a good thing) because they are not homeowners or because they have too little equity in their newly purchased homes. In that case, these consumers are probably still using their credit cards or applying for auto or personal loans. That's why the debt-to-income ratio has only dipped slightly in the past two years. The fact is, though, that we are still borrowing to consume like crazy. Since 1980, disposable income has roughly tripled, but credit/debt outstanding has quintupled.

FEDERAL BUDGET
The U.S. Treasury announced a budget surplus of $21 billion in January after reporting an $11 billion surplus in December. But these two months often see surpluses because they are months in which quarterly taxes are paid. The year-to-date fiscal deficit amounts to $98.3 billion, an improvement over the same period last year when the deficit stood at $109.5 billion. This is the second straight year in which we have seen improvement over this time frame.

Despite the improvement posted over the first four months of the fiscal year, President Bush's estimate for fiscal year 2006 shows a deficit of $423 billion, larger than the FY2005 deficit of $318 billion. According to White House estimates, receipts are expected to increase 6.1 percent this year, while outlays are predicted to rise 9.6 percent. The 2007 fiscal year deficit (estimated at $354 billion) should narrow from the 2006 level as outlays are only expected to grow 2.3 percent with receipts increasing 5.7 percent.

According to the White House press release, President Bush expects to trim entitlement spending by $65 billion over the next five years. At the same time, he is seeking to renew many of the expiring tax cuts. Budget estimates are notoriously - wrong. Many factors can cause estimates to go awry. In any case, the economic scenario on which the estimates are based is reasonable - that is, if you expect real GDP to grow at a 3.2 percent rate indefinitely. The assumption is logical since it would not make sense for the administration to predict a recession over the next five years. However, if the inverted yield curve tells us anything, it does point to a period of slower economic growth ahead. In any case, the majority of economists are not predicting recessions in the near term either.

The Bottom Line
The international trade deficit on goods and services widened in 2005; consumer installment credit increased in 2005, and the budget deficit is still deep in the red in the first four months of fiscal year 2006. Consumer installment credit/debt increased at its slowest pace in more than 10 years, but this reflects a shift towards home equity loans and mortgage refinancing rather than a moderation in consumer borrowing. The borrowing can't go on forever - but a slowdown in consumer spending would surely hamper GDP growth. It is a no-win situation. In the meantime, the White House issued budget estimates for the next five years, which show only a slight moderation in deficit spending.

The excitement of the past week was focused in the Treasury market as the U.S. Treasury brought back the 30-year bond. Economic indicators were sparse. The opposite is true for the upcoming week, which will see many market moving indicators including retail sales, industrial production, housing starts and the PPI. Perhaps more noteworthy will be Chairman Ben Bernanke's testimony before Congress as he remarks on monetary policy on Wednesday. This testimony will be widely followed by market players since it will feature Ben Bernanke for the first time in his new role as Fed chairman.

Looking Ahead: Week of February 13 to February 17

Tuesday
Retail sales increased 0.7 percent in December, posting the fourth straight monthly gain. Motor vehicle sales increased 2.6 percent. Excluding autos, sales edged up 0.2 percent dampened by declines in several sectors. In January, domestic motor vehicle sales rose 5.9 percent and this will boost total sales. Nonauto retail sales may be up modestly - post-holiday sales reports have been mixed.

Retail sales Consensus Forecast for Jan 06: 0.9 percent
Range: 0.5 to 1.2 percent

Retail sales ex autos Consensus Forecast for Jan 06: 0.7 percent
Range: 0.3 to 1.4 percent

Business inventories rose 0.5 percent in November and another rise is expected for December. Manufacturers' inventories rose 0.5 percent in December after posting a smaller 0.3 percent gain in the previous month. Wholesale trade inventories jumped 1 percent in December! Only retail trade inventories are currently missing.

Business inventories Consensus Forecast for Dec 05: 0.5 percent
Range: 0.1 to 0.8 percent

Wednesday
The Empire State manufacturing index moderated in January after accelerating in the two previous months. At 20.1 in January, this survey was pointing to solid growth in manufacturing activity in this Fed region. Many market players consider this a leading indicator for the more well established ISM survey.

Empire State index Consensus Forecast for Feb 06: 18
Range: 12 to 22

The index of industrial production increased 0.6 percent in December, boosted by mining and utilities output; manufacturing production increased 0.2 percent for the month. Factory payrolls inched up in January although the workweek remained unchanged. This could mean a lackluster gain in production for the month.

Industrial production Consensus Forecast for Jan 06: 0.3 percent
Range: -0.3 to 0.6 percent

Capacity utilization rate Consensus Forecast for Jan 06: 80.9 percent
Range: 80.5 to 81.1 percent

Thursday
New jobless claims rose 4,000 in the week ended February 4 to 277,000, bringing the 4-week moving average down to 276,00. This is the fourth straight week in which the jobless claims figures were well below expectations. While these figures can fluctuate dramatically early in the year, claims have simply shown dramatic improvement in the labor market in January and now early February. Whether or not this translates into a large nonfarm payroll gain in February is another question.

Jobless Claims Consensus Forecast for 2/11/06: 285,000
Range: 275,000 to 315,000

Housing starts plunged 8.9 percent in December to a 1.933 million-unit rate with a decrease in single-family construction slightly offset by an increase in multi-family construction. Overall housing activity is expected to moderate in 2006, but housing starts do jump around from one month to the next so it's important to look at the 6-month moving average, the necessary period according to the Census Bureau to establish a trend. An unseasonably warm January could mean a strong month for starts!

Housing starts Consensus Forecast for Jan 06: 2.00 million-unit rate
Range: 1.90 to 2.07 million-unit rate

Import prices decreased 0.2 percent in December after posting a larger 1.8 percent drop in November. Oil import prices fell only 0.9 percent in December after dropping 9.2 percent in November. Crude oil prices were higher again in January and this could boost the index.

Import prices Consensus Forecast for Jan 06: 1.0 percent
Range: 0.5 to 1.3 percent

The general business conditions component of the Philadelphia Fed's business outlook survey fell back to 3.3 in January from a level of 10.9 in December. While the overall levels are much lower than the Empire State manufacturing survey, any level above zero represents growth in manufacturing activity.

Philadelphia Fed survey Consensus Forecast for Feb 06: 10
Range: 5 to 15

Friday
The producer price index increased 0.9 percent in December due primarily to a 3.1 percent hike in energy prices. Excluding energy and food, the PPI inched up 0.1 during the month. Increases in the core PPI have been moderate on the whole in the second half of 2005.

PPI Consensus Forecast for Jan 06: 0.3 percent
Range: -0.4 to 0.5 percent

PPI ex food & energy Consensus Forecast for Jan 06: 0.2 percent
Range: 0.0 to 0.4 percent

In December, the University of Michigan's consumer sentiment index increased about 10 points, rising to 91.5. The January reading did not show a continuation of a rising trend however, and the index fell back to 91.2. Were consumers feeling more confident in February as labor market conditions improved'

Consumer sentiment Consensus Forecast for Feb 06: 91
Range: 89 to 93