So let's sum up this crazy week: 1) Hamas takes the Gaza Strip, putting a possible Iranian surrogate right on Israel's border; 2) interest rates surge to their highest levels in five years, raising fears that the global liquidity boom is at an end; 3) leading Democrats and Republicans introduce protectionist legislation to force China to free the yuan; and 4) new Labor Department data show that consumer prices in May rose at the fastest pace in 20 months.
Yet after some shakiness earlier this week, the Dow industrials surged Wednesday and Thursday and are up 100 points more as I write Friday morning. How can this be? Four problems, four explanations.
1) The 9/11 effect: Since 2001, there has been a certain level of political risk built into the stock market. That may well be why the market's price-earnings ratio has been stubbornly low despite bargain interest rates and strong corporate earnings. The market now has high resilience to Middle East turmoil. Call Wall Street when the B-1 bombers leave Diego Garcia for Tehran.
2) Interest rates: Yes, rates are higher than they were, but they are not high on a historical basis. The economy and market boomed when rates were at these levels in the late 1990s. Plus, the global economic boom means plenty of money washing around that can be funneled back into U.S.treasury bonds. The liquidity boom continues.
3) Trade: Over and over, economists and money managers tell me they fear protectionism more than any other macro threat. And Congress may yet turn those fears into reality. But right now, this is more of a "headline" risk issue until a bill gets passed and some implementation begins. As trade maven Joanne Thornton of the Stanford Group put it today, "These threats are unlikely to materialize before the spring of 2009; even if the legislation is enacted this year--which is not a foregone conclusion. . . Congress ultimately may insist on a new enforcement mechanism against unfair exchange-rate competition; but there appears to be little risk of trade disruption, especially near term."
4) Inflation: Despite surging energy prices, core consumer price inflation remained moderate for the third straight month. Producers continue to absorb higher costs, and energy prices aren't seeping into the rest of the economy nor into inflation expectations as measured by the Treasury's inflation bonds. As Global Insight concludes: "We expect core PCE inflation to dip below the upper limit of the Fed's presumed 1-to-2 percent tolerance band in the second half of the year." That means no more Fed rate hikes.