BONDS
Interest rates trended slightly higher during the week, but rate movements were mild relative to last week's spike that followed the April employment report. Inflation news, measured by the PPI and the CPI this week, was slightly worse than expected. However, market players were already immune to it given that many were following crude oil prices - and those topped $40 per barrel. In their mind, bond investors have moved forward the Fed rate hike from August to June. Labor market indicators are sufficiently healthy and inflation news suggests that inflation risks are not balanced, as the Fed's statement indicated just a week ago. By Friday, bond investors were relieved that the quarterly refunding was behind them and that the supply of new Treasury securities will not pick up until the end of June.

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

April PPI rises faster than CPI
The producer price index jumped 0.7 percent in April, higher than market players expected. Not only did energy prices jump 1.6 percent during the month, but food prices also increased a hefty 1.4 percent. This was the second month in which food prices posted such a substantial gain and it was due primarily to a 10.4 percent spurt in dairy products along with significant hikes in beef & veal, pork, coffee, soft drinks, milled rice and shortening & cooking oil. Excluding food and energy prices, the PPI posted a moderate 0.2 percent gain for the second month in a row. Despite the modest core increase, the year-over-year gain still accelerated in April to show a 1.5 percent gain. The total PPI is now 3.7 percent higher than a year ago.

The consumer price index increased a more moderate 0.2 percent in April, not hit by a similar rise in food and energy prices. Indeed, the 0.1 percent rise in energy prices defies logic, but then energy prices in the PPI and the CPI tend to follow different seasonal patterns so the seasonal adjustment is hardly ever similar. Food prices rose much more modestly in the CPI than the PPI after seasonal adjustment. However, the core CPI (excluding food & energy) posted a 0.3 percent hike after a 0.4 percent rise in March - in both cases, faster than the PPI. Notice the rising trend in the year-over-year increase in the consumer price index: both the total CPI and the core CPI are obviously accelerating from the lows seen at the end of 2003. It is difficult to imagine that just six months ago Fed officials were still concerned about the prospects of disinflation (a slowing in the rate of inflation). There is no question that inflationary pressures are on the rise, though they are not likely to accelerate at a galloping rate in coming months.

Fed officials were waiting to see inflation turn around before beginning to "remove policy accommodation". There is no question the turn has taken place. Keep in mind that the Fed does want to move "at a measured pace" and does not want to raise rates quickly. They learned from the 1994 experience, when they raised rates 300 basis points in 13 months, that jolting the market is not a good idea. In order to get to a neutral fed funds rate with a CPI rate of roughly 2 percent, the Fed will need to raise the fed funds target 2.5 percentage points to 3.5 percent from the current 1 percent rate. However, our best bet is that they will raise the funds rate target by 75 basis points this year (and likely no more than 100 basis points) and then move in moderate increments during 2005.

April production spurt
The index of industrial production increased 0.8 percent in April after dipping 0.1 percent in March. Among major industry groups, manufacturing rose 0.7 percent, mining increased 0.8 percent and utilities jumped 1.5 percent. While total industrial production is 4.8 percent higher than a year ago, production of manufactured goods are 5.1 percent higher than last April. As depicted in the chart below, there is no question that production growth is improving at a steady pace - and certainly more decided than the modest gains seen in 2002. The industrial production index level stood at 115.4 in April, the highest level since November 2000 when the index stood at 115.6. The peak in production was 116.4 in June 2000, so we have a little ways to go before re-attaining the previous business cycle peak.

Retail sales dip
Retail sales fell 0.5 percent in April after recording an upward revised gain of 2 percent in March. Sales at motor vehicles & parts dealers dropped 1.8 percent, reversing a good chunk of March's 2.4 percent hike. Excluding autos, retail sales inched down 0.1 percent in April after rising 1.8 percent in March. Sales were mixed among retailers as furniture stores as well as electronic stores posted healthy gains but building materials stores decreased for the month. (However, after an 11 percent spurt in building materials store sales in March, the 0.7 percent drop is hardly worth noting.)

Clothing and accessory store sales fell along with department store sales. However, food stores, sporting goods stores as well as nonstore retailers posted healthy gains for the month. Market players viewed the April dip as a disappointment, but considering the strong consumer showing in the first quarter, a month's pause, unless it persists, should not be viewed in a negative light. Given the hefty rise in gasoline prices in the past couple of months, with much of the country paying more than $2 per gallon, consumer spending could be crimped. On the positive side, some analysts are looking for healthy tax refunds that could help boost spending a bit this spring. No doubt, the rising mortgage rate environment, up 100 basis points in two months, will likely dampen refinancing activity and cash out refinancing will no longer benefit homeowners. This is likely to hamper the consumer sector as well.

