BONDS
As economic indicators for June were coming in weaker-than-expected, bond investors began to get a hunch that August's FOMC meeting might not see a rate hike let alone a 50 point move that some had previously forecast. However, Alan Greenspan's semi-annual monetary policy report before Congress this week dispelled those views. Greenspan considers the slowdown in June to be a temporary soft patch and is not concerned about a moderation in economic activity. As a result, bond yields jumped again during this week after the testimony. But since Treasury securities are also a safe haven investment, yields dipped on Thursday and Friday as stock prices tumbled. Nevertheless, sentiment has shifted in the bond market as more market players now are looking for a 25 basis points rate hike at the August 10 meeting, along with incremental moves at each of the subsequent meetings this year.

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

Semi-annual monetary policy testimony
Fed Chairman Alan Greenspan faced the Senate Banking Committee on Tuesday and the House Financial Services Committee on Wednesday to deliver his semi-annual monetary policy outlook, formerly known as the Humphrey-Hawkins report. For the record, the Humphrey-Hawkins bill required that the Fed chairman testify before Congress twice a year; the bill expired a couple of years ago but the Fed continues the tradition. The business press also continues its tradition of calling his testimony Humphrey-Hawkins, not the monetary policy outlook as it is named.

Greenspan appeared to surprise markets slightly as bond prices fell and stock prices rose on his hawkish testimony on Tuesday afternoon. He basically claimed that the June slowdown was temporary, just like inflation in the first half of 2004 was due to transitory factors. His view was that the economy would continue to grow at a solid pace through the rest of the year. The Fed finally buried the hatchet on deflation (that was about two years overdue) and also suggested that inflation would not be a problem in upcoming months, and that if it does become a problem the Fed will be flexible and responsive. Translation: if inflation does turn up, the Fed will raise rates much more rapidly than at a "measured pace." One Senator asked Greenspan what he meant by measured. Greenspan said that the Fed was intentionally vague about that. (And he had the good sense to smile when he said it!) However, he admitted that the dictionary definition would describe measured as "gradual".

Greenspan's intent to get the fed funds rate target back to neutral was discussed at length. He indicated that households were ready for rising rates and that these would not impact debt burdens. He may be mistaken here. Consumers have been seduced by credit card companies over the past couple of years into borrowing vast sums of funds at zero interest. Most of the zero interest offers are short-term in nature and many consumers may be stuck with a load of credit card debt in a rising rate environment. In our view, consumers may realize the Fed will be raising rates, but we're not convinced they realize this means higher interest rates and finance charges for their credit card accounts.

Wednesday's testimony was a repeat of Tuesday. The Q&A session didn't yield any heart-stopping information either. Greenspan focused a little bit more on deficit issues on Wednesday and began to harp on the burgeoning deficit. Oddly enough, Greenspan had ignored the deficit until just about six months ago when he also harped on the problems of an accelerating budget deficit at the February testimony.

All in all, Greenspan's testimony should be viewed as a warning that rate hikes will be familiar occurrences at FOMC meetings even if consumer spending doesn't accelerate sharply. The Fed wants to get back to neutral although Greenspan also refused to define neutral. "We'll know it when we see it," he said. At this time, it is reasonable to assume that the Fed will aim for 25 basis point increases in the funds rate target, unless inflationary pressures escalate (then look for 50 basis point hikes).

Housing starts drop in June
Housing starts decreased 8.5 percent in June to a 1.80 million-unit rate. This brought the level 2.6 percent below a year ago. Both single family and multi-family construction dropped for the month. Housing starts are volatile and the Census Bureau believes that it takes five months to establish a trend. Consequently, they prefer that data users look at the five month moving average of housing starts than any single month's data. The chart below depicts the five-month moving average of total housing starts and single-family starts relative to monthly mortgage rate averages. Note that starts peaked in January and have since come down 3.3 percent from the 1.992 million-unit rate high. Single family starts units also peaked in January, but are only down 2.2 percent through June.

Notice that housing construction was already headed lower even as mortgage rates were still declining. When the 30-year mortgage rate bottomed this past March at 5.45 percent, the five-month moving average was already down from its peak. Mortgage rates in May and June are roughly about 10 basis points higher than they were last August.

The Bottom Line
Greenspan dominated market sentiment this week whether market players were anticipating his remarks, digesting them, or regurgitating them. The bottom line is that Greenspan's comments were hawkish; market players and consumers alike need to be prepared for rate hikes at each of the upcoming FOMC meetings.

