The Dow industrials ended at their best level since April while the Standard & Poor's ended at its highest in three years! The Nasdaq composite is at its best level since February.

Is a Santa Clause rally underway' Or will corporate delinquency once again undermine confidence' Corporate profits have been strong but corporate outlooks have been cautious. Though the Dow industrials gained an average of 16 percent during the fourth quarters of the 1990s, the fourth quarters so far this decade have seen the average edge lower.

BONDS
The Federal Reserve's rate hike and signal of future rate hikes were no surprise but still proved negative for bonds, where interest rates moved higher in the week especially for shorter term maturities. Still Treasury yields, especially for longer maturities, remain low and highly stimulative for future economic growth. The Fed has raised rates four times since late June, each in 25-basis-point increments that have doubled the overnight rate to 2.0 percent. Yet the yield on the 10-year Treasury note, which provides the basis for yields in the mortgage market, isn't that far from its lowest levels of the year.

But the 2-year yield is beginning to show more sensitivity to the rate hikes. Ending at 2.82 percent on Friday, the yield compares with a first quarter average of 1.69 percent when expectations for Federal Reserve rate hikes had yet to build. The spread between the 2-year and 10-year notes is the narrowest in several years. Yet compared to June when the Fed's first rate hike hit, the 2-year yield is barely changed.

A key reason for the low yields is strong foreign demand for Treasuries, which stand in contrast to weak foreign demand for U.S. stocks and belie steady and now increasing weakness in the U.S. dollar. Though the bond market is always edgy when it comes to central bank demand, Treasury International Capital data on Tuesday are still likely to show high levels of foreign buying.

The Treasury's quarterly refunding in the week proved to be another smash, no doubt helped by strong foreign purchases. Awards to indirect bidders, a category that includes foreign central banks, were heavy. Demand was especially strong for the 3-year and 5-year note offerings on Monday and Tuesday and was more than respectable for the 10-year note on Wednesday despite a pending FOMC announcement later that afternoon. Strong refundings and strong foreign demand are big pluses for the economic outlook, suggesting interest rates can remain low despite long-term prospects of high U.S. trade and budget deficits (see economic indicators below).

Note the Treasury cancelled this week's 4-week bill auction due to debt limit restrictions, the first disruption to the Treasury's issuance calendar this year. But the trouble is only temporary as Congress is certain to increase the nation's debt limit when it reconvenes this week.

Markets at a Glance

The Economy

Trade deficit narrows as exports rise
The U.S. trade deficit narrowed sharply in September to $51.6 billion vs. $54 billion in August, good news that had little impact on the financial markets. The narrower gap is likely to boost the first revision to third-quarter GDP to be released at month's end (the initial GDP report pegged growth at an already strong 3.7 percent).

A big factor behind the improvement was a narrowing in the petroleum trade gap from $14.4 billion in August to $13.9 billion in September. But the improvement may prove brief as import and export prices for October, economic data also issued in the week, showed a giant 11.7 percent month-to-month increase in the price of petroleum imports. The rise suggests that September's improvement in the petroleum trade gap may reverse in October. In a final twist, however, the downturn in oil prices now underway may help reverse whatever October takes back.

The best news in the report may be the sharp rise in exports indicating quick results from the depreciation of the dollar which fell especially sharply against the euro during September, down 3.2 percent. Exports rose to a record $97.5 billion in the month, led by record exports of both consumer goods and industrial supplies & materials. Exports of autos and auto parts, though lower in the month, were still the second highest on record.

Exports of plastics and chemicals were sharply higher with strong gains also posted for steel and aluminum. The gains suggest U.S. chemical processing and primary metal manufacturers continue to pass through higher raw material costs, pointing to rising profits for these industries and perhaps new inflationary pressures for global prices of crude goods. Exports of drilling & oilfield equipment were sharply higher as were exports of machinery, including machine tools, pulp & paper machinery and railway machinery. These gains point to new investment in the world's economic infrastructure.

U.S. industrial manufacturers are posting strong revenues and earnings and, unlike other groups, are forecasting strong results in the months ahead. Behind the outlook is strong demand out of Asia, still including China, and most importantly ongoing price increases. Many manufacturers, especially among the intermediate and final goods categories, have been unable to pass along higher costs because of pre-set customer contracts. Manufacturers are now re-negotiating these contracts for the new year and putting substantial price increases in place. The group, where good exports often make the difference between profit and loss, is also benefiting from the sudden depreciation in the dollar that will increase foreign demand for their goods.

Still, the trade imbalance is more likely to widen than narrow. The American appetite for foreign consumer goods remains insatiable as always. Policy makers, especially those at the Fed who are less exposed to political necessity, often underscore the dangers of high trade imbalances, which make the nation hostage to foreign inflows and foreign confidence in our economy and our markets. But for now, many foreign economies, themselves weak, are dependent on U.S. consumption.

