What a Week: Bond-Bound

Odds of a Fed rate cut this year have come down from 100% five weeks ago to 48% two weeks ago to 0% today. Meanwhile, odds of a 2007 rate hike have risen to 40% vs. a 0% chance a month ago.

The "no rate cut, possible rate hike" pendulum swing picked up speed this week, as ISM Services, weekly jobless claims, inventory data and the trade deficit all pointed to renewed economic vigor. Meanwhile, a downward revision to first-quarter productivity and upward revision to unit labor costs revived concerns about inflation.

It's actually a bit of a misnomer to say financial markets fear inflation. The markets fear policy makers will take action in response to rising price pressures, and that rate hikes will crimp economic growth, cut off the liquidity that has propelled global stocks to record heights and curtail debt-financed private-equity buyouts.

This week saw rate hikes by the central banks of Europe and New Zealand. On the home front, Fed officials continued to express concern about inflation, with chairman Ben Bernanke saying price pressures are ebbing but remain "somewhat elevated."

Bernanke also said residential housing "appears likely to remain a drag on economic growth for somewhat longer than previously expected," but other Fed speakers reiterated the central bank's predominant concern: inflation.

"Since 2005, the three- to five-year moving average of U.S. inflation has hovered around 3%," said Cleveland Fed President Sandra Pianalto. "This is above where I would like to see the trend settle in the longer run."

Speaking about rising commodity prices, Pianalto added, "there is a risk that the public's trust could erode and inflation expectations could move higher."

Overshadowed by drama in the stock and bond markets, gold tumbled $26 this week, copper prices fell 4.3% and gasoline futures fell 5.2% from their recent peak amid higher-than-expected inventories. But crude hit a nine-month high above $67 per barrel this week before retreating Friday.