Despite the latest week's drop in equity prices, the Russell 2000 and the S&P 500 are slightly above year-end (2003) levels. The Dow and the Nasdaq are below levels recorded at the end of last year.

BONDS
Once again, the employment situation turned out to be weaker-than-predicted by economists. The anemic employment report led to a bond rally on Friday. Yields fell across the maturity spectrum by as little as 10 basis points (30-year bond) and as much as 15 basis points (5-year note). The 10-year and 2-year notes both decreased 12 basis points in the shortened trading session as the bond markets closed early in anticipation of the long weekend. In any case, the weekly decline in bond yields is much smaller than the daily drop since bond yields were on an upswing over the course of the week.

Despite the anemic employment report, bond investors still believe that the Fed will raise the fed funds rate target by 25 basis points on November 10, the next FOMC meeting. This would bring the funds rate target up to 2 percent, still low by historical standards.

Markets at a Glance

Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.

The Economy

Payroll growth remains anemic
Nonfarm payrolls increased a modest 96,000 in September after a downward revised gain of 128,000 in August. All in all, the quarterly pace was weaker than expected and downright anemic for this stage of the business cycle. According to the Labor Department, the preliminary benchmark revisions show that payrolls grew about 20,000 per month more than originally reported over the past year, but it doesn't change the pathetic pace of job growth. According to the Labor Department, hurricane effects are not evident at this time.

Eight months ago, factory payrolls began a promising upward path, but manufacturing employment fell in September and erased about four months of gains. The factory workweek also edged down 6 minutes in September. This combination points to a slight dip in industrial production (barring increases in utilities and mining).

The retail trade picture doesn't look too good either: retail trade payrolls have now declined for three straight months. It suggests that consumers are not spending as much as retailers had anticipated. It could mean that retailers will not hire as many new (temporary) workers for the holiday season if they don't expect robust spending over the next few months.

Jobless rate unchanged
The civilian unemployment rate remained unchanged at 5.4 percent in September. For the second straight month, the labor force decreased, posting a cumulative drop of 373,000 over two months. Household employment also declined by 201,000 in September after growing in the past several months. Since workers often leave the labor force when conditions are less than stellar, they are not counted as unemployed and this obscures underlying labor market problems. We like to look at the employment-to-population ratio which measures employment directly to the nation's population. Once again, this ratio has dipped to 62.3 after rising a couple of months ago. Essentially, employment growth is dead in the water and conditions have not changed very much since the beginning of 2003.

Will the Fed stop raising rates based on this employment report'
Economists are in general agreement that the Fed will probably continue to raise the fed funds rate target by 25 basis points at their meeting on November 10, bringing the funds rate target to 2 percent. Right now, the Fed is more concerned with removing policy accommodation that was too easy over the past year; an accommodation that was essentially insurance against last year's fear of deflation. Fed officials don't always agree, but public comments are almost in unison: the Fed needs to get to a neutral rate. This week, St. Louis Fed president William Poole also claimed (like Janet Yellen several weeks ago) that the neutral rate is in the 3 to 5 percent range. With a fed funds rate target of 1.75 percent today, the Fed is far from neutral.

Several Fed officials have indicated their belief that economic activity will improve in coming months - and so will the labor market. Well, they certainly must believe that the economy will improve in order to continue their path of rate hikes.

Just as economists are pretty much in agreement that the funds rate target will be increased in November, some are going along with the "pause" argument for December. That is, as long as economic and employment growth is moderate, the Fed would be able to raise rates at a measured pace, but need not raise them at a rapid pace. Given that December tends to have low liquidity in the markets, Fed officials don't usually like to raise rates at that time. Thus, the argument for a momentary pause is reasonable.

ISM non-manufacturing survey moderates again
The business activity index, the headline number for the ISM non-manufacturing survey, decreased for the second straight month in September to 56.7. Indeed, it appears that the July figure was an aberration in a longer-term trend of moderation since this spring. Any level above 50 signals economic growth. Any level above 60 signals extraordinary growth; thus the decline in the index to the mid to high 50s suggests that activity remains respectably healthy. However, market players and economists are concerned with monthly changes because we are interested to see whether economic growth is moderating or accelerating. The current moderating trend is not encouraging.

Mortgage rates rise in latest week
The Freddie Mac weekly mortgage survey showed a rise in rates in the week ended October 7. The 30-year fixed rate increased 10 basis points to 5.82 percent; the 15-year fixed rate rose 12 basis points to 5.24 percent; and the 1-year adjustable rate rose 11 basis points to 4.08 percent. Undoubtedly, these rates remain low by historical standards! Oddly enough, rates are lower today than they were on June 29, the day before the Fed's first rate hike. The fed funds rate stands 75 basis points higher, but the 30-year fixed rate is roughly 45 basis points lower. Indeed, consumers have probably seen increases of 75 basis points in their home equity loan rates. But, mortgage rates are tied to market rates - not the fed funds rate target or the bank prime rate. Friday's drop in Treasury yields might lead to another dip in mortgage rates next week.

