Every key stock market index that we follow is now well below year end levels. The S&P 500 is currently outperforming other key reports - it is only down 4.3 percent. The Dow industrials are down 6.1 percent and the Nasdaq composite index is 11.1 percent below year end levels. Until a few weeks ago, the Russell 2000, which measures the small cap market, was outperforming other key stock indexes. That is no longer the case, and this index is 6.7 percent below year end levels, worse than the S&P 500 and the Dow, although still outperforming the Nasdaq composite index.

BONDS
What a difference a week makes! Collapsing stock prices coupled with weaker-than-expected economic statistics and an outright stunning employment report led to a sharp rally in the bond market. Yields were generally headed lower over the course of the week, but on Friday there were no holds barred. At the long end of the yield curve, Friday's rally led to a mere 12 basis point drop in yields, but at the shorter-end of the curve (the two-year note) yields fell by 27 basis points just on Friday. The difference in yields since last week was a bit larger given that yields already were falling throughout the week.

Bond investors are pretty much counting on a Fed rate hike of 25 basis points in the federal funds rate target on Tuesday when the FOMC meets. However, most financial market players had generally counted on 25 basis point rate hikes at the September, November and December meetings as well. Given the anemic employment report for July, all bets are off. The Fed could very well continue to raise the funds rate target since they have indicated that they need to bring the funds rate back to neutral (although Greenspan refused to define "neutral" at the semi-annual monetary policy testimony a few weeks ago). After all, inflation has begun to worry Fed officials and higher energy prices are just as likely to stir inflationary pressures as they are to weaken consumer spending.

While the employment report was anemic, other July economic indicators reported this week weren't all that bad (motor vehicle sales, ISM surveys). Probably, whether or not the Fed continues its measured pace of increases in the fed funds rate target will depend on the August employment report - released on September 3rd, well in advance of the next FOMC meeting.

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

Payrolls slow to a crawl but jobless rate dips too
Nonfarm payroll employment rose a measly 32,000 in July after downward revised gains of 78,000 in June and 208,000 in May. To put it mildly, the employment path does not look good! Employment growth peaked in March and has steadily moderated ever since. In a typical recovery, it isn't unusual to see monthly gains of 300,000 to 500,000 in nonfarm payrolls that eventually slow to 250,000 and to 175,000 as the recovery matures. As anyone can see from the chart below, payroll gains never saw even a close approximation to the typical business cycle pattern. Nonfarm payrolls moderated across the board. Even temporary help services only added 5,000 workers to their payrolls after dropping 11,000 in June. It appears that employers are not even confident enough about economic conditions to add temporary workers - hardly a good sign. There was one positive bit of news in the payroll data: manufacturing employment increased 10,000, more than reversing last month's 1,000 drop and continuing the upward trend that began in February.

The other employment survey - coming from the household sector - actually showed a better picture of the current labor market situation. The civilian unemployment rate dipped 0.1 percentage point to 5.5 percent after hitting a plateau at 5.6 percent for the three previous months. The unemployment rate is riddled with problems surrounding the volatility in the labor force. Consequently, we (along with Fed policymakers) like to look at the employment-population ratio which disregards monthly movements in labor force participation and regards employment with respect to the nation's population. This indicator improved measurably in July - rising from 62.3 in June to 62.5 in July. This was the highest rate posted for this ratio since January 2003.

It isn't unusual to see employment measured by the household survey at odds with employment measured by the establishment survey. The major difference between the two surveys is that household employment includes self-employed workers along with farm workers, while the establishment survey does not. Clearly, we don't expect the number of farm workers to fluctuate dramatically from month to month, so that should not play a major role in causing a difference between the two series. But when it is difficult to find a job, there certainly might be more workers willing to go solo (consulting) or start a business.

Household employment counts people, nonfarm payrolls count jobs. Thus, when economic conditions are robust and employment demand is sturdy, many workers may have more than one job. When conditions are soggy, multiple job holders decrease. Notice that nonfarm payrolls rose more rapidly than household employment in the mid-to-late 90s but then grew less beginning in 2002. Likewise, the number of multiple job holders increased from 1994 through 1999 and then began to moderate. The level has been roughly constant since 2002.

So how can we make sense of these two surveys' On the whole, it appears that employment conditions have improved marginally in the past couple of months, measured by the household data's employment-population ratio. Nonfarm payrolls are not growing as rapidly as household employment suggesting that fewer workers are able to attain multiple jobs. In some cases, workers take on extra jobs to earn extra money - not necessarily because they couldn't live without it. But in some cases, people take on extra jobs because each of those jobs is part-time - and they couldn't make ends meet with just one part-time job. Thus, it is entirely possible the lower unemployment rate together with the higher employment-to-population ratio is concealing the economic hardship of families where parents may very well be underemployed.

