With just three days left in the month investors have a chance to drive a few more nails into one of the stock market’s more famous aphorisms.

Here in the US, anybody who sold equities in May and went away should by now be contemplating alternative employment. The Dow Jones industrial average broke through record highs on most days in the past month and, even after a rocky week last week, is still up by more than 3 per cent since May Day. The broader measure S&P 500 is tantalisingly close to its all-time high, and is up by almost 5 per cent for the month. It would take a mighty tumble in the next three days to make May 2007 anything other than just another impressive month of gains for the great US bull market.

But what has been really interesting about the past month is not the continuing upward march of US equities but the fact that it has gone on even as a key rationale behind it has changed. I am not talking here about the impressive corporate earnings background. As I have noted before, a large part of the explanation for the stock market’s strong performance in the past couple of months has been better than expected earnings in the first quarter of 2007. Nor am I talking about that other important engine of recent stock market growth – the merger and buyout frenzy. The gusher of investment dollars that keeps pumping out of private equity firms has been a driver of broader demand for US stocks.

No, what has changed – in fact, what has completely reversed – is the interest rate backdrop, reflecting a radical shift in investors’ perceptions of the economic outlook.

For much of the year equities have been propelled higher in part by a belief that US interest rates will decline, making stocks considerably more attractive relative to bonds even if earnings growth decelerates in a weaker economic environment. Most economists at the big US banks and investment houses have been convinced since about mid-February that the US economy would slow markedly this year, forcing the Federal Reserve to cut short-term interest rates.

Bond yields have reflected this pessimism about growth. For much of the year the yield on the benchmark ten-year treasury bond has been below that on two-year maturities. This inversion of the traditional relationship between short and long-term interest rates has often been associated with an impending recession and many investors and economists have duly assumed the worst about the US. The Fed, however, has been consistently more optimistic about growth and consequently more nervous about inflation – which, as it has in the UK, hit a decade-long high in the past year. With the housing market a slow-motion car crash for the past six months, investors believe the Fed would eventually be forced to join them in expecting much weaker growth.

But an odd thing happened on the way to the slump. In the past few weeks longer-term yields have been rising sharply again, reflecting spreading economic optimism, and a bit more worry about that old Fed bugbear, inflation. Last week the ten-year treasury rate went back above the two-year rate for the first time in almost a month and at just under 4.9 per cent now the ten-year yield is at its highest level since January. Expectations for a rate cut by the Fed have receded somewhat. The dollar has also been buoyant as expectations for US rates have adjusted upward.

Fed officials, in fact, can feel moderately pleased with themselves that things have so far turned out closer to their judgment this year than that of their vocal critics in the market. But it is the lot of central bankers that their work is never done. The US is not out of the woods yet, on either growth or inflation, but this week should give us some indication of how much more dense forestation there is as the Government publishes a number of important economic reports.

On Thursday we will get a revised estimate for the first-quarter’s gross domestic product. The initial cut said that GDP grew at an annual rate of only 1.7 per cent in the first three months of the year but that figure is almost certain to be revised down.

A very low number might trigger a renewed bout of recession-worrying but it should be recalled that it is an historic figure and the data for the second quarter so far suggest that a low figure will not be repeated.

Much more important and contemporaneous will be Friday’s employment figures. If the jobs market continues to post solid gains and a low unemployment rate, you can expect markets to continue to adjust expectations towards the inflation rather than the slow growth end of the economic spectrum.

As for the stock market, it seems to be in one of those happy moods right now where all news is good news. Weaker than expected economic growth is good because it means interest rates will fall. Stronger than expected economic growth is good because, well, let’s be honest, it is just good.

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