BONDS
Flatter and flatter! A bond market rally that began on Thursday with friendly economic news extended into Friday with more bond-friendly economic news along with some international jitters over potential problems with Iran. In the old days (whenever that was), a flat or inverted yield curve signaled an impending recession. An increasing number of analysts are concluding that things "are different these days."

Trends do change and sometimes old relationships do not hold. However, I hate hearing, "things are different now" as though standard economic theory is old fashioned. Most of the time, things aren't quite so different! If the flat/inverted yield curve is not signaling recession, it is certainly possible that it is indicating a period of sub par economic growth.

Markets at a Glance

The Economy
A HO-HUM HOLIDAY OR A HEALTHY ONE'
Between Black Friday and the end of the year, we heard daily reports about holiday sales. Some retailers posted healthy gains while others were not as happy. On the whole, economists and retail analysts were pointing to a moderate holiday season. In fact, total retail sales grew 0.7 percent in December, a 6.4 percent gain over the previous year - and this is not a bad showing. A more accurate reflection of retail spending is measuring the year-over-year change in total retail sales excluding the auto group and gasoline stations - and this series posted a 6.8 percent gain over the previous December. On the whole, one could say that the season was at least mildly successful.

Some of the components of retail sales were oddly weak, though, in the December report. Sales at electronics and appliance stores dipped 0.1 percent in December after rising 0.4 percent in November. These retailers however were quite happy with their strong sales showing over the holiday season, suggesting that perhaps component might be revised higher next month.

While year-over-year sales were relatively healthy, we tend to monitor our economic activity on a monthly or quarterly basis. How will retail sales impact fourth quarter GDP' The chart below depicts quarterly growth rates for total retail sales, nonauto sales and nonauto, nongas sales. In order to see underlying demand for consumer goods, the latter is the best gauge. However, in order to see what will happen to personal consumption expenditures in the GDP report, look at total retail sales - and these were showing a meager 2.3 percent growth rate for the fourth quarter, compared to a 6.9 percent growth rate in the third quarter. Personal consumption expenditures also include spending on services, which is not included in retail sales, but this report suggests that consumption expenditures will be much weaker in the fourth quarter GDP report than in the third.

2005 PPI SPURT DUE TO ENERGY - WHAT A SURPRISE...
The producer price index jumped 0.9 percent in December, reversing November's 0.7 percent drop. Food prices increased 0.9 percent and energy prices spurted 3.1 percent after a brief 4 percent drop in the previous month. Excluding food and energy prices, the inflation picture looks much better, recording a slight 0.1 percent hike for the month.

In 2005, the PPI posted a 5.4 percent gain, its largest annual rise since 1990 when it was up 5.6 percent. The continued upward march was primarily due to surging energy prices which rose a whopping 23.9 percent in 2005 after increasing 13.4 percent in 2004 and 11.4 percent in 2003. Without a question, U.S. consumers have seen sharp energy price hikes over the past three years, which have depressed real income. Excluding food and energy prices, the PPI increased 1.7 percent in 2005, an improvement over the 2.3 percent gain recorded in 2004.

Market players have become accustomed to monitoring the producer price index at earlier stages of processing. The intermediate materials index increased 8.4 percent in 2005, less than the 9.2 percent gain posted in 2004. Excluding food and energy prices, this index rose 4.5 percent in 2005, nearly half the 8.3 percent 2004 rise. The crude materials index surged 22.1 percent in 2005 after gains of 17.4 percent in 2004 and 19.5 percent in 2003. This index has a much heftier weight on energy products than either the intermediate or finished goods PPI. This means that energy prices play a larger role in the crude materials index than either of the other two. Excluding food and energy products, the crude materials index rose 4.8 percent in 2005, a sharp improvement over 2004's 20.5 percent hike and 2003's 21.6 percent hike. Crude materials prices are much more sensitive to business activity than other prices and the moderation in this component signals not only a slower inflation rate, but perhaps a more moderate rate of growth because demand for commodities has calmed down.

