Investors better keep an eye on bonds this week.

While the stock market may be more fun to follow, fixed income is often a stronger gauge of investor expectations of the economy, future U.S. Federal Reserve policy, and inflation.

With the consumer price index (CPI) safely in the books for another month, economists can now turn their focus to wholesale inflation with the release of the May producer price index (PPI).  Economists, mistakenly, often disregard the energy component of this data each month and focus mainly on the so-called “core” releases - which excludes “volatile food and energy prices.”

While food and energy prices often suffer from month-to-month volatility based on seasonal factors, they cannot be overlooked these days as they continue to have significant impact on the global economy.

Also, Lehman Brothers Holdings Inc. (NYSE: LEH, Stock Forum) can’t seem to avoid the limelight, as the eyes and ears of the investment community will be sharply focused on its earnings announcement today (Monday), which also is expected to detail plans for its much needed capital infusion.

U.S. Treasury Secretary Henry Paulson welcomes his friends from China for Strategic Economic Dialogue IV, as both countries are sure to bicker over unfair trade practices, protectionism, and currency valuations. (And, “bickering” has become a very popular sport in Washington as of late… too late for the Beijing Olympics?)

Market matters

So let the partisan bickering and political pandering begin.  With the executive branch up for grabs in November, the Democratic-led U.S. Congress introduced legislation that has virtually no chance of passing, merely to be used as ammunition as the campaign season heats up.  So-called “Big Oil” became the latest villain with politicos proposing windfall profit taxes on record company earnings.  Our friends within the Organization of the Petroleum Exporting Countries (OPEC) did not escape the wrath of the Dems, who want to file suits over perceived price-fixing.

In typical partisan fashion, Republican Presidential candidate John McCain has touted his opponent, U.S. Sen. Barack Obama, as a traditional “tax-and-spend” liberal, the wrong choice during this period of economic challenges.  Sen. Obama pegged his opponent as a continuation of the previous eight years of failed policies that have led the country into recession/inflation/deflation.

Lehman Brothers has remained front and center in the “who will be the next Bear Stearns watch” as the financial giant attempted to raise $6 billion in new capital to compensate for its disastrous second quarter.  The company also bid a (not-so) fond farewell to two high-ranking executives as it goes to great measures to regain some lost public trust.  Over a four-day time frame, its stock gave up more than $4 billion in shareholder value.

Always a day late, Moody’s Investors Service (NYSE: MCO, Stock Forum) jumped in to protect investors by downgrading the firm from “Stable” to “Negative.”  In other business news, transactions headlined the week as Staples Inc. (NASDAQ: SPLS, Stock Forum) will be acquiring the Dutch office supply company, Corporate Express NV (NYSE: CXP, Stock Forum), for $2.7 billion.  Anheuser-Busch Cos. Inc. (NYSE: BUD, Stock Forum) turned to Mexican brewer Grupo Modelo SA de CV (OTO: GPMCY, Stock Forum) to help fend off an unsolicited offer by rival InBevNV (OTO: INBVF, Stock Forum).

Meanwhile, Yahoo Inc. (NASDAQ: YHOO, Stock Forum) finally said good riddance (presumably, for the last time) to Microsoft Corp. (NASDAQ: MSFT, Stock Forum) in any merger, partnership, or other relationship (and jumped into bed with Google Inc. (NASDAQ: GOOG, Stock Forum) with a search ad agreement).  Apparently, McDonald’s Corp. (NYSE: MCD, Stock Forum) remains recession/inflation proof as the fast food chain reported strong domestic and global sales in May. 

Crude traded within a $10 range throughout the week to settle around the $135-a-barrel level as traders over-analyzed news of declining demand, OPEC made comments about “unjustifiable rise on oil prices,” and polls blaming industry insiders for “unethical behavior.”  In the “misery-loves-company” category, the United States is not the only nation to struggle with energy-related inflation.

China’s Shanghai Composite Index fell to its lowest level of the year as the country attempted to fight off related price pressures. Likewise, India reported that its inflation rate climbed above 8% in May, while Vietnam devalued its currency because of soaring prices.  Closer to home, Broadway ticket sales are down more than 10% from last year’s levels - meaning that even the “rich-and-famous” group of consumers are suffering the ill-effect of soaring oil and gas prices. 

After an extraordinary day in the markets that saw the Dow plunge close to 400 points and oil surge to almost $140 per barrel on June 6, any recent volatility seemed tame by comparison.  While investors searched for bargains in equities, the fixed-income markets struggled mightily last week as prospects for future Fed rate hikes grew more likely.  The yield on the benchmark 10-year Treasury surged past 4% (and beyond), reaching its highest level of the year.  Anyone inside the Beltway you’d care to blame, senators McCain and Obama?

Economically speaking

Undoubtedly, a universal theme is emerging at the Fed and other world central banks: Inflation, Inflation, Inflation.

And, on that note, most Fed-watchers believe that the next move in rates will be higher. 

Last week, Fed Chairman Ben S. Bernanke reiterated his concerns about price pressures and many of his partners in crime followed in step by towing the company line.  Dallas Fed President Richard Fisher and his counterpart in New York, Tim Geithner, promoted the prospects (rather realities) of rising energy costs and the declining dollar as major concerns.  Boston Fed President Eric Rosengren echoed the sentiment by stating that higher energy prices were “trickling through the economy.”

Philly Bank President Charles Plosser went so far as to predict that the Fed would have no choice but to raise rates to combat inflation.  Even the Fed’s Beige Book reported that the domestic economy remained sluggish through May, and has been “pinched by rising food and energy prices.” On the global front, European Central Bank President Jean-Claude Trichet targeted July as a date the ECB would look to hike rates should inflationary pressures continue. 

Meanwhile, the Bank of Canada held off on a much anticipated rate cut because of - what else - higher energy costs.

For now, however, the recent data showed that inflation (outside of food and energy) remained well-contained as the core CPI climbed by a modest 0.2% in May. (WE have warned you about looking only at the “non-core” figures).

By the way, the CPI, as a whole (including food and energy), experienced its largest one-month-rise in six months.  Consumer activity offered perhaps the most promising news of the week as May retail sales surged by 1% as many Americans took those government rebate checks from the stimulus package directly to the malls.  Even after removing gasoline sales from the equation, the retail data still experienced its best showing in a year.
 

Weekly economic calendar