Budget deficit also narrows but ...
Strong foreign demand for U.S. assets will also be needed to offset what are likely to be stubborn fiscal deficits in the years ahead. On the same day the Commerce Department issued September's trade gap data, the Treasury issued October's fiscal deficit - $57.3 billion and down $12.2 billion from October 2003. Corporate income tax receipts, reflecting a sharp year-on-year improvement in profits, more than doubled from last October. In contrast, individual income tax receipts slipped 4.6 percent. Since corporate receipts are a small fraction of individual receipts, total receipts could only inch 0.8 percent higher.

Though social security payments, the category that costs the government the most, rose 5 percent, spending on both defense and medical care fell. Overall, outlays decreased 5.4 percent compared to the prior year. But can October's improvement be repeated in the month's ahead' Will the Bush administration and the Republican Congress cut spending' Will the economy continue to grow and tax receipts along with it' Or will Republican tax cuts exceed revenue benefits'

As shown in the graph below, the deficit in October, the first month of the government's fiscal year, remains very deep with the improvement coming against a weak comparison.

The more U.S. assets held by foreigners, the greater the risk that a downturn in U.S. prospects could trigger an avalanche of foreign selling. U.S. officials, including Alan Greenspan, play down this risk, a contrast to policy makers in other countries, especially out of Europe.

Consumer spending good and bad
Retail sales proved better than expected in October, at least if you don't look at auto sales. Sales excluding motor vehicles rose a very sharp 0.9 percent in the month, better than a 0.8 percent gain in September and a 0.3 percent gain in August. But much of September's gain came from higher sales at gas stations, which benefited from higher prices. Excluding both vehicles and gas stations (graph below), sales rose 0.5 percent, still a healthy result. Sales from this same category rose 0.8 percent in September and 0.3 percent in August.

The gains suggest that high gas prices are not draining sales from other retailers, a big plus especially if gas prices begin to come down in line with declining crude prices. The strengthening jobs market may be encouraging consumers to dip into their pockets. Very low savings levels - 0.4 percent as posted in the third-quarter GDP report and 0.2 percent in September's personal income & outlays report - seem to confirm consumer willingness to spend.

Retailer gains in September were spread widely across categories including general merchandise and department stores. Sales at restaurants and bars were strong for a second month, as were sales at clothing retailers. These gains point strongly to rising consumer spirits. The University of Michigan's mid-November consumer sentiment index, released after the retail sales report, in fact showed sharp improvement in the first two weeks of November. This is a period that includes the outcome of the presidential election, and the results should raise optimism of continued gains in sentiment readings.

But sentiment isn't sales and clothes and dining are only part of the equation. Auto sales, the single most important category for retail sales, were very weak, down 2.2 percent. Did consumers, staying clear of dealer lots, spend more freely elsewhere' The weak auto sales weren't a surprise given poor monthly sales results posted in the prior week when vehicle sales fell to a 13.2 million annual rate compared to expectations for a 13.6 percent rate and a sizzling 14.3 percent rate in September.

On-again, off-again manufacturer incentives may have played a role as well as the model-year changeover. Auto sales in September after all rose a sharp 4.3 percent, nearly double October's decline. Auto sales can be volatile month-to-month and a recovery in November would help lift the economic outlook further. Motor vehicle sales on December 1 will be among that week's most important indicators.

The Bottom Line
Markets were in a flurry in the week with oil moving lower to ease concerns that high fuel costs would continue to limit economic growth. The decline gave a boost to the stock market and probably took a dent out of the bond market. The dollar grabbed center stage, testing all-time lows against the euro, while gold even pushed itself into the spotlight hitting a 16-year peak near at $440 per ounce.

Economic data in the week were highlighted by the economy's doomful dyad: its trade gap and its budget gap. These deficits suggest that foreigners are holding more and more dollars and dollar-denominated assets.

But deficits are for the long term. The short term saw a rise in retail spending for October in line with the improving jobs market. If the "soft patch" of the summer is indeed history, the consumer side of the economy may begin to move in pace with the already strong industrial side in an outcome that points to stronger growth and stronger markets in the months ahead. The combination would also justify the Federal Reserve's vigilance.

The PPI and CPI will dominate the financial markets early in the week. A second month of pressure on the core rates could firm expectations further for an FOMC rate hike in December and could trigger a second tough week for the bond market. Data later in the week will likely be more interesting than market-moving, including October's industrial production report and November's Philadelphia Federal Reserve report. But watch for Friday, when four Federal Reserve officials, headed by no other than Alan Greenspan himself, will be in front of microphones.