How do the market and the Fed make sense of this' There is no question financial market players focus on nonfarm payroll data. Over the years, they have been taught (by economists and Fed officials) that this is the more reliable employment figure to monitor (although no one indicator reveals "the truth" and it is always best to synthesize a set of information). The Fed will need to monitor both payrolls and the unemployment rate. As such, the Fed will certainly be able to justify a rate hike next week since inflation data is not all that great and the unemployment rate dipped during the month. However, the Fed will need to be careful in making future rate hike decisions (in September, November & December).

Bits of positive news in employment report
The employment report is called the mother of all indicators because several of the components are either used directly or indirectly by other government agencies that compile economic statistics. For instance, the manufacturing hours worked data from the employment report help generate initial estimates for the index of industrial production. Factory payrolls increased (0.1 percent) in July, and so did the manufacturing workweek (0.2 percent). As such, this points to a slight rise in the index of industrial production. (A rough and dirty way of estimating production from these numbers' Add the percent changes plus add 0.2 percent for productivity and you come up with a forecast of 0.5 percent in industrial production. Keep in mind that mining and utilities are also a part of the index of industrial production and these may work for (add to production) or against (subtract from production) in any given month.

Personal income is also derived to some extent from the employment report. Wages and salaries, the lion's share of income, can be estimated (remember rough and dirty) by the sum of the percent change in nonfarm payrolls (0.0 percent) and the average workweek (0.3 percent). Wages and salaries make up an important component of personal income, but sometimes, special factors in other components obscure the underlying trend. In any case, income growth should still be positive for July.

More promising news from ISM surveys
The employment report is not only all encompassing but also timely, making it the mother of all indicators. But in fact, a few other indicators reported this week also gave us a hint on the month of July. The ISM surveys enjoy credibility in the financial markets, and both the manufacturing and non-manufacturing indexes increased in July from their June levels. The manufacturing survey rose more modestly, from a level of 61.1 to 62 in July. However, the business activity index from the non-manufacturing survey managed to post a nearly five-point jump to 64.8 from June's level of 59.9. While the business activity index is not at the stratospheric level it posted in April, it remains strong and at the higher end of its 7-year history. While the second quarter began on a high note in April and then moderated, it is possible that the third quarter is beginning from a lower level in July and will rise through the rest of the summer, as suggested by the non-manufacturing ISM in the chart below.

Motor vehicle sales jump (incentives!)
Domestic cars were sold at a 5.5 million-unit rate in July, up 10 percent from June's 5.0 million unit selling pace. At the same time, domestically produced light trucks were sold at a whopping 8.5 million-unit rate, up 18.1 percent from the June period. Is this a case of "produce the vehicles" and consumers "will come to the showrooms"' Well, automakers aren't that powerful. Actually, the primarily factor that is driving consumers to dealer showrooms is incentives. Without incentives, consumers can live without new cars. After all, there are a good number of new cars on the road already. Incentives boost sales for "extra" family cars. They may not all be sports cars or convertibles, but more and more families have a car for every family member - and then some.

Automakers clearly believe they can adjust incentives to match whatever level of production they choose. The problem, though, is that the average consumer becomes accustomed to incentives and won't purchase a vehicle without them. In the meantime, profit margins are compromised. Granted, automakers are benefiting from strong demand for SUVs - an area with higher profit margins than autos. And despite the rapid run-up in gasoline prices and all the moaning about high prices, the percent of light truck sales is still running at 60 percent.

The Bottom Line
Market players were stunned Friday as nonfarm payroll employment once again grew much less than expected. As we indicated above, taking into account the household survey, with a drop in the unemployment rate and a rise in the employment-to-population ratio, the overall employment situation may not be as beleaguered as indicated by the headline number. But the labor market report may set in motion a different path for Fed policymakers than they originally anticipated at their June meeting. After all, not all July indicators were in the doldrums. Motor vehicle sales surged (with the help of incentives) and the ISM surveys showed pretty good activity in both the manufacturing and non-manufacturing sectors.

The Fed will meet on Tuesday, August 10 and will surely have an interesting discussion. Market players are expecting the Fed to go ahead and raise the federal funds rate target by 25 basis points. After all, higher energy prices will certainly lead to some increase in measured inflation, and price stability does remain a key policy goal. Financial market players will surely be alert for the post-FOMC statement at 2:15 PM ET on Tuesday for signs of the Fed's direction.

