Wall Street will still be stewing next week over whether the economy and the stock market can handle higher interest rates, setting the stage for even more volatility as traders settle into a new paradigm.

As the yields on U.S. Treasury bonds rose beyond 5% last week, the stock market took a left hook to the chin.

The

Dow Jones Industrial Average

ended the week down 1.8% -- and that was including a 1.2% rebound Friday. The

S&P 500

rallied back 1.1% on Friday, but also was down 1.8% on the week. The

Nasdaq Composite

finished the week down 1.5%, after rallying 1.3% on Friday.

"The often debated, often postponed, much anticipated (by some) market correction is finally here," writes John Roque, technical analyst at Natexis Bleichroeder. He accurately wrote Friday morning that the market could "produce a bounce" after the "nasty" market internals Thursday, when the market saw 11 stocks fall for every one that gained, with 94% of

New York Stock Exchange

volume moving to the downside.

But Roque adds that the S&P 500 is likely to be choppy for some time. "In short, the corrective phase is here and it likely stays a while," he writes.

Indeed volatility has increased as uncertainty about rates and the economy boils over. The so-called fear index, or the CBOE Volatility Index (VIX), jumped 16.11%, though Friday's stock market climb pulled it back 13% to 14.84.

"The days of the VIX at 10 are behind us for now," writes Richard Bernstein, U.S. equities strategist at Merrill Lynch.

Much of the angst about the move in Treasury yields centers on whether bonds were repriced last week due to a stronger economy or rising inflation. The 10-year Treasury bond yield broke out through the 5% psychological level to end Friday at 5.12% -- an 18 basis point rise on the week.

Most economists believe that bond yields are adjusting to stronger economic growth, rather than to the idea that the

Federal Reserve

is behind the curve with the fed funds rate at 5.25%. Last week, the Institute for Supply Management's survey of service sector activity was stronger than expected. The manufacturing data has likewise been strong as businesses are spending more, building inventories and adding jobs to the economy.

If Treasury bond prices move higher due to an improved economic outlook, corporate earnings won't likely suffer too much. If the rise is about inflation or inflation expectation rising, not much good can come of it.

Inflation expectations remain only slightly higher due to climbing gas and food prices grabbing attention in the marketplace. Debate will surely rage for some time, however, about whether higher interest rates will curb the economy's recovery, particularly when the heart of the slowdown was the housing market's decline. Higher rates tighten up the reins on lending to consumers for mortgages and other types of debt.

On one side, Joe Lavorgna, chief U.S. economist at Deutsche Bank writes, "This sharp tightening in financial conditions is not going to help economic growth."

On the other, Morgan Stanley's Richard Berner writes, "Some perspective on this change in financial conditions: It is modest, and the dollar, credit spreads and credit availability leave financial conditions still favorable."

The next reads on inflation come on Thursday and Friday, when the Labor Department reports the producer price and consumer price indexes, respectively.

Analysts predict core producer prices, excluding food and energy, rose 0.2% in May after staying flat in April. On the consumer side, prices are also expected to have climbed 0.2%, excluding food and energy.

Putting energy and food back into the tally, prices for consumers are expected to have jumped 0.6%. Currently, core consumer inflation is running at 2.3% year over year.

Next week also brings May's retail sales figures, which are expected to show a modest improvement from April's weak numbers.

And as for profit reports, the brokers will kick off their earnings season next week.

Lehman Brothers

(LEH)

will post results Tuesday, while

Bear Stearns

(BSC)

and

Goldman Sachs

(GS) - Get Report

weigh in on Thursday.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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