As a result, the Nasdaq stood 1.2 percent below year-end levels, as of the end of May (it recovered slightly in the first couple of days of June). The Russell 2000, measuring the small cap market, still is outperforming the other key indexes. The Dow Jones Industrials are running ahead of the S&P 500.

BONDS
The drop in consumer confidence did not impact the bond market in the same way as the stock market. Bond investors remained concerned about inflation and further Fed tightening despite the suggestion that consumers might moderate their spending plans. Moreover, market players perceived the FOMC minutes of the May 10 meeting, released on Wednesday, as hawkish. Consequently, bond yields rose and ended the month much higher than they were at the end of the first quarter (3/31/06). However, just a few days later, May's employment situation shifted perceptions about the strength of the economy and a good portion of investors who were expecting a Fed rate hike in June, jumped ship. Yields fell on Friday and were several basis points lower across the maturity spectrum. While several key economic indicators, to be released in the next few weeks, will play a key role in helping the Fed determine whether or not they should raise the fed funds rate target to 5.25 percent, many bond investors now believe that the Fed will pause in June. At this point, the decision could go either way.

Markets at a Glance

The Economy
NONFARM PAYROLLS MODERATE FOR THIRD STRAIGHT MONTH
Nonfarm payrolls increased 75,000 after posting downward revised gains of 126,000 in April and 175,000 in March. All told, the downward revisions subtracted 37,000 from the previous two months, and the May report showed 100,000 fewer jobs than expected. This sets labor market conditions on a slightly different path than market players, Fed policymakers and economists have been considering over the past month. Some economists discounted the May weakness, indicating that difficulties with seasonal adjustment at this time of year could have caused payrolls to drop unexpectedly. However, if that were the case, the majority of economists would have taken that into account and predicted a much weaker employment figure for May.

The U.S. had some dislocations due to severe hurricane activity in 2005 that could be playing havoc with the monthly data. By looking at the 6-month moving average (rather than the 3-month moving average) of monthly nonfarm payroll growth, we are able to see longer-term trends. The chart below shows that nonfarm payroll growth has been in a tight range running from 125,000 to 195,000 since April 2004. This suggests that average growth has certainly moderated in the near term, but is not out of the range of activity over the past couple of years.

Among the components of nonfarm payrolls, construction and manufacturing employment have moderated in the past few months. Residential construction is already seeing the negative influence of rising mortgage rates. The drop in factory payrolls was concentrated in motor vehicles. Indeed, sales of motor vehicles have been on the decline recently as well. Retail trade payrolls have also decreased sharply in both April and May; this is more disconcerting given that retail sales have generally been good in 2006. Other service-producing sectors showed moderately healthy gains, except for motion picture and sound recording industries, which reduced payrolls by 11,000 in May after a 6,000 payroll loss in April. (Perhaps people really aren't going to the movies anymore!)

In contrast to the soggy payroll performance, household employment posted a healthy 288,000 gain. Over the past three months, household employment increased an average 240,000 per month, clearly much better than the payroll figures. As a result, the employment-to-population ratio remained steady at 63 percent and the jobless rate dipped to 4.6 percent. Market players and some economists tend to discount the household employment figures because they are not considered as reliable as the payroll figures on a monthly basis, but over the long haul, these two series tend to move in tandem. Thus, one should be concerned if the two series are moving in opposite directions. Which one will adjust in coming months? Will payroll growth accelerate or will household employment start declining? The chart below reveals that the two series can be out of whack for more than a few months - and by a wide margin (note the second half of the 1990s!)

Even though former Fed chairman Alan Greenspan was a big fan of the Establishment Survey, there is no question that the Fed monitors both series. And the new Fed chairman, along with the rest of the Fed staff and FOMC will be studying what is causing a divergence in the two series. They are not likely to discount the household survey entirely even though many market players did.

Fed officials must consider more than employment. They also closely monitor wage growth. While average hourly earnings increased only 0.1 percent in May after posting a sharp 0.6 percent hike in April, the year-over-year rise is still high at 3.7 percent. Granted, this simply means that wage earners are keeping up with inflation (the total CPI was up 3.5 percent in April on a year-over-year basis). Fed officials have some leeway on wage growth given that productivity growth has remained relatively stable at 2.5 percent (year-over-year) in the two most recent quarters. But if Fed officials don't worry about inflation, who will?

