When bond traders returned from the Labor Day weekend, there was no end-of-month buying as in the previous week, no safe-haven support for the long weekend, and no economic data for guidance. After making hefty gains in August, they decided to take some profit.

But signs were accumulating that the Fed had no reason to make another hike. Inflation indicators were tame and oil prices were falling. Some economic data showed weakness. Industrial production reportedly slipped in August, the first contraction in seven months. And numerous housing indicators were reflecting a sharp cooling in the highly influential sector.

The tipping point for the market was reached on the 19th, the day before the Fed meeting. The Producer Price Index for August was released that day and revealed a core (ex-energy and food) decline that was the largest since April of 2003. July's core index had also fallen, constituting the first back-to-back decline since November and December of 1997. The report on housing starts was also released that day and was weaker than predicted (see below). Despite the proximity to the Fed meeting, bonds rallied.

As expected, the Federal Open Market Committee (FOMC) decided to leave interest rates alone, noting that "moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market." But, as was the case in previous meeting statements, September's said that "some inflation risks remain" and that "The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information." Interestingly, Richmond Fed President, Jeffrey Lacker, disagreed with the other committee members, preferring as he did in the August meeting to hike the fed funds rate by 0.25%.

The initial reaction in the bond market to the Fed statement was an attempt to take some profits, but the move lacked conviction and Treasuries returned to unchanged levels for the day. The rally picked up steam in the next few sessions, however. During this time, a key regional manufacturing indicator, the Philadelphia Fed Index, posted its first contraction reading in over three years. Within five sessions, the yield of the 10-Year Treasury Note fell by 26 basis points, from its highest level of the month to its lowest (yield moves inversely to price).

Bond prices fell in the final week of the month as month and quarter close-out activity included some profit-taking. Traders were also being pressured by new supply in the form of the monthly 2- and 5-Year Treasury Note auctions. Bonds were also feeling competition from the stock market as the Dow approached its record high of January of 2001. By the end of the month, the 10-Year Note yield had lost a total of 10 basis points. This followed a drop of 25 basis points in August. Similarly, the average 30-year, fixed rate mortgage rate declined in each week of August and September except the week ending September 7.

Housing :

The housing indicators released in September were generally negative, though the sales picture for August was somewhat brighter than expected. The construction-related news was bleak. Residential construction spending (seasonally adjusted, annualized pace) fell sharply in July, a fourth consecutive monthly decline and the largest in two years, leaving the rate at its lowest level in fifteen months. The near-term outlook for starts was also grim. The rate of building permit issuance took a seventh consecutive monthly drop to its lowest level in four years.

The rate of housing starts in August was also extremely bearish. It fell for a sixth month in the previous seven and the rate was the lowest since April of 2003. Moreover, June and July's rates were also revised lower than previously reported.

Another sign of weakness was the National Association of Homebuilders Housing Market Index. Its Septemberreading came in at its lowest level since February of 1991.

As noted, the home sales data were stronger than had been predicted, reflecting consumer reaction to a recentdecline in mortgage rates. The rate of existing home sales still declined in August but only byhalf-a-percent. This was still a fifth monthly deceleration and the rate was the lowest since January of2004. Other details in the existing home sales report were also indicative of a weakening market. Inventoriesof existing homes for sale rose for an eighth straight month to a record high in August and given theprevailing sales pace, their projected time on the market was the longest since 1993. In addition, medianand average home prices were lower in August than they were a year earlier.

The rate of new home sales rose in August. As a matter of fact, the gain was the largest in five months.But the gain depended on a sharp downward revision to July's pace. May and June's rates were also trimmed.