The jobs report for June was a mixed bag as the 112,000 new hires were much less than the anticipated 250,000 which had been suggested by most forecasters. Although the unemployment rate remained unchanged at 5.6% and June's payroll increase was the 10th straight month of gains, the less than expected number was discouraging for several reasons. First, factory jobs declined for the first time in 5 months as manufacturers lost 11,000 jobs in June and, secondly, average weekly hours worked dropped across the board. While these are not significant concerns, they raise questions about future Fed policy because rising incomes are needed to offset increases in interest rates.

The creation of 1.3 million jobs so far this year and signs of inflation prompted the Fed to nudge rates up a notch at its June 30 FOMC meeting.

In an effort to satisfy worries about inflation, the Fed raised the funds rate by 25 basis points to 1.25%. This is the first upward move in four years and is likely the beginning of a series of rate hikes over the next several years. We believe the Fed is trying to hit a level that allows for economic growth with low inflation but it never works quite the way they intend. There are a number of forecasters hinting that inflation is accelerating faster than the Fed believes and they argue that more aggressive stance is needed. However, the boys at the Fed have repeatedly stated that they will do whatever is necessary to contain inflation. At the same time, they are also convinced that commodity prices will moderate, that the economy will slow modestly in the second half of the year, and international competition will play a key role in controlling inflation for goods and services. Our thoughts follow simple logic: higher interest rates are not bad and those that save and invest might be grateful for an opportunity to enjoy better yields on bond investments. Those that borrow have been the recipients of low rates for the past 4 years, including the federal government, and a shift towards higher rates is good.

The second quarter was the worst bond performance going back to 1980 as investors prepared for a certain move on June 30 by the Fed. However, the market improved by 25-35 basis points after the anticipated announcement. On April 1, the 10-year Treasury note had a yield of 3.70% and by mid-June it had jumped to 4.67%. After the announcement, the yield had dropped back to 4.45% and today investors are trying to gauge fair value going forward. Our belief is that the 10-year will trade in the 4.50 to 5.00% range during the second half of the year as bond traders continually monitor the pace of inflation. Moreover, the futures market is quite clearly stating that the bond market is expecting the federal funds rate to be at 2.25% by March 2005, and we agree. Now, if the 10-year spread to federal funds is consistent with past experience of 125 basis points, then the 10-year between 4.50% and 5.00% appears cheap. In other words, if bond yields increase from current levels, we would add bonds to our own portfolios.

Rising gasoline prices are not preventing consumers from spending more on cars, apparel, and other goods. Consumer spending remains strong, housing activity continues to be robust, businesses are replenishing inventories, American companies are generating huge amounts of cash, and higher interest rates do not appear to be slowing this activity. Meanwhile, inflation concerns are real. The CPI and PPI are much stronger than originally thought and will likely cause concern in coming months. The current account deficit reached a record $145 billion during the first quarter and could be a problem if the dollar weakens in the third and fourth quarters.

The steep yield curve tells us that the forward economy is going to do very well. Maybe a little inflation, perhaps a few more rate increases, but the economy will be good! As in Virginia and California, the federal government will see higher tax revenues from a better economy which means smaller deficits---Hmmm.