BONDS
As usual, bond investors are getting ahead of the Fed. Since the March employment report released on April 2, Treasury yields have headed higher. Special occasions have marked more pronounced increases. Greenspan's testimony on April 20 was cause for alarm as he first suggested that the Fed would eventually raise interest rates. The post-FOMC statement surely indicated that the Fed was ready to initiate rate hikes, although Treasury investors appeared relatively mellow that day. But they were less mellow after seeing the stronger-than-expected April employment report, as yields jumped the equivalent of one 25-basis-point rate hike in the 2-year, 3-year, and 5-year arena. Yield gains were more "subdued" at the long end of the maturity spectrum. Since April 1, Treasury market yields have increased dramatically and suggest a minimum of four 25 basis point rate hikes in the near term. April's employment report will surely be the impetus behind a rate hike, probably at the June 29-30 FOMC meeting. Though the Fed promised it will be "measured" as it tightens monetary policy, some market players believe the April jobs data were so stellar that they consider a 50 basis point increase is a possibility. While the nonfarm payroll data were vigorous, the household survey didn't show a similarly outstanding improvement. (See comments on the employment situation below.)

It is not surprising that the Treasury market is ahead of the Fed. It isn't unusual to see market players anticipate Fed rate movements on the way up as well as the way down.

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

Another upside surprise on payrolls
Nonfarm payroll employment increased 288,000 in April after upward revised gains of 337,000 in March and 83,000 in February. Nonfarm payrolls have now posted eight consecutive monthly gains, and the most recent two are something to talk about. The goods-producing sector increased 42,000 in April, about half the March pace. But whereas the March gain was focused in construction, the April hike was concentrated in manufacturing! Factory payrolls have now posted three straight monthly gains - a sight we haven't seen since early 2000 when factory payrolls increased in the first four months of the year. Nonfarm payrolls in the service-producing sector increased 246,000 in April after an equally healthy 255,000 in March. Gains were recorded pretty much across the board. Temporary help workers did post moderate gains, but so did all other industry sectors. Employers are not focusing on hiring temporary help.

Perhaps the gains in factory payrolls prevented manufacturers from putting in extra hours. The factory workweek decreased 18 minutes to 40.6 from a level of 40.9 in March and a recent high of 41 hours in January and February. At the same time, the private workweek remained unchanged at 33.7 hours in April.

The rise in employment came with a rise in hourly earnings. Average hourly earnings increased 0.3 percent in April after a smaller 0.1 percent hike in March. On a year-over-year basis, hourly earnings rose 2.2 percent, faster than the previous month's 1.8 percent hike. The upward trend is encouraging for consumers, but it remains to be seen whether hourly earnings will continue to increase at this same rate or will flatten out in the next few months. Higher earnings would certainly make consumers less annoyed about spending more at the gas pump. With much of the country paying $2 per gallon (or more) on unleaded gas, the price of gas is roughly 50 cents higher than consumers were paying just five months ago.

The civilian unemployment rate edged back down to 5.6 percent in April after a brief uptick to 5.7 percent in the previous month. Household employment increased 278,000 in April, roughly the same amount as the payroll hike. At the same time, the labor force grew by a smaller 91,000. While there is no question that the payroll figures are good, the household data are not revealing a robust labor market. The employment-to-population ratio, which does not consider workers entering and leaving the labor force, inched up to 62.2 in April from 62.1 in March - a meager rise and not even as good as January's recent high of 62.4.

Some market players were expecting the Fed to come in today and raise the federal funds rate on the back of the robust payroll report. That was unlikely to happen since the Fed does indeed monitor the employment-to-population ratio. Yes, eight straight months of improvement in nonfarm payrolls is good and supports an increase in the funds rate target, finally. Nevertheless, the jobs improvement isn't extreme enough to warrant inter-meeting action by the Fed before its regularly scheduled FOMC meeting on June 29-30. Incidentally, many more economists are now suggesting that the Fed is more likely to raise rates in June than wait until August.

The Fed promised that they will take "measured" steps in raising the fed funds rate target. Today's employment situation does not change that view. The economy is clearly improving and the labor market is finally in position to show steady gains. But a rapid fire rate hike policy - particularly during an election year - is not the best bet. We stand by our view that the Fed has room to raise the fed funds rate target twice, and possibly three times this year in 25 basis point increments.

