[The following commentary is from the latest issue of the Weekend Update (Volume V, Issue 32) at Iacono Research. For subscription details, click here.]

Over the last few weeks, prices for stocks and bonds have been rising together in what is a most unusual sequence of events where, clearly, one of the two is wrong about the future direction of the economy. Typically, higher bond prices (that result in yields being pushed lower) indicate economic weakness ahead and the lack of pricing pressure, whereas, rising equity markets are typically a harbinger of stronger economic growth and higher consumer prices.

As best I can tell given the recent spate of disappointing economic reports and the beginning of the process where Wall Street economists begrudgingly revise their growth estimates lower rather than higher, the bond market is the one that has it right at this juncture. But, the stock market is now taking its cues (to some degree at least) from the recent talk about quantitative easing (i.e., money printing) and, along with the natural resource sector, prices are being bid higher in anticipation of this effort being successful, that is, at least insofar as it inflates asset prices.

One thing is certain, the economic recovery in both the U.S. and elsewhere in the world at just past the mid-point in 2010 is not what it was expected to be just a few months back when stock prices were soaring and American workers were being hired by the hundreds of thousands. Last week’s labor report was dismal given that we are supposedly more than a year into an economic recovery and the prior week’s Q2 GDP now looks even worse a week later after the latest data came in.

As shown below, absent any other changes, the 2.4 percent growth rate in the April-to-June period is set to be revised downward to about 1.7 percent after the latest inventory data fell well short of where it was estimated for Q2 GDP.

Note: The animated image above should be alternating from 2.4% and 1.7% growth for Q2.

Recall that after skittish managers were, understandably, unsure about future demand back during The Great Recession, they cut back on production and let inventories plunge, all of which added to the severity of the downturn. Then, as the worst of the slowdown passed, they ramped up production again and let inventories grow, the positive change in inventories being responsible for almost two-thirds of all economic growth since the recession supposedly ended about a year ago.

As indicated in the latest data on new orders from the ISM manufacturing index (as detailed in The Economy section above), inventories are highly unlikely to provide this same level of support going forward, in fact, last week’s data showed that some inventory components contracted in June for the first time in a year, rather than expanding as previously believed when the advance estimate (the first of three estimates) for second quarter GDP was prepared.

It’s Still About Housing

This week’s retail sales report follows two months of declining sales and will provide new clues about the state of mind of the American consumer who has been a relative non-participant in the economic recovery so far. While accounting for 70 percent of all economic activity, personal consumption has accounted for only one-third of economic growth over the last year and this has much to do with a new outlook by many Americans, one of modest spending, job insecurity, and a shaken belief system regarding the fickle value of assets, most importantly, the value of real estate, what was once a bedrock of their finances.

More important than the impact of inventory changes on slowing growth in the GDP data is the “stimulus-free condition” of the nation’s housing market and the impact this has on consumer attitudes, a truer state of the housing market soon to be revealed in the level of existing home sales in July set to be released later this month.

Mark your calendar for Tuesday, August 24th, because it is possible that we’ll all be reading headlines about 20-year lows or all-time record lows for existing home sales along with rapidly rising inventory and falling home prices. As shown below, if existing home sales maintain their historical relationship with pending home sales, we could see a seasonally adjusted annual rate (SAAR) of below 4 million units, down by almost half from the boom-time sales rate of more than seven million units, all of which will surely produce even more downward price pressure, the important question being how much.

If not for tax credits and historically low mortgage lending rates that, last week, sunk below 4 percent for 15-year loans and below 4.5 percent for 30-year mortgages, the nation’s housing market would not appear to have stabilized over the last year. In fact, “propping up” home prices was a key part of the recovery effort that began in earnest during the summer of 2009.

While some may think that we’ll see a relatively modest post-tax credit correction over the summer and then stability later in the year, in my view, that is simply wishful thinking. With the “foreclosure pipeline” now holding anywhere from a few million to up to 10 million homes, it seems quite unrealistic to think that the housing market will not falter. Surely we’ll see a double-dip in home prices and, once again, it is simply a matter of the degree.

If home prices decline a few percent later this year after having posted modest gains since last fall, no one will really notice. But, if home prices are on their way to another 10 or 20 percent decline, then we’re in for another credit crisis of some sort and confidence in the economic recovery will fade quickly. I’m of the opinion that we’ll see about another 8 or 10 percent down for home prices nationally – not a disaster, but enough of a decline to rattle markets and shake confidence.

Waiting for the Fed to Act

As I’ve commented to a number of subscribers in recent weeks, at this point, it all comes down to what Ben Bernanke and the Federal Reserve do in the months ahead. Absent the recent talk about QE II, I doubt that we’d have stock prices and oil prices as high as they are now and a gold price of over $1,200 an ounce at this point in the summer would be unlikely.

In the absence of a Congress willing to act in the run up to the fall elections, there is a growing expectation that the central bank will step in to provide support to a faltering economic recovery, likely announcing plans to ratchet up its money printing as soon as this week in an effort to raise expectations for in-flation so as to combat growing fears of de-flation.

The question is whether they’ll act sooner or later.

If the policy making committee fails to provide some signal of further easing to come at the conclusion of this week’s meeting, a big sell off in risk assets is likely. If, on the other hand, the Fed takes bold action, we could see sharply higher prices for nearly all asset classes. More likely, we’ll see something in between (see the Federal Reserve section above for more on this) and, then, it becomes a question of what comes next.

If, in the months ahead, the course chosen is outright monetization of the national debt as recommended by James Bullard and as detailed here last week (see Volume V, Issue 31), things could quickly get out of hand with all manner of rising asset prices, but, Fed economists would surely embrace this problem rather than having to deal with the alternative in de-flation.

As for the typical American, things certainly aren’t getting better as jobs are still scarce and small businesses have participated in the recovery even less than consumers so far if this poll from Gallup last week is any indication.

The fall elections are now less than three months away and we’ll likely have a new political landscape of some sort by the end of the year. It seems that more and more people are realizing how poorly the government is serving their needs at a cost that continues to soar, one that, up until just a few months ago, politicians did not hesitate to pass on to future generations.

Now a full year into the “recovery” with the labor market showing little improvement and small business owners about as pessimistic as the long-term unemployed, the widespread perception that elected officials in Washington and the central bank are more concerned about the health of Wall Street than Main Street is well founded, a condition that is not likely to change until major reforms are enacted, what seems impossible until there are major changes in how Washington works.

It’s possible that we’ll see a major shakeup in November that will lead to the sort of reforms that are needed, but, I wouldn’t bet on it. What I would bet on, however, is that between now and then, risk assets will seem a whole lot riskier and, absent bold moves by the Federal Reserve, there will be more sellers than buyers.