Commodities and sovereign debt remained volatile last week. US equities managed to rise 0.7% and the dollar rallied back 1% as the bond market fluctuated before closing up. At one point, 10 year bonds sold for more than 4%, and the initial pricing of a 30 year auction on Thursday raised eyebrows. But, things snapped back sharply in the final sessions, as demand returned.

Globally, Brazilian and Indian markets edged higher, while the Russian and Chinese markets lost ground. Russia?s decline was a surprise given that oil rose 5.3% to trade above $72/bbl. Thus far, the commodities market appears to have momentum, but investors are getting ever more nervous of a correction over the summer, not least as disappointing economic data continue to trickle through.

The focus, though, remains on the bond market (See Chart 1), which continues to drive equities and global risk aversion. Consensus is still divided on what is moving the bond market most: inflation fears, fiscal indiscipline (closely related to inflation of course) or general economic improvement.

Chart 1: US 10 Year Treasury Yield, Getting Volatile

Last week, the market also moved when Russia clumsily (or politically) expressed its intention to diversify its reserves out of US debt. There is a genuine point of concern here. Certainly, China can?t afford to stop buying treasuries, doing so would incapacitate its number one customer. Yet, there is a clear logic to some diversification globally. Commodities will continue to be traded, and priced, in dollar terms for now, but inter-governmental swap agreements being put in place offer governments the opportunity to reduce their direct dollar dependence.

As I have said many times over the last year or two, we are living history. The world is ever more quickly progressing away from its post war reconstruction order toward economic multi-polarity. Those keen to celebrate the end of US economic hegemony would be well advised to refer first to their history books. It was the gold standard pricing, under Bretton Woods, that helped war-torn economies recover. This exchange system broke down when the US could no longer sustain a strong dollar in the interests of global development. This policy cost it substantial competitiveness and ultimately led to the current imbalances.

The fixed exchanges with Europe broke down first (in the 1970s), but now we are seeing a breakdown of the remaining fixed currency regimes ? those with the emerging world. This change is crucial to the stabilisation of future economic development.

What, then, of the chances for funding the US deficits? There is likely to be a healthy trade rebalancing, as US consumers learn frugality and the weaker dollar allows for more exports. Deficit financing will continue to come from a variety of sources, both domestic and international. There should be no mistake that the early Obama days have seen disastrous fiscal control, perhaps an implicit acknowledgement that cost cutting was impossible during a period when government policy called for aggressive counter-cyclical spending. But, whatever is behind the current yield shift, it is already serving as notice to the US authorities. Tighten up or pay the price. If yields continue to rise at their recent rates, inflation will become a self-fulfilling prophecy.

Bond prices will continue to drive developed world equities, at least until the hopes of green-shoots have played out one way or another. As we noted last week, expectations of rate hikes this year seem premature (click here). There is a case for concern as to whether central banks can exit their less conventional easing policies in a timely manner ? rather than inflate a new bubble. But, this concern remains, for now, balanced by the fact that we are experiencing an exceptional economic adjustment. Policy normalization should come in a timely fashion, but the time at which it should come is not yet close. And, this point should serve as a sharp warning to equity market bulls.

For its part, the emerging world outlook is less gloomy and more complex. In many ways, the emerging market story is back where it was a year ago. Yes, prices are substantially lower than they were before the Lehman Brothers blow-up, but the dynamics are again healthy. In the early phase of the credit crisis, I argued that emerging markets were not automatically condemned to suffer equally with the developed world. Structurally they stood in complete contrast. As it transpired, the collapse of global finance in 2H09 brought global markets into close correlation.

But, now with financial markets normalising and emerging market governments stimulating growth rather fighting inflation, expansion is back on track. Huge flows of capital are moving from the developed world as yield hungry investors seek to participate. And well they might: relatively speaking, the outlook for emerging economies is inspiring. Yet, the case is not as clean cut as headlines might imply. Investors moving into emerging markets need to remember that these are volatile and risky asset classes. The forward growth trend is different from that of recent years, with two major factors lacking (the US consumer and the liquidity created by a hyper-active shadow banking sector).

Summer often sees a lull, but for now, there are reasons to hope the emerging market growth trend remains in place. Even so, investors should steal themselves for substantial volatility, and less easy returns than they have previously enjoyed.

Here are some of the key points we are watching this week:

Over the week: News about the reshaping of financial regulation in the US. It would be nice to see a substantial overhaul bringing those responsible for the recent crisis to account, and eliminating the too big to fail mentality. There is little chance of the status quo being sufficiently shaken.

Monday
US ? Empire State Manufacturing Index (June). The market expects stabilisation of the New York manufacturing sector, indeed this is the least we should hope for, but it is a far cry from a healthy recovery.

Tuesday
Europe – CPI (May). The market expects zero inflation, but will likely be calmed by the idea of rising commodities prices providing support going forward.
US ? Housing Starts (May), PPI (May) and Industrial Production(May). The expectation is for a MoM housing start recovery, although this is arguably down to seasonality and is likely to represent yet another false dawn for housing bulls. PPI should come in positive MoM, but negative YoY. The market has been forward thinking recently, so anything but a substantial negative shock is unlikely to impact prices. As for industrial production, there is no hiding the real economic trend. One can talk up the second derivative, but capacity utilisation and output production continue to fall.

Wednesday
US ? Bernanke Speaks, CPI (May). Consumer prices, as with PPI, remain positive MoM, but show their weakness on last year?s levels.

Thursday
US ? Leading Indicators (May), Philadelphia Fed (June). Leading indicators are expected to again guide with optimism for May, much of this can be explained by artificial monetary and fiscal policies. Small wonder that the Fed is unlikely to raise rates this year. The Phili Fed index of general economic indicators should remain weak in June, but less so than in May. That second derivative again.

Friday
US ? Triple witching options expiry, expect extra volatility, whichever way the market goes.