Homeowners are taking advantage of the recent declines in mortgage rates to refinance their home loans. The chart below depicts the 4-week moving average (which smoothes out unusual weekly fluctuations) of the Mortgage Bankers Associations purchase index and refinance index. Notice the upward trend in refinance activity - although by recent standards, the increases appear modest. With home equity loan rates increasing more rapidly than mortgage rates, it might make sense for homeowners to wrap their home equity loans (and perhaps even credit card loans) in lower rate mortgage loans. In the long run, this may not benefit consumers, since are tapping into their home equity.

The Bottom Line
Another disappointing employment report - how many have we seen now' The bulk of Wall Street economists were hopeful that employment trends would improve - but once again their forecasts were too high. Fed officials on the chicken circuit have indicated their desire to remove policy accommodation and make sure that the fed funds rate target approaches neutral (3 percent to 5 percent). Thus, market players still are looking for one more rate hike this year.

The bulk of next week's key economic news will be reported on Thursday and Friday. The Treasury budget is scheduled to be released this week, but when the information is available for the entire fiscal year, the release time and date may differ from the normal monthly schedule.

Looking Ahead: Week of Oct 11 to Sept Oct 15

Wednesday
The Treasury will release September budget figures - and also the budget deficit for the entire fiscal year 2004. The average budget surplus was $36 billion over the past 10 years for the month of September, although the surplus was smaller than that in 2003. The total fiscal year deficit amounted to $374.3 billion last year; estimates have the budget deficit for fiscal year 2004 at roughly $425 billion. The Treasury may release this information on a different day and time, as is usually the case when the entire fiscal year budget is reported.

Federal budget Consensus Forecast for Sept 04: NA
Range: NA

Thursday
New jobless claims fell 37,000 in the week ended October 2 to 335,000 after rising 54,000 in the three previous weeks. Nonetheless, the moving average increased to 348,500. According to Labor Department officials, the latest week's rise was not hurricane related; seasonal adjustment is typically difficult this time of year.

Jobless Claims Consensus Forecast for 10/9/04: 340,000 (5,000)
Range: 325,000 to 350,000

The international trade deficit on goods and services narrowed to $50.1 billion in July after surging in June. Higher oil prices will keep imports growing through the next few months, perhaps more rapidly than exports. This time of year also generates import orders for holiday sales.

International trade on goods & services Consensus Forecast for Aug 04: $-51.5 billion
Range: $-54.3 to $-49.1 billion

Last month, import prices jumped 1.7 percent, spurred by higher petroleum prices. Economists' forecasts are all over the board for September. Crude oil prices, though, have been on the rise.

Import price index Consensus Forecast for Sept 04: 0.5 percent
Range: -0.2 to +0.8 percent

Export price index Consensus Forecast for Sept 04: NA
Range: NA

Friday
Retail sales dipped 0.3 percent in August, due primarily to a drop in motor vehicle sales. Excluding autos, sales rose a modest 0.2 percent for the month. Motor vehicle sales increased nearly 5 percent in September - and this should help boost total retail sales for the month.

Retail sales Consensus Forecast for Sept 04: 0.7 percent
Range: 0.4 to 1.1 percent

Retail sales excluding autos Consensus Forecast for Sept 04: 0.3 percent
Range: 0.1 to 0.5 percent

The producer price index edged down 0.1 percent in August, the second time in three months. Food prices dipped 0.2 percent while energy prices edged up 0.2 percent. Excluding food and energy prices rose 0.3 percent in August, on par with the average of the past several months. Higher gasoline prices generally help boost the PPI.

PPI Consensus Forecast for Sept 04: 0.1 percent
Range: -0.3 to 0.4 percent

PPI excluding food & energy Consensus Forecast for Sept 04: 0.1 percent
Range: 0.1 to 0.3 percent

The New York State Empire manufacturing survey accelerated in September after moderating in August. If the "soft patch" has truly ended, as Fed chairman Alan Greenspan has claimed, then October figures should start accelerating again.

Empire State Manufacturing index Consensus Forecast for Oct 04: 24
Range: 17.5 to 30.7

The index of industrial production inched up 0.1 percent in August, after a healthier gain in July. The drop in factory employment and the workweek point to a dip in September production, although the market consensus is looking for a slight gain. The capacity utilization rate moves in tandem with production.

Industrial production Consensus Forecast for Sept 04: 0.2 percent
Range: -0.1 to 0.5 percent

Capacity utilization rate Consensus Forecast for Sept 04: 77.4 percent
Range: 77.1 to 77.7 percent

Business inventories jumped 0.9 percent in July. Manufacturers' inventories rose 0.5 percent in August, half as fast as in July. This suggests that total inventories (also including wholesale and retail trade) could moderate in August.

Business inventories Consensus Forecast for Aug 04: 0.7 percent
Range: 0.5 to 1.1 percent

The University of Michigan's consumer sentiment index fell back in September to 94.2 after a stronger showing during the summer months. Rising energy prices without improving employment trends is taking a toll on consumer attitudes.