The housing market appears to be moderating slightly. Responding to a Senator's question, Greenspan gave a convoluted explanation for the decline in permits that suggested housing numbers aren't as weak as they look. Perhaps not, but rising interest rates will still put a damper on this sector of the economy that has been soaring for years! Housing activity may need to take a rest. Hopefully other economic sectors will take up the torch.

Looking Ahead: Week of July 26 to July 30

Monday
Existing single-family home sales rose 2.6 percent in May to a 6.8 million-unit rate, the fourth consecutive monthly rise. Sales have fluctuated in a narrow range in the Northeast, but the Midwest, the South and the West have posted healthy gains over the past several months. The drop in housing starts in June, however, suggests that the strong climb may be reaching its end point.

Existing home sales Consensus Forecast for June 04: 6.55 million-unit rate
Range: 6.20 to 6.90 million-unit rate

Tuesday
The Conference Board's consumer confidence index jumped almost 9 points in June to reach 101.9, its highest level in two years. The University of Michigan's mid-month reading in July showed little improvement, perhaps suggesting that consumer confidence won't see another big jump in July.

Consumer confidence index Consensus Forecast for July 04: 102
Range: 99.5 to 105

New single-family home sales surged 14.8 percent in May to a 1,369,000-unit rate, more than reversing the previous month's drop and catapulting new home sales to a new peak. But the June drop in housing starts may be the precursor of a drop in new home sales. Mortgage rates, though still low by historical standards, are nevertheless up from a few months ago.

New home sales Consensus Forecast for June 04: 1,250,000 unit rate
Range: 1,200,000 to 1,360,000-unit rate

Wednesday
Durable goods orders fell 1.8 percent in May after declining 2.7 percent in April. While orders are notoriously volatile, the two-month drop was disconcerting. Among the major industry groups, only primary metals increased in May.

Durable goods orders Consensus Forecast for June 04: 1.5 percent
Range: 0.0 to 3.5 percent

The Fed's Beige Book will be released on Wednesday afternoon. Market players will be looking to see whether economic activity showed signs of improvement in July after the less stellar performance exhibited in June. Equity and bond investors will also look for signs of inflationary pressures and improvement in labor market conditions. But even if economic activity resembles the June pace, the Fed may still be inclined to raise the fed funds rate target at its August meeting based on comments by Alan Greenspan at his semi-annual testimony on monetary policy last week.

Thursday
New jobless claims decreased 11,000 in the week ended July 17 to 339,000, bringing the 4-week moving average down to 336,750. A variety of special factors have caused more weekly volatility than normal around this time of year. Perhaps claims are back on track and once again reflecting current conditions.

Jobless Claims Consensus Forecast for 7/24/04: 340,000 (1,000)
Range: 330,000 to 360,000

The employment cost index rose 1.1 percent in the three months ending April, putting the yearly rise at 3.8 percent. Wages & salaries rose a modest 0.6 percent for the quarter, but benefits costs jumped 2.4 percent. Wages & salaries are likely to continue their modest gains, but benefits costs may moderate in the second quarter as the largest gains for this component are often in the first quarter.

ECI Consensus Forecast for June 04: 0.9 percent
Range: 0.8 to 1.1 percent

Friday
Real GDP expanded at a 3.9 percent rate in the first quarter, not far off from the fourth quarter pace of 4.1 percent. A slowdown in retail sales suggests that second quarter GDP growth will moderate from the first quarter pace. The GDP deflator increased at a 2.8 percent rate in the first quarter, boosted by higher energy costs. High energy costs could once again boost the deflator.

Real GDP Consensus Forecast for Q2-04: 3.5 percent annual rate
Range: 2.9 to 4.2 percent annual rate

GDP deflator Consensus Forecast for Q2-04: 3.0 percent annual rate
Range: 2.0 to 3.5 percent annual rate

The NAPM-Chicago survey surged in May and then fell sharply in June with the business barometer at 56.4. The Chicago survey is considered a leading indicator of the ISM manufacturing survey, but the NAPM-Chicago also includes non-manufacturing activity. In the past few months, the NAPM-Chicago has not mirrored changes in the ISM. This index is best interpreted cautiously.

NAPM-Chicago Consensus Forecast for July 04: 60
Range: 52.5 to 66.7

The University of Michigan's consumer sentiment index inched up to 96 at the mid-July reading from the final June level of 95.6. This index has increased more slowly of late than the Conference Board's confidence index.