BONDS
The dismal employment report created a happy day in the bond market as yields dropped across the maturity spectrum. While some economists are suggesting that the employment situation report is not accurately depicting improvement in the labor market, bond investors are taking the report at face value. If taken at face value, there is no question that the Fed will have to put on hold any inclination to raise its federal funds rate target from today's 1 percent level. This will keep bond investors happy in the near term - and interest rates low.

Incidentally, this could help spur another round of mortgage refinancing. At 3.82 percent at Friday's close, the 10-year note yield is at its lowest level since July 14, 2003. Since 30-year fixed rate loans are typically tied to the 10-year Treasury, this should help reduce mortgage rates this upcoming week. In the week ended March 4, the 30-year fixed mortgage rate averaged 5.59 percent.

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.

Notice: I changed the way the euro-dollar exchange is reported in this table so that it is consistent with the yen-dollar exchange rate. Now the table will reflect euros per dollar. Thus an increase in this value represents a rise in the FX value of the dollar; conversely a drop in this value represents a decline in the FX value of the dollar.

The Economy

Payrolls inch up in February, jobless rate holds
Nonfarm payroll employment edged up 21,000 in February after downwardly revised gains of 97,000 in January and 8,000 in December. The 3-month moving average shows that after improving through November, payrolls are once again on a downward trend. That is not encouraging news for the growth prospects of the economy. After all, if consumers aren't working, they won't be generating income to make purchases! It's no wonder that motor vehicle sales plunged in January and held at the new lower level in February. It's no wonder that the Conference Board's consumer confidence index and the University of Michigan's consumer sentiment index sank in February after jumping in January. Labor market conditions appeared pretty miserable in February.

The civilian unemployment rate held at 5.6 percent in February but reflects a 392,000 drop in the labor force combined with a 265,000 decline in household employment. Thus, the number of unemployed workers declined - but primarily because they were no longer in the labor force. The chart below compares the jobless rate to the employment-population ratio that disregards movements in the labor force but simply looks at employment conditions. The ratio reverted back to 62.2 in February after a January uptick to 62.4. While the jobless rate has declined 0.7 percentage points from its peak in June at 6.3 percent, the employment-population ratio is 2.5 percentage points below its peak of 64.7 way back in April 2000. There are legitimate reasons for dropping out of the labor force - to raise a family, to go back to school, to take care of family members that have become ill. However, one can't help but believe that the drop in the labor force in the past year is misleading and that the employment-population ratio is giving a more reliable estimate of lost employment.

The cock-eyed optimists will find slivers of good news in the employment report. The average workweek held at 33.8 hours in February for the second straight month and for the third time in four months. It does appear that the average workweek has reached a new level in the past four months relative to a good chunk of 2003 when the workweek was lower on average. The average workweek in manufacturing also picked up steam, rising to 41 hours in February, the highest level since November 2000! Typically, employers will increase the number of hours worked before they hire new employees. The workweek figures do bode well for employment gains down the road.

Productivity growth accelerates in 2003
Everyone knows that healthy productivity growth has hampered employment gains during this recovery. The Labor Department's revised estimates revealed that nonfarm productivity grew 5.4 percent in 2003 after a healthy 4.3 percent gain in 2002. It isn't unusual to see productivity growth accelerate in the early phase of a recovery. Look at 1991 and 1992! Productivity growth accelerated then too before moderating as the economic expansion matured and new workers were hired. This is typical historical behavior. The important question, though, is whether productivity can be further enhanced as we enter the third year of recovery (the recession ended November 2001). Based on at least the experience of the early 1990s, it is conceivable that productivity growth will ease and employment growth will accelerate.

One must remember that there is another side to this equation. While no one will argue that productivity growth curtailed employment gains in this recovery, it is also true that real GDP has grown at a less rapid pace in 2002 and 2003 than it did in 1992 and 1993. Thus, we also need to be concerned with the demand side of the equation: GDP growth also needs to accelerate before employment gains will be more pronounced.

One would be remiss if outsourcing was not considered a factor in sluggish employment growth in this recovery. There is no question that technology has created a smaller world where trade on all levels is simplified. But outsourcing is not the primary reason for dismal employment growth. Were we to see more rapid GDP growth, employment gains would surely follow.