Productivity accelerates in Q1
Despite the employment growth measured by nonfarm payrolls, nonfarm productivity increased at a 3.5 percent rate in the first quarter, faster than the 2.5 percent pace registered in the fourth quarter of 2003. At the same time, unit labor costs rose at a 0.5 percent rate in the January-to-March period after remaining unchanged in the final three months of the year. Quarterly growth changes in productivity and unit labor costs tend to fluctuate dramatically. To get a better view of the underlying trend, we like to look at the year-over-year change in productivity and unit labor costs. Nonfarm productivity was 5.4 percent higher than a year ago. At the same time, unit labor costs were 1.3 percent lower than a year ago. These trends have remained in place for several quarters.

Now that nonfarm payrolls are finally starting to show some zest, productivity growth is likely to moderate. Indeed, Fed Chairman Alan Greenspan has been predicting a slowing trend in productivity for many months now. It is likely that his prediction will finally be realized in the coming quarters as long as nonfarm payrolls continue to grow at least 150,000 per month, consistently.

ISM Surveys
The manufacturing and non-manufacturing ISM surveys both showed that robust growth continued in April, just like the employment situation. The non-manufacturing survey appeared stronger as the business activity index increased almost three points in April, to a level of 68.4, the highest yet in the history of this series that began in 1997. The manufacturing ISM diffusion index that incorporates five components (new orders, production, employment, supplier deliveries and inventories) inched down a tick to 62.4 in April from 62.5 in March. The level for February, March and April is down slightly from the highs reached in November, December and January. Nevertheless, manufacturing activity is percolating at a vigorous rate. After all, factory payrolls finally turned the corner after declining for four straight years!

Factory orders surge in March
Factory orders jumped 4.3 percent in March after a smaller 1.1 percent hike in February and a 0.9 percent drop in January. Both a 3.5 percent hike in nondurable goods new orders and a 5 percent gain in durable goods orders helped propel the total figure. Despite, the healthy rise, the first quarter growth rate of 9.2 percent looks small compared with the larger gains reported in the previous two quarters. Nevertheless, as one can see from the chart below, the path of factory orders is never smooth. Nondefense capital goods as well as information technology orders posted healthy growth in the first quarter. These gains bode well for industrial production as the new orders, along with a backlog of unfilled orders, support hearty activity in coming months.

Motor vehicle sales remain in doldrums
Motor vehicle sales were lackluster in April as they dipped back down to a 13.1 million-unit rate after rising to a 13.3 million-unit rate in March. While sales fluctuated in 2003, they were certainly better in the second half of 2003 than in the first four months of 2004. The lackluster sales pace caused GM, Ford, and Daimler-Chrysler to reinstitute incentives on certain models. Will the incentives lure consumers back into the showrooms' Perhaps. But it is possible that the heavy duty incentives of the past few years, along with generally low rate loans, caused many consumers to accelerate their purchases. Anecdotal evidence (daily driving around town and down the I-5 corridor) indicates that there are a lot of new vehicles on the road. At some point, consumers are going to have to switch their spending from cars to other retail sales. It is possible that swelling employment rolls will help spur vehicle sales down the road. But, then again, maybe not.

The Bottom Line
Financial market players had a tough week - having to deal with an FOMC meeting and the employment situation in one week! The post-FOMC statement was revised to suggest that the Fed now stood ready to "remove policy accommodation" at a "measured" pace. According to Laurence Meyer, former Fed governor, it suggests that the Fed will move in 25 basis point increments and will probably not raise rates at every FOMC meeting. Indeed, after Friday's employment report, many Fed watchers are beginning to call for two or three rate hikes this year. While this may seem traumatic to equity and bond investors, keep in mind that the current federal funds rate target is only 1 percent and three 25 basis point moves would get it to a whopping level of 1.75 percent! That is hardly going to stop the economy in its tracks (a fear among equity investors). Removing policy accommodation means that the Fed will have to get the funds rate back to a neutral stance - somewhere closer to 3.5 percent. But this process will take more than a year - and certainly won't happen during an election year.

The employment situation was good. No doubt, policymakers are hoping that the friendly news will continue for months to come. The manufacturing sector also revealed itself to be expanding briskly, although the same can't be said for domestic motor vehicle sales. Are consumers taking a break or deciding to spend their money elsewhere' Certainly, a lot more household income is going to fill up the family gas tank these days.

While the Fed has stressed that inflation is not yet a concern, financial market players are somewhat worried about the accelerating pace of various inflation measures. Next week brings both the CPI and PPI (that is if the Bureau of Labor Statistics finally gets their act together on the NAICs conversion for producer prices). Also, the retail sales report will reveal if consumers were spending their discretionary income on anything other than gasoline in April.