Looking Ahead: Week of Nov 15 to Nov 19

Monday
NY Empire State Index fell back sharply in its October reading to 17.43 vs. 27.26 in September. The decline did not foretell a similar decline in the subsequent release of the Philadelphia Federal Reserve Index, though details of the Philadelphia report did prove soft. The New York report showed a falling growth rate for new orders and a contraction in backlog orders. Employment growth also slowed and price readings showed continued pressure.

NY Empire State Index Consensus Forecast for November: 20.0
Range: 12.0 to 22.4

Tuesday
Producer Price Index rose only 0.1 percent in September but the core rate, like the core rate in the subsequent CPI report, showed greater pressure, rising 0.3 percent to a year-on-year rate of 1.9 percent. But a positive in the report was mild readings at lower stages of production, including a 4.2 percent decline in crude level prices and only a 0.1 percent rise in intermediate goods prices. Core readings at these levels were mixed, down 2.5 percent at the crude level but up 0.7 percent at the intermediate level. Energy prices fell sharply in September but the Labor Department warned they may pop back up in October.

Producer Price Index Consensus Forecast for October: 0.6 percent
Range: 0.3 to 1.0 percent

Producer Price Core Index Consensus Forecast for October: 0.1 percent
Range: -0.2 to 0.3 percent

Wednesday
Consumer Price Index rose a moderate 0.2 percent in September to a year-on-year rate of 2.5 percent. But the reading was overshadowed by an unwelcome 0.3 percent rise in the core rate that pushed the year-on-year rate to 2.0 percent, a barrier often cited by Federal Reserve policy makers as the limit for acceptable inflation. The core excludes food as well as energy prices, which actually declined 0.4 percent in September. The Labor Department, however, warned at the time of a "substantial" increase in energy prices for October's report. A repeat of the September core rate, not to mention a negative impact from energy prices, could solidify expectations for an uninterrupted series of Federal Reserve hikes.

Consumer Price Index Consensus Forecast for October: 0.4 percent
Range: 0.1 to 0.6 percent

Consumer Price Core Index Consensus Forecast for October: 0.1 percent
Range: 0.1 to 0.3 percent

Housing Starts fell a sharp 6.0 percent in September to a 1.898 million annual rate. Starts fell in all regions but were weakest in the Northeast. Though multi-family starts rose 4.7 percent in the month, single-family starts fell 8.2 percent. Offsetting the negatives, however, was a 1.8 percent rise in permits to a 2.005 million rate that points to higher starts ahead.

Housing Starts Consensus Forecast for October: 1.950 mln annual rate
Range: 1.900 to 2.050

Industrial Production inched only 0.1 percent higher in September keeping the capacity utilization rate unchanged at 77.2 percent. The Federal Reserve, which compiles the report, estimated that hurricanes restrained production by a "noticeable" 0.3 percentage point in September. Manufacturing and mining output declined in September while utility output, helped by temperature swings, rose sharply. Weakness in manufacturing jobs data, the only negative in an otherwise stellar October employment report, points to weakness for November's industrial production data as manufacturing jobs fell 5,000 with weekly hours and overtime edging lower.

Industrial Production Consensus Forecast for October: 0.3 percent
Range: -0.2 to 0.8 percent

Capacity Utilization Consensus Forecast for October: 77.4 percent
Range: 76.9 to 77.7 percent

Thursday
Jobless Claims settled down in the November 6 week and are predicted to do the same for the November 13 week. Initial claims rose 2,000 to 333,000 in the November 6 week but ended more than two months of severe volatility tied to hurricanes that were felt not only in the Southeast but in the Mid-Atlantic and Northeast as well. The four-week average fell 5,500 to 336,000. Thursday's results will be closely watched as the November 13 week is the same as the survey weeks for the November employment report. Note the four-week average for initial claims stood at 348,750 on October 16.

Jobless Claims Consensus Forecast for November 13 Week: 335,000
Range: 325,000 to 343,000

Leading Indicators slipped 0.1 percent in September following 0.3 declines in both August and July. The Conference Board said the index is pointing to economic slowing in the months ahead but is not indicating that a recession is in the works. Though economic data appear to be improving, the leading indicators report for October may once again slip given declines in the factory workweek, consumer expectations (which have since risen), and a narrower yield curve.

Leading Indicators Consensus Forecast for October: -0.1 percent
Range: -0.2 to 0.1 percent

Philadelphia Federal Reserve Business Outlook Index rose sharply in October to 28.5 from 13.4 September but still remained well off its recent peak in July of 36.1. A disappointment in the October results was a slip in new orders to 24.6 from 26.4 that points to weakness for the November results. Employment also declined, down to 14.1 vs. 21.5 in October. Price readings continued to show pressure.