The ISM Surveys
Both the manufacturing and non-manufacturing ISM surveys moderated in February after reaching new cyclical highs in January. The February declines don't suggest that the manufacturing sector or the service sector is in any danger of collapsing. After all, both the manufacturing diffusion index (which is a combination of five components) and the business activity index from the non-manufacturing survey are well above 50 percent - and in fact over 60 percent. The non-manufacturing business activity index has been near or above 60 percent since June 2003. The manufacturing ISM index has surpassed 60 percent for four straight months. This bodes well for industrial production. Indeed, even February's bleak employment report showed improvement in manufacturing with a longer workweek and a minuscule 3,000-drop in factory payrolls, the smallest monthly decline since July 2000 when factory payrolls last posted a gain.

The Bottom Line
It was something of a roller coaster week. A few indicators were stronger than expected and some were weaker than expected. The most disappointing news came from the labor market with a meager 21,000 gain in nonfarm payrolls for the month of February.

While there is no question that Fed officials monitor closely all sorts of economic indicators, the bleak employment report had to set them back. How can the Fed justify raising the federal funds rate target even 25 basis points when employment hasn't yet staged a recovery since the 2001 recession' In this election year, there is no question that a Fed rate hike in the face of sluggish employment growth would cause quite a stir. (Although perhaps Fed Chairman Alan Greenspan doesn't care about causing controversy as he did a couple of weeks ago when he declared tax increases unnecessary, saying that social security benefits could be cut to lower budget deficits).

The Fed will have to point to significant employment improvement before they hike interest rates. Many economists and policymakers are pointing to problems with the nonfarm payroll figures. Some of these have merit. But aside from a decline in the number of layoff announcements as measured by the Challenger report, which has its own controversial elements, we haven't seen any improvement in the Conference Board's help wanted index while new jobless claims have remained in a tight range.

Looking Ahead: Week of March 8 to March 12

Wednesday
The international trade deficit on goods and services widened by $4 billion in December to reach a $42.5 billion shortfall, the largest since March 2003. Exports edged down in December after increasing for several months. Imports surged in December after some moderation during the year.

International trade balance Consensus Forecast for Jan 04: $-42.6 billion
Range: $-43.7to $-40.0

Thursday
New jobless claims fell 7000 in the week ended February 28 to 345,000. This lowered the 4-week moving average to 352,250, the first drop after four weekly gains. Claims are up in February, the first monthly gain since last April. This does not bode well for the labor market.

Jobless Claims Consensus Forecast for 3/6/04: 345,000 (unch)
Range: 338,000 to 350,000

Retail sales edged down 0.3 percent in January, more than reversing the previous month's 0.2 percent gain. A sharp 3.9 percent drop at motor vehicle dealers hampered total sales. Excluding autos, retail sales jumped 0.9 percent in January, recording the largest monthly gain since August 2003. Department stores reported healthy chain-store sales in February and this could bode well for retail sales ex-autos. Motor vehicle sales were roughly unchanged in February from January levels, although there was a shift in mix from SUVs to cars, which are usually lower priced. That could translate into a drop in sales at motor vehicle dealers.

Retail sales Consensus Forecast for Feb 04: 0.5 percent
Range: -0.1 to 1.0 percent

Retail sales ex autos Consensus Forecast for Feb 04: 0.5 percent
Range: 0.3 to 1.0 percent

The U.S. Treasury reported a federal budget deficit of $1.4 billion in January, a month that is typically associated with a surplus because estimated tax payments are due for the month. Over the past 10 years, the federal budget deficit averaged $51.5 billion for the month of February. Given the sharp deterioration in the federal budget, expect a deficit that is much larger than the average!

Treasury budget Consensus Forecast for Feb 04: $-100 billion
Range: $-90 to $-110 billion

Friday
Business inventories rose moderately in the past couple of months suggesting that manufacturers and retailers would like to have more inventories on hand now that economic activity is percolating. This should continue to boost industrial production in coming months.

Business inventories Consensus Forecast for Jan 04: 0.3 percent
Range: 0.1 to 0.4 percent

Consumer sentiment plunged 9.4 percentage points in February to 94.4 after surging to 103.8 in January. Some economists blamed poor weather conditions in February for the sharp decline in the University of Michigan's confidence index. Most likely, consumers were concerned about labor market conditions.