Global markets have been decked hard again this week as talk continues to surround the possibility of higher interest rates in the G-7. Too bad the global economy can’t handle a round of monetary tightening as deflation continues to accelerate across housing markets in the United States, Europe and Australia.

Under formidable pressure to stabilize the dollar and halt a massive runaway bull market in commodities prices, the Federal Reserve is talking a tough game on inflation and verbally supporting the dollar. Government commissions are currently investigating commodity trading and are attempting to pin the blame on soaring food inflation on Wall Street.

The Federal Reserve, for the first time in more than 20 years, is verbally supporting the dollar in its vein to halt commodity inflation.

Short-term bond yields in the United States have surged since Monday as traders brace for higher interest rates later this fall. The Fed Funds futures predict a 75% chance the Fed will tighten by October.

Is this possible? Is the economy rebounding quickly enough to warrant a tightening of monetary policy amid the worst housing bear market in 70 years? Will the Fed, in an election year, actually hike lending rates as unemployment rises and bank credit is still fractured amid the ongoing credit crunch?

No, the Fed and the market are wrong. Interest rates will stay at current levels and won’t rise for at least another 9-12 months or until housing and labor markets stabilize.

The bond market is too aggressive discounting a rate hike. An interest rate hike is virtually impossible because it would sink the economy into a deep recession. It would be the most reckless policy response in the history of central banking. It would also mark the first time the Fed has raised interest rates as housing and labor markets continue to decline.

As a result of the Fed’s threat to raise rates, short-term bonds and high quality corporate debt have been smashed hard this week. Though I would not buy short-term bonds at these levels, the corporate debt market remains very attractive with yields now approaching 52-week highs and offering about 300 basis points more compared to T-bonds.

Short-term government bonds, which saw yields compress to historically low levels earlier in March ahead of the Bear Stearns rescue, were too low and are now experiencing a normalization process or correction. To be sure, the sell-off has been brutal and is infecting other segments of the bond market that don’t deserve the burden of higher interest rates in the middle of a credit crisis, housing collapse and rising unemployment.

High-grade corporate debt remains cheap. I also like ten-year Treasury bonds as yields above 4% are starting to look attractive again in a slowing economy.