Looking Ahead: Week of May 10 to May 14

Wednesday
The international trade deficit on goods and services narrowed in February to $42.1 billion due to a 4 percent hike in exports that surpassed the 1.6 percent gain in imports. The trade deficit was the smallest in three months. Stronger economic growth in the U.S. could boost import demand despite the relatively weaker foreign exchange value of the dollar.

International trade balance Consensus Forecast for Mar 04: $-43 billion
Range: $-41.9 to $-45.7 billion

Import prices jumped 0.9 percent in March due to a spurt in energy prices. Excluding petroleum, import prices increased by a smaller 0.2 percent during the period. Export prices also rose 0.9 percent in March, due largely to a spurt in agricultural prices.

The federal budget usually records a large surplus in April due to the large number of tax receipts for the month. In the past 10 years, the April surplus has averaged nearly $94 billion. The April surpluses in fiscal years 2002 and 2003 were smaller, roughly one-half to two-thirds of the 10-year average.

Treasury budget Consensus Forecast for Apr 04: $18 billion
Range: $15 to $44 billion

Thursday
New jobless claims fell 25,000 in the week ended May 1 to 315,000, the lowest weekly pace in several years. This brought the 4-week moving average to 343,250. While the decline in jobless claims was encouraging, the April average is higher than the March average by a small margin.

Jobless Claims Consensus Forecast for 5/8/04: 320,000 (5,000)
Range: 310,000 to 335,000

Retail sales increased 1.8 percent in March after a healthy 1 percent rise in February. Indeed, retail sales have increased for six months in a row. Excluding the volatile auto component, retail sales rose 1.7 percent in March after a 0.6 percent hike in February and a 1.5 percent gain in January. It was a good quarter. Will this heady pace continue into the current quarter'

Retail sales Consensus Forecast for Apr 04: -0.2 percent
Range: -0.9 to +0.6 percent

Retail sales ex autos Consensus Forecast for Apr 04: -0.2 percent
Range: -0.7 to +0.5 percent rate

The producer price index increased 0.5 percent in March after inching up a modest 0.1 percent in February. Both higher energy and food prices contributed to the gain. Excluding food and energy prices, the PPI rose 0.2 percent in March after a 0.1 percent hike in February. The Bureau of Labor Statistics is hoping to hold to the originally scheduled date for the PPI, after having problems these past few months. If it can't report on the 13th, it will issue an announcement on the 12th.

PPI Consensus Forecast for Apr 04: 0.3 percent
Range: 0.2 to 0.6 percent

PPI ex food & energy Consensus Forecast for Apr 04: 0.2 percent
Range: 0.1 to 0.5 percent rate

Friday
The consumer price index increased 0.5 percent in March after rising 0.3 percent in February. Higher food and energy prices contributed to the gain, but the CPI excluding food and energy prices jumped 0.4 percent in March. Fed officials didn't appear concerned about the March hike, but if the core CPI were to increase by that magnitude for more than two months in a row, they certainly would be worried about inflationary pressures.

CPI Consensus Forecast for Apr 04: 0.3 percent
Range: 0.0 to 0.4 percent

CPI ex food & energy Consensus Forecast for Apr 04: 0.2 percent
Range: 0.0 to 0.3 percent

Business inventories rose 0.7 percent in February, the largest gain in over a year. The largest gains were in wholesale trade and manufacturing. Retail trade inventories rose less sharply in the first couple of months of the year, perhaps because of the strong retail sales figures.

Business inventories Consensus Forecast for Mar 04: 0.5 percent
Range: 0.3 to 0.6 percent

The index of industrial production fell 0.2 percent in March after increasing 0.8 percent in February. The market group breakdown reveals that production of consumer goods and business equipment fell in March, but defense & space equipment as well as construction supplies posted gains.

Industrial production Consensus Forecast for Apr 04: 0.6 percent
Range: 0.2 to 0.8 percent

Capacity utilization rate Consensus Forecast for Apr 04: 76.9 percent
Range: 76.5 to 77.3 percent

The University of Michigan's consumer sentiment index decreased in April after increasing in March - bringing the sentiment index back to the February level. The January spurt is a bit of an aberration, but nonetheless, consumer attitudes are generally higher in early 2004 than in the second half of 2003.

Industrial production Consensus Forecast for mid-May 04: 96
Range: 95 to 98