Looking Ahead: Week of Aug 9 to Aug 13

Tuesday
Nonfarm productivity increased at a 3.8 percent rate in the first quarter, slightly faster than fourth quarter 2003 but not as strong as the middle quarters of 2003. A moderate pace of GDP growth coupled with moderate employment growth suggests that productivity slowed in the second quarter. Unit labor costs increased at a 0.8 percent rate in the first quarter, growing at a slower rate than in the previous quarter. Usually, slower productivity gains are accompanied by more rapid gains in unit labor costs.

Nonfarm productivity Consensus Forecast for Q2 04: 2 percent annual rate
Range: 1 to 3 percent annual rate

Unit labor costs Consensus Forecast for Q2 04: 2 percent annual rate
Range: 1.3 to 3 percent annual rate

The FOMC is meeting on Tuesday. Market players are generally expecting a 25 basis point rate hike - which would bring the fed funds rate target to 1.50 percent. Don't forget that banks usually increase their prime rate soon after the Fed. This affects home equity loans and many credit card loans.

Fed funds rate target Consensus Forecast for Aug 10, 04: 1.50 percent (+0.25 basis points)
Range: NA

Wednesday
Over the past ten years, the federal budget has averaged a $22.4 billion deficit during the month of July. In July last year the Treasury deficit was more than twice as large as the average so it wouldn't be surprising to see a large budget deficit this year as well. The administration recently estimated the total budget deficit will amount to $480 billion for fiscal year 2004. This is slightly lower than the estimate announced earlier in the year but corresponds to budget deficit estimates made by private economists.

Treasury budget Consensus Forecast for July 04: $-61 billion
Range: -$50.7 to -$66 billion

Thursday
New jobless claims fell 11,000 in the week ended July 31 to 336,000; despite the drop, the 4-week moving average shot up to 343,500. A variety of special factors have caused more weekly volatility than normal around this time of year. Perhaps claims will soon be back on track and once again reflect current conditions.

Jobless Claims Consensus Forecast for 8/7/04: 340,000 (4,000)
Range: 330,000 to 355,000

Retail sales fell 1.1 percent in June after posting healthier gains in previous months. Retail sales were hurt badly by weak motor vehicle sales. Excluding autos, retail sales edged down 0.2 percent in June, with declines in most major categories except furniture and electronics. Soggy chain-store sales in July point to another month of a less-than-stellar nonauto component, although a spurt in motor vehicle sales could help boost the total.

Retail sales Consensus Forecast for July 04: 1.2 percent
Range: 0.8 to 2.1 percent

Retail sales ex autos Consensus Forecast for July 04: 0.4 percent
Range: 0.1 to 0.8 percent

Import prices fell 0.2 percent in June after posting hefty gains in previous months. The June drop was the first since last September. Export prices also declined in June but monthly increases have been much smaller for exported goods than imported goods due to sharp energy price hikes.

Import prices Consensus Forecast for July 04: 0.4 percent
Range: 0.0 to 0.8 percent

Export prices Consensus Forecast for July 04: NA
Range: NA

Business inventories rose 0.4 percent in May, slower than April's 0.7 percent hike. It is good to see increases in business inventories when demand is high because it means producers want to keep up with demand. However, rising inventories with declining sales is not good because it eventually points to declining production. It still appears that rising inventories are good for our economy at this stage of the game.

Business inventories Consensus Forecast for June 04: 0.6 percent
Range: 0.3 to 0.8 percent

Friday
The producer price index fell 0.3 percent in June after posting a 0.8 percent spurt in May. In June, energy prices dropped 1.6 percent, reversing the previous month's gain. Food prices also fell in June after rising sharply in May. Excluding these two volatile components, the PPI rose 0.2 percent in June, in line with the average of the past several months.

PPI Consensus Forecast for July 04: 0.3 percent
Range: -0.2 to 0.5 percent

PPI ex food & energy Consensus Forecast for July 04: 0.1 percent
Range: 0.0 to 0.3 percent

The international trade balance on goods and services recorded a $46 billion shortfall in May, reflecting a narrower trade deficit than in the two previous months. Although both exports and imports posted increases in May, the rise in exports was significantly larger than the rise in imports.

International Trade Balance Consensus Forecast for June 04: $-47.5 billion
Range: $-45 to $-48.5 billion

The University of Michigan's consumer sentiment index edged up to 96.7 at the mid-month reading from a level of 96 in June. Consumer sentiment has shown modest improvement in the past few months but has not increased significantly.