INTERNATIONAL TRADE DEFICIT NARROWS IN NOVEMBER
The international trade deficit on goods and services narrowed to $64.2 in November after posting a shortfall of $68.1 billion in October. Exports rose 1.8 percent during the month while imports fell 1.1 percent. Exports accelerated their year-over-year pace while imports moderated on a year-over-year basis. In November, a rise in civilian aircraft helped to boost nonauto capital goods exports. Exports of consumer goods and autos were also higher during the month. In contrast, imports of industrial supplies declined even though crude oil imports rose. Imports of capital goods excluding autos were roughly unchanged as were auto imports. Imports for consumer goods declined during the month, an odd result in light of the holiday season build-up that normally takes place.

There is no question that net exports will be an even bigger drag on fourth quarter GDP growth than in the previous quarter. The average monthly deficit for the two months of the fourth quarter is running about $6 billion higher than in the third quarter. After one annualizes that result, it sums up to a pretty large net export deficit!

The Bottom Line
Market players were disappointed with December retail sales, but on the whole, they were not all that bad - especially after one takes into account the entire quarter. It is also useful to keep in mind that gift cards are creating a more dominant presence on Christmas Day, but this has not yet been factored into the seasonal adjustment process (which uses five years of data). Consequently, we could see stronger numbers in January when consumers go and spend those lovely cards.

Luckily two headline figures come out of the PPI report. While the total PPI gain for finished goods was miserable, the core PPI that excludes food and energy prices was sanguine. As a result, market players were generally pleased with the inflation report.

An abundance of economic news will be reported next week - and numbers will bulk up over 4 days instead of the usual five due to Monday's holiday. Market players are likely to focus on inflation (CPI), industrial production and housing starts.

Looking Ahead: Week of January 16 to 20
Tuesday
The Empire State manufacturing index increased in both November and December after moderating for a few months in the fall. At 28.7 in December, this survey was pointing to solid growth in manufacturing activity in this Fed region.

Empire State index Consensus Forecast for Jan 06: 21
Range: 12 to 27.4

The index of industrial production increased 0.7 percent in November, boosted by mining output; manufacturing production increased 0.4 percent for the month. Factory payrolls rose in December although the workweek decreased slightly. This could mean another moderate increase in production for the month.

Industrial production Consensus Forecast for Dec 05: 0.5 percent
Range: 0.4 to 0.9 percent

Capacity utilization rate Consensus Forecast for Dec 05: 80.6 percent
Range: 80.4 to 80.9 percent

Wednesday
The consumer price index decreased 0.6 percent in November after posting sizable gains in previous months. Energy prices fell 8 percent in November, dampening the overall CPI. Excluding food and energy, the CPI rose 0.2 percent for the month.

CPI Consensus Forecast for Dec 05: 0.1 percent
Range: 0.0 to 0.5 percent

CPI ex food & energy Consensus Forecast for Dec 05: 0.2 percent
Range: 0.1 to 0.2 percent

The Beige Book will cover business activity through about the middle of January and thus will give investors anecdotal evidence on the state of the economy for the beginning of 2006. Each Fed district compiles regional information based on their discussions with local business leaders.

Thursday
New jobless claims rose 17,000 in the week ended January 7 to 309,000, still relatively low for a holiday week. Since the past two weeks have included holidays, it will be easier to interpret trends later in January.

Jobless Claims Consensus Forecast for 1/14/06: 315,000
Range: 297,000 to 360,000

Housing starts increased 5.3 percent in November to a 2.123 million-unit rate with increases in both single-family and multi-family construction. Housing activity is expected to moderate, but 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 Dec 05: 2.05 million-unit rate
Range: 1.92 to 2.10 million-unit rate

The general business conditions component of the Philadelphia Fed's business outlook survey inched up to 10.9 in December from a level of 10.7 in November. 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 Jan 06: 13.2
Range: 8 to 18

Friday
In December, the University of Michigan's consumer sentiment index increased about 10 points, rising to 91.5. No doubt, consumers are feeling more optimistic now that gasoline prices have declined from their highs.

Consumer sentiment Consensus Forecast for Jan 06: 92.5
Range: 91 to 94