Sailing downwind can be very tricky; certainly not as easy as it looks. A slight shift in the wind can send the mainsail boom sweeping across the boat with terrific speed and force. An alert skipper or crewmember who sees the sail flatten abruptly yells the warning  jibe which means to duck or find yourself in the drink with a knot on your head. 

The market has sailed briskly with the wind at its back since early March without much of a care. Many have warned about various risks, but blithely it sailed along. The winds suddenly shifted this Tuesday. The thinking had been that the Federal Reserve would lower rates in response to a slowing economy by the end of the year. But just as the wind can quickly and unpredictably shift, so can market concerns. Bonds, which usually lead the stock market, began sounding a warning on Tuesday as yields on the 10-year Treasury fast approached 5%. In the last three days, the 10-year note fell the most in more than three years. 

Traders abruptly shifted their bets from a Fed rate cut to a 44% chance the Fed will raise rates 25 basis points by December. Bill Gross, manager of PIMCO, the largest bond fund in the world, says he likes bonds “from this point forward for the next six months.”  “But we do suggest in 2008, 2009 and 2010 that interest rates will be moving mildly higher.” He reiterated his view that housing would slow the U.S.economy and the Federal Reserve will cut interest rates in the “latter part of 2007.” But most traders took the opposite view when the government reported a surprise drop in productivity. With that report any hope they had for a rate cut this year was brutally swept off the deck.

The relatively new fear is of inflation, not growth. The vast majority of economists believe thatU.S.growth will pick up through the end of this year, according to the monthly Bloomberg News survey. Economists now forecast the economy will expand at an annual rate of 2.6% this quarter, compared to 2.2% projected last month and a 0.6% pace in the first quarter. The economy will expand at a 2.9% rate by the final three months of 2007, according to the median of 69 estimates in a survey taken from May 30 to June 7.

Increased spending on business equipment is driving the economy now. The Institute for Supply Management’s factory index for May rose to the highest level in 13 months, and a government report this week showed orders for business equipment rose for a second straight month in April. The rate of unemployment at 4.5% remains near a five-year low.

But is inflation really coming back? What happened to the deflationary pressures of global competition? What about the millions of new workers joining the workforce in China and India willing to produce the same goods cheaper than the industrialized nations can produce them? Are these influences suddenly meaningless?

Jim Glassman, senior U.S.economist at JP Morgan says “the rise in unit labor costs is completely meaningless in a quarter when growth is flat. Every move in the market doesn’t have to be about the news we’re seeing. There’s lots of other stuff going on around us.” He adds that the deceleration in hourly compensation to 3.2% on a year-over-year basis is the real news. “It was running at 5 to 6% last year, now it’s more in line.” Caroline Baum of Bloomberg adds that it is also likely that productivity declined in the first quarter because there was no growth in the first quarter. It may not necessarily suggest that the productivity miracle of the 90’s is over.

Last week’s Brief pondered whether the Fed had engineered the perfect soft landing for the economy. This week, the central bank of New Zealand rocked global markets when they raised their benchmark lending rate while other central banks seem to be holding firm. The Bank of England announced this week that they would hold steady their benchmark rate.

It seems that investors are second guessing both the Fed and their own forecasts of declining inflation. In sailing jargon, the wind has become rater fluky. Economists predict the wind will remain at our backs, but the central banks now add a flukiness or uncertain policy. Best bet for now? Keep the sails up and heads down.