Treasury Bulls Battle Bernanke's Hawks

Bernanke's hawkish talk on inflation jogged the Treasury market away from a fierce early-morning rally. But Treasury prices still ended the day higher as investors are still focused on growth data rather than inflation rhetoric. The 10-year ended the day up 8/32 in price to yield 4.5%, while the 30-year bond rallied 11/32 to yield 4.59%. The two-year note gained 2/32 to yield 4.68%.

The market action reinforces the need for Treasury traders to tame their rate-cut fever.

"Memo to the markets: 'Alan Greenspan is no longer the Fed chairman,' " says James Bianco, president of Bianco Research, adding that Greenspan's focus in setting policy was real economic growth, and "he dismissed inflation."

With Bernanke, "Fed policy starts and stops with inflation," says Bianco. "I still think the markets just don't get that yet."

That said, the Fed may have confused the bond market by repeatedly stating that slowing growth will do the work of bringing down inflation. This rhetoric put investors' focus on growth. But what they may have misunderstood is that the slow growth is just the optimal means to the ultimate end -- lower inflation. Growth is not the driving force of monetary policy.

Indeed, Bernanke surprised investors who knew him as an inflation-targeter when he started to focus his forecast for inflation on slowing growth. Bernanke and other officials' recent speeches show that the Fed is backtracking somewhat on that forecast. They have insisted they do prioritize inflation over growth, even if it takes more rate hikes to get there. The challenge for the Fed is to reorient the market to the same order of priorities without making any drastic pronouncements about rate hikes.