The Federal Reserve raised their benchmark interest rate for the 17th consecutive time yesterday which was a surprise to no one.  But in a surprise to many, they suggested for the first time that a pause might be coming soon.  Their statement said “the extent and timing of any additional” rate increases “will depend on the evolution of the outlook for both inflation and economic growth.” Stock markets surged on the news.  The Dow Jones Industrial Average soared to close 217.24 points higher than when the statement was released, a gain of about 2% - its best day in more than three years. The NASDAQ Stock Market was up 3%, its biggest one-day rally since March 2004. Long-term bond yields edged down as prices rose.

The Federal Reserve has increased rates by a quarter of a percent 16 times including their May increase without a major market drop, but one would think that the likely quarter point increase at the end of this month will be the straw that breaks the veritable camel’s (err bull’s) back.  Since that May 10th meeting the Federal Open Market Committee has become a ‘federal open mouth committee, as termed by one of our favorite economists, Ed Yardeni.  The mixed signals have rattled markets of all stripes, from stocks, to bonds, to commodities. 

May was very unkind to investors.  The S&P 500 declined 3.1% making it the worst monthly decline since 2004.  The Dow Jones 30 fared a little better, declining by 1.6%.  The NASDAQ has been on its longest decline since 1994.  With inflation fears running high, uncertainty about how close the Fed will come to ruining the economy, high energy and commodity prices, and fears of what will happen in Iran, Iraqall piled on after the Fed’s May 10th meeting to send many to the exits.  The biggest losers were the emerging markets as investors feared that investors’ capital would leave these risky markets as interest rates rise. 

Last week we discussed the abundance of global economic growth and how, so far, it had not been accompanied by excessive inflation.  Even in the face of commodity prices rising straight up, record oil prices, rising wages, and tight supplies in almost all raw material category.  The pressure relief valve is productivity.  It has been rising steadily all over the world, keeping a lid on inflation. 

The Fed may be near the end of its long-term tightening process according to minutes released from their last Open Market Committee meeting.  Since the release the equity and commodity markets have soared. The CRB index of commodities was up 5% in the following two days, led by petroleum, gold, copper, and platinum.  The stock market gains were boosted by materials, energy, and industrials.  Extra lift came from some superb earnings reports from individual companies in the groups just mentioned, as well as from some leading technology companies, banks, brokers, and pharmaceuticals. Is the return of “irrational exuberance” in our future?  One could argue that it already exists in the commodities and metals markets as well as the related company stock prices.  They are up huge this year following a two-year bull market. 

The airplanes of September 11th, the tech-bust of 2000, the corporate scandals of 2001, the wars in Afghanistan and Iraq, the relentless credit tightening of the Federal Reserve, spiraling oil prices, and increasing global Islamic unrest, separately or combined have failed to stop this economy of ‘steel.’  Will virus infected birds finally accomplish what the prior challengers have been unable to wreak?  The predictions range from not at all, to a total global depression. 

Interest rates are rising across the board.  Just last week we discussed the inverted yield curve and the problem it posed for banks and for those who borrow from banks.  Since our last Brief, the yield on the 10-year note has gone up 10 basis points, or a tenth of a percent, while shorter maturities such as the 2-year note is up only modestly.  The result has been a yield curve that is a bit more accommodative for banks.  Our experts believe the yield curve will not change much from here, remaining relatively flat (short term rates close to long-term rates), therefore challenging for banks, but not disastrous for them or the economy.  If the Fed raises the funds rate to 5% by May as many predict, then the 10-year Treasury bond yield will also likely to rise to 5%.

After a month and a half since our office flood we are now back to normal.  The wood floor is installed, carpets cleaned and laid, walls and baseboards replaced and painted, art hung on the walls, and furniture returned from various idle locations in our 30-story office building.  ‘Normal,’ whether real or imagined is nice, even if for a short while.  It’s what gives us a chance to catch our breath before the next round of challenge and growth. 

The year is progressing pretty much as investors anticipated.  Analysts continue to lower their earnings expectations as many corporate managers downplay their guidance for the coming quarters.  Mr. Bernanke of the Fed says he will continue to fight inflation as hard as his predecessor Alan Greenspan, yet he has some changes in mind.  The steady supply of oil continues to be clouded by instability inNigeria,Venezuela,Iraq, and most recently,Saudi Arabia.  But with current supplies high and prospects for slower global economic growth, the price of oil is down 4% for the year so far.  The same is not true, however, for gold, up 7.5% for the year, likely on inflation and global security fears.  But the best leading indicator of all, the stock market, is up.  The Dow Jones, S&P 500 and NASDAQ indices are each up about 3.5% so far this year while our model portfolios are doing better than that.  But, with all the uncertainty, the ride has been bumpy and should continue that way.

The stock market with all of its intraday gyrations finishes the week up nicely.  Following a decline on Monday, the last three days have culminated in a 1.8% rise in the S&P 500.  In contrast to last week, when good news was bad, investors decided the liked the sound of a roaring economy, especially if Fed Chairman Ben Bernanke doesn’t drown it out with the inflation drum.  On Tuesday, the government reported the strongest monthly gain in retail sales in nearly two years confirming that the economy is as strong as ever.  The Dow industrials rose 136 points, or 1.25% to 11028.