Week's rally fades on Friday
Economic news was sparse but strong this week and should have been negative for the bond market. But instead it was discounted. Bond investors are long accustomed to a strong housing market, while improvement in jobless claims hasn't yet translated into real job growth. The market moved instead on rumors (Bin Laden was captured, Bin Laden wasn't captured) and remarks by foreign and domestic officials.

On Friday, the Treasury issued a questionnaire to dealers regarding the size of the upcoming auction. They also broached the subject of issuing 20-year TIPS. The Treasury has not issued 30-year TIPS in several years, limiting TIPS to 5-year and 10-year notes. Results of the questionnaire will be closely watched, but the announcement raises the possibility that a 20-year TIPS issue may appear as early as the February 4th refunding announcement.

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

Housing starts surge in December - and 2003
Housing starts rose 1.7 percent in December to reach a new high for this cycle, a 2.088 million unit rate. This put total starts 15 percent above year-ago levels. Single-family housing starts dipped 0.6 percent in December to a 1.664 million unit rate, but were still 13.8 percent higher than a year ago. Multi-family construction was a major force behind the December increase, surging 11.6 percent after a 12.8 percent spurt in November. The chart below shows the quarterly path of total and single-family housing starts over the past few years. After all is said and done, housing starts were in a 1.5-to-1.7 million unit range from 1999 through mid-2003. Starts jumped to a pace of 1.88 million units in the third quarter of this year and then to 2.04 million in the final quarter. Single-family housing starts increased in 2002 and more sharply in 2003.

Given the low level of interest rates, it isn't surprising that housing activity has soared in the past few years. Notice, however, that starts picked up steam in the second half of 2003 even as interest rates were rising from their June low.

The annual pace of housing construction reached 1.85 million units in 2003, the highest level since 1978. Single-family housing starts reached 1.5 million units in 2003, the highest level since 1977. But then again, mortgage rates have not been this low in more than 30 years.

It remains to be seen whether the hectic pace of housing starts can continue in the coming year. But interest rates, even if they increase modestly, are likely to remain at historically low levels. Moreover, overall economic growth is predicted to improve in 2004 over 2003, meaning income growth should accelerate as well. But predictions of stronger economic growth are predicated on an improvement in the jobs market. Without that, the upside should be limited.

It is worth noting, however, that both new and existing home sales have moderated from their peak over the past few years. Unless new home sales pick up again, we may see a rise in the inventory of unsold new homes. Eventually, housing construction would have to slow in order to realign supply with demand.

In the meantime, increased housing construction generally leads to increased demand for home furnishings and appliances. New homes are often outfitted with carpeting, tiles, hardwood floors and a few major appliances (if not all of them). Even if new homes don't sell immediately, home furnishings would still get a boost.

Jobs and the Fed
The FOMC will be meeting on Tuesday and Wednesday. While Fed officials will be reassured that housing is strong, they will be primarily worried about the employment situation. While many economic indicators have shown strength over the past few months, Fed officials are finding that waiting for labor market conditions to improve is like waiting for Godot. No doubt, they were as surprised as everyone else when December payrolls increased by a measly 1,000. (The number is so small, it isn't statistically significant to even call it a rise!)

Normally in early stages of economic recovery, Fed officials worry that accelerating economic growth will move too fast and generate inflationary pressures. But that's not the case today. Until just a month ago, the majority of Fed officials were primarily concerned with the prospect of disinflation. In the past month or two, several governors and district bank presidents have indicated that the risk is now more balanced and that the likelihood of inflation is roughly equal with that of disinflation. Since inflation is not really a concern, Fed officials have the luxury of maintaining a low interest-rate environment for a longer period of time.

The Fed has two mandates: to maintain price stability and to promote full employment. While the price stability issue is less pressing these days, labor market conditions are a priority. The unemployment rate has indeed declined to 5.7 percent in December from a high of 6.3 percent in June. The household survey, from which the unemployment rate is derived, has shown employment growth of 1.5 percent between December 2002 and December 2003. But the size of the labor force grew only 1.2 percent during this period. In 2002, the first year of recovery from the 2001 recession, the labor force rose a meager 0.5 percent. Historically, labor force growth increases after the first year of recovery because more job seekers, previously discouraged, feel more confident that they will be able to find work. At this point, it appears that potential job seekers remain too discouraged and are simply not participating in the labor force.

Fed officials are well aware with the problems of labor force and employment measurement. But even if the establishment survey is underestimating employment growth, the household survey is not fully reflecting the potential number of job seekers and in turn the unemployment rate. This will keep Fed officials quite concerned about labor market conditions for several more months. It also allows the Fed to maintain an easier monetary policy than they would normally in the second year of recovery.