MANUFACTURING ISM MODERATES
The manufacturing ISM index dipped to 54.4 in May from a level of 57.3 in April. Most of the key components moderated as well, although the price index increased for the third straight month. As long as the ISM is above 50, it signals expansion in the manufacturing sector, but the May level was at its lowest since last August (remember hurricane season, anyone?). This moderation in the ISM index appears to ratify the moderation in the nonfarm payroll figures to some extent.

MOTOR VEHICLE SALES DECLINE
Motor vehicle sales moderated again in May. Domestic light trucks were sold at a 7 million-unit rate while domestic cars were sold at a 5.1 million-unit rate. Domestic vehicle sales peaked in January, but these sales included a significant fleet portion. Excluding the fleet sales, December was actually stronger. And sales have been declining ever since. To some extent, it is likely that consumers are not willing to cash out as much home equity with rising mortgage rates and don't have as much extra cash to spend on discretionary items.

Gasoline prices are certainly having an impact on the type of vehicle sold. Notice that the share of light trucks (SUVs) was still running high until last summer - and then took a dive as consumers faced $3/gallon (or more) pump prices. Prices are near $3/gallon again in April and May and this is hurting the SUV market. Some analysts are claiming that $3/gallon gas is not having much impact on consumers. In fact, we have seen the personal saving rate go deeper and deeper in the red. Consumers, thus far, have ignored the gas prices and used savings rather than cut back on their total expenditures. This can't go on forever. Moreover, we haven't experienced $3/gallon gas for a sustained period yet. Notice that gas prices had dropped during the fall and winter months. We need to see what impact this will have the economy as $3/gallon persists.

The Bottom Line
The employment figures shifted the perception in the financial markets quite dramatically. Before the employment number, the fed funds futures market was suggesting a 70 percent probability that the Fed would raise rates at the June meeting. After the employment report, the futures market indicated that the probability had dropped slightly below 50 percent.

There is no question that the employment situation is a key economic indicator and often has led the Fed to make policy changes. However, it is only one report - and several other indicators such as retail sales and the consumer price index are two more key reports that will be dissected by Fed officials. The core CPI and the core PCE deflator are both above the Fed's comfort zone. Fed officials don't want to make the mistake of tightening so much that the economy will slow down too fast, but neither do they want to see inflationary expectations develop in the economy.

The economy may be moderating - consumer confidence is down, motor vehicle sales are down, and housing and manufacturing activity is slower than it was a few months ago. But with a 4.6 percent unemployment rate, the Fed must be cautious in policy deliberations. Stay tuned - and watch those indicators!

Looking Ahead: Week of June 5 to June 9

Monday
The business activity index from the ISM non-manufacturing increased 2.5 percentage points in April to 63. While the index level is not exceptionally high, it still reflects expanding business activity.

Business Activity Index Consensus Forecast for May 06: 60.0
Range: 58.0 to 62.1

Wednesday
Consumer installment credit increased $2.5 billion in March after growing more rapidly in previous months. Softer retail sales are contributing to the slower pace of credit growth.

Consumer Credit Consensus Forecast for Mar 06: $3.5 B
Range: $2 B to $5 B

Thursday
New jobless claims rose 7,000 in the week ended May 27 to 336,000, and the 4-week moving average increased to 333,500. The May average is higher than the April average - which was higher than the March average. This is not a good trend if one hopes to see more employment growth.

Jobless Claims Consensus Forecast for 6/3/06: 325 K
Range: 320 K to 345 K

Friday
The international trade deficit on goods and services narrowed in March showing a $62 billion shortfall after narrowing in February as well. Exports rose 2 percent in March while imports decreased 0.8 percent during the month.

International trade balance Consensus Forecast for Apr 06: -65.0 B
Range: -63.5 B to -68.5 B

Import prices rose 2.1 percent in April as petroleum import prices surged 11.5 percent for the month. Crude oil prices were higher in May and this could boost the index again.

Import prices Consensus Forecast for May 06: 0.7%
Range: 0.5% to 1.2%