Oddly enough, rapidly rising gasoline prices are not significantly affecting consumer attitudes. The University of Michigan's consumer sentiment index was unchanged at the mid-month reading for May. Consumer confidence hasn't improved for several months, but then neither has it deteriorated. Granted, market players were expecting some improvement in consumer sentiment, but this survey is not as heavily geared towards labor market conditions as The Conference Board's index.

Trade deficit widens in March
The international trade deficit on goods and services widened in March to show a $46 billion shortfall; this was nearly $4 billion worse than the February deficit. While both imports and exports posted gains during the month, the 2.6 percent rise in exports was no match for the 4.6 percent spurt in imports. Both exports and imports are rising at a healthy clip from a year ago. While export growth was expected, due to the weaker value of the dollar in the foreign exchange market, import demand is robust, stemming partly from increased oil imports but also from imports of consumer and capital goods.

The other deficit
The U.S. Treasury recorded a surplus of $17.6 billion in April, which is typically a surplus month because of quarterly individual and corporate tax receipts. This April, the surplus was the smallest since fiscal year 1994. With just seven months of the fiscal year in place, the budget deficit amounts to $281.8 billion for fiscal year 2004, a new record. Surpluses are typically recorded in June and September, but these certainly won't be large enough to keep the budget deficit in check. Economists are estimating that the total fiscal year deficit will amount to $425 billion.

The burgeoning deficit will clearly require greater borrowing needs by the federal government. This means that the size of the Treasury auctions is likely to drift higher over the course of the year. Foreign investors are already purchasing large quantities of our securities, helping to hold down interest rates. Should this demand dissipate over time, the massive supply of Treasury securities will require higher interest rates to entice investors.

The Bottom Line
The combination of $40 per barrel crude oil and $2 per gallon gasoline is frightening investors. Forget about the nasty effects of deflationary pressures, investors are now worried about the impact of inflation - beginning with Fed tightening.

While the monthly gain in the PPI was larger than expected, the monthly rise in the CPI was relatively benign. However, there is no question that year-over-year gains in the core components are accelerating from the lows we saw just a few months ago. Equity and bond investors are rightly expecting the Fed to start raising the federal funds rate target.

Are the worries overblown' Of course they are. It was inevitable that the Fed, at first sign of clear improvement in the labor market, would begin to raise the fed funds rate target from its highly stimulative rate of 1 percent. While everyone concurred that the 1 percent rate was unsustainable, it still appeared as though investors were shocked when Fed officials began ruminating about "removing policy accommodation".

Rising energy prices will certainly hamper retail sales as consumers must spend more money filling their tanks. But an improving labor market situation does at least create better income prospects for a larger segment of the population - which will now have more money to spend on goods and services.

Looking Ahead: Week of May 17 to May 21

Monday
The Empire State manufacturing survey, which covers the New York region, jumped more than 10 points in April to 36.1 from a level of 25.3 in March. Any level above zero reflects an expanding manufacturing sector.

Empire State manufacturing survey Consensus Forecast for May 04: 35
Range: 27.5 to 36.8

Tuesday
Housing starts jumped 6.4 percent in March to reach a 2.01 million unit rate after declining in January and February. No doubt, housing activity was spurred by falling mortgage rates during the month. Mortgage rates increased 38 basis points in April, the first - and largest - gain since last August when mortgage rates rose 63 basis points.

Housing starts Consensus Forecast for Apr 04: 2.00 million unit rate
Range: 1.89 to 2.10 million unit rate

Thursday
New jobless claims rose 13,000 in the week ended May 8 to 331,000, reversing part of last week's 20,000 decline. Despite the uptick, the 4-week moving average fell back to 335,750. May now begins on a lower level than the April average and this bodes well for employment gains in May.

Jobless Claims Consensus Forecast for 5/15/04: 330,000 (-1,000)
Range: 325,000 to 335,000

The index of leading indicators edged up 0.3 percent in March after remaining unchanged in February. Among components already available, the factory workweek, jobless claims, vendor performance and consumer expectations are negative for the index. Stock prices and the spread between the fed funds rate and the 10-year note rose during the month. Note that the leading indicators index uses the monthly average of stock prices rather than the month-end figure. Most of the time, the two figures move in the same direction, but this time the monthly average of the S&P 500 was up in April even though month-end figures dropped.

Leading indicators index Consensus Forecast for Apr 04: 0.1 percent
Range: -0.1 to +0.3 percent

The Philadelphia Fed's business outlook survey improved in April as the composite index rose to 32.5 during the month from a level of 24.2 in March. Any level above zero suggests that manufacturing activity is expanding. The Philly Fed index does a good job of predicting the index of industrial production.