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Midwest Investment Management
The Tower at Erieview | 1301 East 9th St | Suite 1110 | Cleveland, OH 44114
Introduction
In this issue...

By Joseph A. Harrison, CFA, Partner

The early summer run in bond prices reached levels that correspondingly dropped the yield on 10-year U.S. Treasury Notes to 3.1%, capping a 22-year decline from 15.8%. As the second quarter developed, stocks were recovering nicely, but the stillhesitant economic recovery prompted speculation that deflation was a real risk and interest rates would go lower.

Decline in rates

In times such as these, some perspective is required. We had seen an 80% decline in interest rates over a 22- year period, including a 45% decline from spring of 2002. Clearly, interest rates were as unsustainably LOW in June 2003 as they were unsustainably HIGH in September of 1981. In the early 80’s, double-digit inflation and double-digit interest rates were a severe hindrance to economic activity. It was clear those conditions could not persist. Either or both conditions threatened our well-being and had to end.

Deflation concerns

Recently the threat has been deflation. Record levels of personal and corporate debt, along with declining asset levels and incomes, created a potential formula for economic disaster. However, while still a consideration, deflation should not be a serious concern for now. Should we be concerned that the recent sharp increase in interest rates will stop the economy in its tracks? Not right now. Rates have only returned to the lower end of the range that existed for the past 12 years when rates were between 41&Mac218;2% to 8%.

A changing landscape

Mortgage refinancing will no longer fuel the economy, nor will debt-financed uneconomic expansion by corporations. Financial disciplines are more in vogue today. Unless inflation reappears, I believe we can expect a 3% to 4% Federal Funds Rate (it is currently 1%) and a 4% to 51&Mac218;2% rate on 10-year Treasury Notes. In summary, while the bond markets declined sooner than anticipated, we believe they will offer reinvestment opportunities at more attractive levels.

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Our clients with managed account portfolios will be pleased to learn that we sold bonds with maturities in excess of five years prior to the June 25th press release by the Federal Reserve Board summarizing its two-day meeting. This enabled us to capture meaningful profits, at 15% capital gain rates for taxable accounts.