Investors' repositioning for the new year collided with interest rate fears to kick off 2007 with trepidation and anxiety running through the financial markets, with the notable exception of tech and biotech stocks.

Friday's stronger-than-expected jobs number forces the markets to wrap their arms around the idea that a recession is unlikely, and that is a relief. But they also need to embrace that the Federal Reserve is not opening the door to rate cuts anytime soon, and that is disappointing to many investors.

The Dow Jones Industrial Average fell 0.6% Friday and 0.5% on the week to close at 12,398.33. The S&P 500 slipped 0.6% on Friday and 0.6% for the week to close at 1409.68. Only the Nasdaq Composite can call the first week of the year a strong one, thanks largely to Thursday's rally.

The index shed 0.8% on Friday as providers of cell-phone components and chips reacted to Motorola's ( MOT) profit warning, but the Comp gained 0.8% on the week to close at 2434.25.

The minutes from December's FOMC meeting, released Wednesday were, in sum, hawkish in that the Fed maintained a bias toward tightening amid concern about inflation. That wasn't a big surprise, but an early morning rally reversed when traders realized the central bank was not discussing a move to a more neutral policy stance.

Friday's stronger-than-expected 167,000 non-farm payrolls report was a surprise, given payroll processor ADP's earlier employment forecast of 40,000 jobs lost in the month. To cut rates, the Fed would need to see some softening in the labor market to mark a true slowdown in the economy.

Instead, the unemployment rate remained steady at 4.5%, while average hourly earnings, rose 0.5%, putting wage growth at 4.2% year over year -- well above the two-decade average of 3.2%, writes Michael Darda, chief economist at MKM Partners. A tight labor market, evidence of excess liquidity in narrow credit spreads and signals that the housing market has seen its worst day mean expectations for Fed rate cuts are "hideously off base," according to Darda.

The fed funds futures market shows investors are at least extending expectations for rate cuts -- again. The pushing back of these rate-cut bets is reminiscent of the constant "one and done" battle that went on for a year before the Fed paused its tightening campaign in August.

As of Friday afternoon, better than 50% odds of a cut don't come into play until June -- at 58%, down from 86% on Thursday, according to Miller Tabak. A cut in January is almost out of the picture, at 2% odds. At the start of December, the market was pricing in 30% odds of a cut in January, 70% odds in March and a second rate cut by the May meeting. Odds of a second rate cut at some point next year have slipped to 80% from 100% Thursday.

The Treasury bond market reacted to the payrolls report by pushing rates higher Friday, though the yield on the 10-year benchmark note is lower on the week. The 10-year finished the day yielding 4.65%, down from 4.71% as of last Friday.

"One of the scenarios that could happen in 2007 is that the markets will have a 'the sun will come out tomorrow' theme running all year -- always expecting the Fed to cut, but not at this meeting," says Ethan Harris, chief economist at Lehman Brothers. "They could continue to forecast that for a long time. There is a bias in the market to expect a more dovish Fed than reality."

A more dovish Fed means lower rates, which is the key to many strategists' forecasts for stocks. "Our bullish case for 2007 rests on the idea that the yield curve has to normalize," says Barry Hyman, equity market strategist with EKN Financial. Without bringing down the funds rate and normalizing the yield curve, the spread between short- and long-term Treasury yields, expectations will ratchet down for higher multiples for growth stocks, says Hyman.

"The growth story depends on the Fed being cooperative," he says.

Stocks finished the first, shortened week of the year on a down note. Interest rate and Fed expectations were in play, as were worries about the commodities selloff that accelerated this week. While low oil prices are good for the inflation picture, large drops in copper and gold make investors concerned about the global economy. That said, other liquidity-sensitive asset classes such as junk bonds and emerging-market debt did not see risk premiums rise, a typical reaction to economic concerns.

Open Those Windows

Investors this week unloaded some of last year's best-performing stocks, in a classic undoing of window-dressing, notes Brian Belski, U.S. sector strategist at Merrill Lynch. Investors may have chased the strong stocks of 2006 when the rally persisted through last fall, but they are letting them go this year in favor of "growthier" parts of the market such as technology, biotech and consumer discretionary stocks.

Telecom, energy and materials stocks, last year's three strongest sectors, posted the worst performance this week, writes Belski. "Every energy name in the S&P 1500 posted negative returns for the week," he writes.

Oil rebounded about 1% Friday, closing at $56.31, but remains down 7.8% on the week. Exxon Mobil ( XOM) and BP ( BP) slipped 4.5% and 3.2%, respectively, in a week that also included a warning from Nabors Industries ( NBR) and cautious comments from ConocoPhillips ( COP).

Shares of metals miners Phelps Dodge ( PD) and Freeport McMoRan ( FCX) fell 2.6% and 7.9%, respectively, on the week.

Biotechnology companies fared well as several companies were upgraded in the week. Shares of Amgen ( AMGN), and Genzyme ( GENZ), rose 4.7% and 7% on the week, respectively.

In sum, as the markets began the new year, many bullish forecasts hinged on a first-half rate cut. So signs of economic strength are now met with consternation, as was certainly the case with Friday's jobs report. As the year unfolds, it could just be the adjustment and acceptance that the Fed is not cutting rates soon that spurs a much-anticipated correction.

RealMoney Barometer Poll

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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 here to send her an email.

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