Market Digesting rate rise

The economy, though continuing to struggle in many areas, has remained remarkably resilient on the jobs front. This has been a blessing for consumer spending, since few Americans monitor business and market events and set their confidence levels and spending habits accordingly. Most consumers gauge their spending to their immediate job market. They don't cut back until they, or someone they used to work with, loses their job. At the moment, even in spite of a continued decline in the housing sector, very few workers are experiencing that hardship.

With consumer confidence still strong, consumer spending has held up. This week's retail spending numbers were legitimately strong. In fact, most of the economic releases in the past couple of weeks suggest that those who fear a recession is around the corner (and that has included me) may be in for a pleasant surprise.

The downside of all this good news is that the bond market, too, has been expecting a recession. A short while ago, short-term rates stood higher than long-term interest rates, which is unusual, except as a foreshadowing of a recession. As recession fears lift, the shape of the "yield curve" resumes a more normal structure. Long-term rates have increased precipitously and short-term rates have dropped a little.

So far, the stock market loves this latest development. Inflation sensitive energy and materials stocks are leading the market higher. Higher interest rates, however, send bond prices lower. Conservative investors, who have shunned high-risk stocks for the safety of bonds, are losing money and purchasing power. So far, the stock market has the upper hand. It will be a real test of this economy, though, to see if consumers can withstand record high gas prices, rising mortgage payments, and a continued decline in the residential construction sector. That's a lot of bad news for any market to digest.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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