The futures markets are starting to discount an interest rate hike by the Federal Reserve in October. Bond yields have risen sharply off their four-year lows in mid-March, core inflation is strengthening and the broadest gauge of money supply, the expansion of credit, is running at a dizzy 16% annualized rate. This data suggests the Fed is way behind the inflation curve and will start raising lending rates this fall.

Or, is the market wrong altogether?

I think the markets are too premature predicting an interest rate hike. In fact, I’d say the Fed’s job is not even done yet with regard to easing credit conditions even further. I’m still forecasting a Fed Funds rate of at least 1% before this easing cycle is over. The Fed Funds now sits at 2%.

In order for the banking system to become profitable again, the Fed must remain accommodative. Housing, in a complete freefall and showing no signs of bottoming, is another industry that can’t afford higher rates. Plus, with the unemployment rate gradually rising since last winter, the Fed will unlikely start cutting off precious liquidity when consumers and companies need cash flow.

Banks are still bleeding losses into June as it becomes increasingly clear that the credit crunch is far from over. Wachovia and Washington Mutual won yesterday’s booby prize for dropping another bomb on the financial services sector.

The Federal Reserve will sacrifice the dollar in its desperate attempt to revive growth and bank lending. Provided the bond market doesn’t fall apart along with stocks, this strategy should continue for the remainder of 2008. I don’t expect the dollar to post big losses from these levels, but it won’t post a major bear market rally under these circumstances, either. Eventually, and assuming oil prices come down, the euro will start to deflate along with other European currencies, which I view extremely overvalued against the dollar.

The way to play this sluggish economy is to remain invested in select commodities, including gold, high grade corporate bonds, blue-chip global multinationals (excluding most banks) and Asian currencies, including the yen.