Fed Doves Rally Bulls

Traders saw only doves Wednesday, despite the hawk, or perhaps the vultures, circling high above.

The Federal Reserve kept the fed funds rate steady at 5.25%, as expected, but changed the language in the accompanying statement to soften its tightening bias. Traders read the statement as solidly dovish and indicative of a near-term rate cut, even though the Fed also took pains to emphasize that inflation is the key risk to its outlook.

The stock and bond market rallied immediately after the statement was released. Stock traders shrugged off earlier concerns about FedEx's(FDX Quote) earnings and comments about an uncertain economy, sending major averages on their sharpest rally this year.

The Dow Jones Industrial Average jumped 160 points, or 1.3%, to close at 12,447.52. The S&P 500 gained 1.7% to close at 1435.04, and the Nasdaq Composite gained 48 points, or 2%, to close at 2455.92. FedEx ended the day down 1.2%.

The bond market likewise rallied. The 10-year Treasury bond rose 4/32 to yield 4.53%. The dollar weakened on the Fed's statement, and gold was up slightly.

While longer-duration Treasury bonds did not rally so dramatically, shorter duration bonds rallied more sharply, indicating traders' belief that the fed funds rate will soon be lower. The 2-year Treasury's yield dropped nine basis points to 4.52% -- and is no longer inverted to the 10-year's yield.

Ultimately, the Fed covered its proverbial rear end with this statement. The central bank gave itself the wiggle room to cut rates if need be -- to respond to some kind of financial crisis or fallout from the subprime mortgage market's current malaise. But it reasserted concerns about inflation, enough to maintain its credibility and to let markets know that a cut is not imminent.