The Bottom Line
While no one expects the Fed to raise the federal funds rate target at this meeting (or even very soon), market players will be on pins and needles to see how the Fed phrases its post-FOMC statement. Will they remove that little phrase "for a considerable period" or leave it in' That is the question - or at least one of the questions.

Looking Ahead: Week of January 26 to January 30

Monday
Existing home sales fell 4.6 percent in November to a 6.06 million unit rate. This was the second straight monthly decline for existing home sales that peaked at a 6.68 million unit rate in September. Home sales often move in tandem with new home sales and single-family housing starts, but that has not been the case over the past few months as starts continued to rise through November, although they did post a slight dip in December.

Existing home sales Consensus Forecast for Dec 03: 6.10 million unit rate
Range: 5.90 to 6.40 million unit rate

Tuesday
The Conference Board's consumer confidence index dipped to 91.3 in December after reaching a recent high of 92.5 in November. Market players may make a big deal about the one percentage point difference, but in essence consumer sentiment was virtually unchanged. In mid-January, the University of Michigan's consumer sentiment index surged more than 10 points and could point to a similar surge in the Conference Board's January index as well. That would be a big deal!

Consumer confidence Consensus Forecast for Jan 04: 97
Range: 89 to 106

Wednesday
Durable goods orders declined 2.5 percent in November after posting a cumulative gain of 6.1 percent over the two previous months. While all the major categories posted declines during the month, computers and electronic products posted a sharp 10.7 percent plunge after recording six straight monthly gains. A rising trend in durable goods orders is crucial in getting solid production growth.

Durable goods orders Consensus Forecast for Dec 03: 2.0 percent
Range: 0.5 to 3.1 percent

New home sales decreased 2.4 percent in November to a 1,082,000 unit rate, recording the third straight decline. November sales were 9.8 percent below the 1,200,000 peak reached in June. Single-family housing starts were still rising through November, although they did post a slight dip in December. While mortgage rates remain at historically low levels, improvement in employment and income would help encourage stronger housing activity.

New home sales Consensus Forecast for Dec 03: 1,095,000
Range: 1,025,000 to 1,150,000

At the beginning of the year, and at mid-year, the Federal Open Market Committee meets for two days to discuss what will be in their semi-annual report to Congress. Market players do not expect that the Fed will change its federal funds rate target at this meeting, but are particularly anxious to read the post-FOMC statement.

Federal funds rate target Consensus Forecast for today: 1 percent (no change)

Thursday
New jobless claims fell 1,000 in the week ended January 17 to 341,000. This brought the 4-week average down to 344,500, a recent low. This points to an improving labor market, although one does need to view these data cautiously around the holidays and we have yet to see significant improvement in nonfarm payrolls.

Jobless Claims Consensus Forecast for 1/24/04: 340,000 (-1,000)
Range: 335,000 to 355,000

The employment cost index rose 1 percent in the three months ending September 2003. This put the ECI 3.9 percent above year-ago levels. Wages and salary gains remained subdued, rising 0.7 percent for the quarter and 2.9 percent vs. a year ago. However, benefit costs jumped 1.5 percent for the quarter and were 6.5 percent higher than a year earlier. The pattern of soft gains in wages & salaries coupled with spikes in the benefits cost component is likely to continue for a while.

Employment cost index Consensus Forecast for Q4-03: 0.9 percent (q/q)
Range: 0.8 to 1.7 percent

Friday
Real GDP expanded at a whopping 8.2 percent rate in the third quarter after growing at a more modest 2.5 percent rate in the first half of the year. Consumers were the primary impetus behind growth with strong gains in consumption expenditures as well as residential investment. However, business fixed investment grew at a healthy rate and net exports narrowed, giving growth a further kick. No one expects this rate of growth to have continued into the fourth quarter - particularly since consumer spending increased at a slower pace.

Real GDP Consensus Forecast for Q4-03: 5 percent annual rate
Range: 4 to 6 percent annual rate

GDP deflator Consensus Forecast for Q4-03: 1.2 percent rate
Range: 1.0 to 1.9 percent rate

The business conditions index of the NAPM-Chicago edged down nearly 2 points in December to a level of 61.2. Despite the monthly drop, there is no question that business activity remains strong in this region. Keep in mind that this index includes manufacturing as well as non-manufacturing activity and thus will not be a perfect leading indicator for the ISM manufacturing index. Nevertheless, the two series often move in tandem (in direction if not by magnitude).

NAPM-Chicago Consensus Forecast for Jan 04: 62
Range: 54 to 65

The University of Michigan's consumer sentiment index surged to 103.2 at the mid-month January reading. Even if the mid-month level doesn't hold, it is likely that the index will still show a healthy rise for the month given that mid-month and month-end readings do not historically vary by a wide margin.