BONDS
Treasury securities traded in a very tight trading range this week. The bulk of the excitement was on Tuesday when the CPI unexpectedly posted a 0.1 percent drop. But the impact of the better-than-expected figure was muted due to other market concerns. Oil is a major concern in the bond market as well as the equity market, although when investors are moving funds out of stocks they do need a place to park them - and this means that a spurt in oil prices may not be as negative for the bond market as one might expect. Also, high oil prices are likely to hamper economic growth - and that is usually considered a positive in the bond market.

Several key indicators will be reported in the coming week, but market analysts are not expecting any of them to move markets. In addition to a 2-year Treasury auction next week, bond investors are likely to follow the antics at the Republican convention.

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

July CPI dips
The consumer price index fell 0.1 percent in July after rising 0.3 percent in June and 0.6 percent in May. The dip surprised economists and market players because they weren't expecting a 1.9 percent drop in energy prices. Food prices remained stable, rising 0.3 percent for the month. Excluding food and energy prices, the CPI rose 0.1 percent for a second straight month. After rising for several months, apparel prices decreased 0.8 percent helping to keep down the overall index. In addition, prices for recreation fell 0.2 percent and education & communication costs fell 0.1 percent. All in all, it was a good month. At as a result, the CPI posted a 3.0 percent year-over-year gain, less than in June. The core CPI (excluding food & energy prices) posted a year-over-year rise of 1.8 percent, just a tad less than the prior month.

Many pundits believe the Fed knows what its doing and that inflation is clearly not a threat. Perhaps, but the chart below depicting inflation rates for goods and services prices is not convincing. Notice goods prices did decline on a year-over-year basis in July, a reflection of lower energy prices as well as lower apparel prices. Most analysts are convinced the CPI will indeed see higher energy prices going forward. And even if apparel, recreation, and communication costs continue to decline in coming months, the declines are not likely to offset gains in energy prices.

Also, keep in mind that goods in the CPI account for 40 percent of the index while prices of services account for 60 percent. Note the upward trend in prices of services. These tend to move much more slowly than good prices, but once the upward trend has begun, it is likely to continue for a little while at least.

Housing starts rebound
Housing starts jumped 8.3 percent in July to a 1.978 million-unit rate after falling 7.7 percent in June to a 1.826 million-unit rate. Both single-family starts and multi-family starts, after decreasing by similar amounts in June, rebounded in July. While mortgage rates were higher in May and June due to expectations of Fed rate hikes, they tumbled in July. In the first three weeks of August, 30-year mortgages have averaged 5.88 percent, down 18 basis points from the July average. This could bode well for housing construction in August as well.

Analysts have been expecting housing construction to moderate as interest rates rise. However, despite two Fed rate hikes since June 30, rates have come down. Eventually, if the Fed continues to increase the fed funds rate target, one would certainly expect the general level of interest rates to rise. That would mean that mortgage rates would also increase eventually. While we are not seeing a rapid rise in housing construction as we did a few years ago, there is no question that any rise in housing starts and new home sales will be accompanied by gains in appliances and home furnishings.

Production inches higher in July
The index of industrial production rose 0.4 percent in July, not quite offsetting June's 0.5 percent drop. Total industrial production was lifted by a 0.5 percent hike in manufacturing activity along with a 1.2 percent spurt in mining, more than offsetting a 2 percent drop in utilities. Utilities production also fell in June, down 2.6 percent after surging 4.6 percent in May.

For a second straight month, the year-over-year rise in industrial production moderated, although it remains relatively healthy at just under 5 percent. The yearly rise in manufacturing is stronger, up 5.8 percent. Among key sectors, production of motor vehicles & parts fell 0.7 percent in July marking the fifth straight monthly drop! In contrast, high tech products posted a 2.5 percent gain in July. This sector has not posted a drop since August 2001.

The outlook for August is still positive, though two Fed surveys suggest that manufacturing activity moderated during the month. The business conditions index for the Philadelphia Fed's business outlook survey dipped 7.6 points to 28.5 in August, although this merely pushes the index back to June levels. The Empire State manufacturing index posted a much sharper drop suggesting that the region's activity moderated more dramatically. However, the Empire State survey lacks enough history to know for sure whether it is a good predictor of industrial production. The Philadelphia Fed's survey, however, has historically moved in the same direction as industrial production. Based on these two surveys alone, it is likely that production will be positive in August but perhaps not an improvement from the July pace.

The Bottom Line
All in all, economic news was relatively positive this week with inflation low and growth rising in housing construction and industrial production. Keeping in mind the Fed may continue to raise the fed funds rate target, it is likely that mortgage rates will once again turn higher, and that will eventually hamper housing starts. And high oil prices may do their share to slow growth in industrial production.

Looking Ahead: Week of Aug 23 to Aug 27

Tuesday
Existing home sales rose 2.1 percent in June to a 6.95 million-unit rate. It was the fifth consecutive monthly gain. Consumers are certainly taking advantage of the historically low interest rate environment. Eventually, a rising fed funds rate target will translate into a higher interest rate environment. In the meantime, mortgage rates remain below 6 percent.

Existing home sales Consensus Forecast for July 04: 6.85 million-unit rate
Range: 6.75 to 7.10 million-unit rate

Wednesday
New orders for durable goods rose 0.9 percent in June after declining in both April and May. Excluding defense orders, new orders dipped 0.2 percent in June, the third straight monthly drop. In order for the manufacturing sector to improve, new orders need to pick up steam.

Durable goods orders Consensus Forecast for July 04: 1.0 percent
Range: 0.0 to 1.7 percent

New home sales fell 0.8 percent in June to a 1,326,000 unit rate after surging 11.7 percent in May. Record low mortgage rates are still helping to boost home sales. This should lead to gains in home furnishings and appliances as well.

New home sales Consensus Forecast for July 04: 1,300,000-unit rate
Range: 1,250,000 to 1,350,000-unit rate

Thursday
New jobless claims fell 3,000 in the week ended August 14 to 331,000; as a result, the 4-week moving average dropped to 337,000. This was the fourth drop in five weeks and is perhaps setting a new lower trend for new claims.

Jobless Claims Consensus Forecast for 8/21/04: 340,000 (+9,000)
Range: 320,000 to 351,000

Friday
The Bureau of Economic Analysis initially estimated that real GDP grew at a 3 percent rate in the second quarter. Economists are looking for a downward revision this week since the merchandise trade deficit was dramatically larger than expected in June.

Real GDP Consensus Forecast for Q2 04: 2.7 percent annual rate
Range: 2.3 to 3.0 percent annual rate

GDP deflator Consensus Forecast for Q2 04: 3.2 percent annual rate
Range: 3.2 to 3.3 percent annual rate

The University of Michigan's consumer sentiment index fell back to 94 at mid-month as consumers likely reacted to higher oil prices as well as intensified skirmishes in Iraq. Nothing has changed since - oil prices are still high and there is still fighting in Iraq.