Stocks Shake Fed's Hawk Talk

Updated from 3:24 p.m.

Stocks rallied Tuesday as investors bought the notion that there are other rescuers besides the Fed out there.

The Dow Jones Industrial Average slumped briefly this afternoon on news that the Federal Open Market Committe was holding rates steady, as expected. Driving the selloff was the tenor of the Fed's policy statement, which indicated inflation fears haven't abated.

But a day after a huge swing that ended with the DJIA firmly in the black, the Dow recovered again Tuesday to rise 35 points, or 0.3%, to close at 13,504.30.

According to many traders, the Federal Reserve refrained from giving them what they claimed to want -- a sign that the central bank would respond to a financial crisis, or a nudge closer to an easing of the overnight borrowing rate.

The Fed kept the fed funds rate at 5.25% for the ninth consecutive meeting, and upheld its assessment that inflation remains the greater risk to the economy.

The S&P 500 gained 0.6% on the day to close at 1476.71, while the Nasdaq Composite closed up 0.6% to close at 2561.60.

Still, "The market liked what they heard from the Fed," says Todd Leone, head of listed trading at Cowen & Co. "They didn't want the Fed to bail out the credit markets."

Either way there are rumblings on Wall Street to suggest that liquidity has not dried up with the junky credit markets. Investors over the last month have fled junk-rated debt of all stripes, widening the spreads between risk-free Treasury bonds and riskier paper.

The widening spreads have caused the once-hot leveraged buyout pipeline to freeze, leaving big U.S. banks and brokerages facing the possibility of significant losses on their balance sheets.

Meanwhile, the collapse of the once-robust market for securities tied to subprime mortgages has been forcing smaller mortgage lenders out of business and hammering big financial stocks.

Government sponsored entities Fannie Mae(FNM Quote - Cramer on FNM - Stock Picks) and Freddie Mac(FRE Quote - Cramer on FRE - Stock Picks) may be part of what pulls the markets up from their bootstraps, say traders.

News on Monday that the two entities may be allowed to expand their portfolios and buy more troubled mortgages helped drive Monday's rise in the overall stock market. Fannie gained 3.1% and Freddie added 2.7%.

Prudential Financial(PRU Quote - Cramer on PRU - Stock Picks) last week also said it is still buying subprime mortgage-backed securities. Its vice chairman said last week on a conference call that the prices of some of the higher-rated subprime investments are "disproportionate to the underlying risk and are primarily liquidity driven. ... As a consequence, we see selective opportunities to take advantage of that."

Their wading into the troubled mortgage securities echoes Citadel Investment Group's decision in late July to purchase the busted credit portfolio of Sowood Capital. There are others out there looking to speculate in damaged credit portfolio space as well.

That's what David Darst, chief investment strategist for Morgan Stanley's private wealth management group, said in an interview on CNBC interview Monday. He noted that "billions and billions" were raised over the weekend to "be the next Citadel." He called them "dislocation funds."

Action on Wall Street in the past week has focused in large party on whether the Fed's statement would acknowledge the carnage in the housing and mortgage markets.

Some investors believed the Fed could bolster investor confidence in the markets by indicating a readiness to intervene should a credit crunch threaten the broader economy.

Others believed that the Fed would be loath to do so because to reduce rates now risks bailing out speculators, and signaling an ease would suggest the Fed is worried about a financial crisis.

The Fed gave a balanced read on the situation, but firmly reiterated it will not be contributing any new liquidity with rate cuts. The FOMC added a statement acknowledging the recent turmoil in the credit markets, but it also added words to highlight the strong global economy. The statement once again ended with "the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected."

"Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing," the committee wrote.

But it also added that, "Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy."

The Fed believes that "the price of risk has returned to normal levels," writes Michael Darda, chief economist at MKM Partners, adding that "wider credit spreads and the volatility in equities don't present a material risk to the Fed's expectation for modest growth to continue."

The financial sector continued to rebound off of what traders call oversold conditions Tuesday as the Amex Securities Broker Dealer Index jumped 1.2% and the KBW Bank Index added 0.8%.

Shares in Countrywide Financial (CFC Quote - Cramer on CFC - Stock Picks), the biggest independent mortgage lender, and Bear Stearns (BSC Quote - Cramer on BSC - Stock Picks), one of the largest dealers in mortgage securities, plunged last week amid rumors that both firms were under siege as mortgage-backed bonds failed to find buyers. Bear jumped 2.7% Tuesday and Countrywide added 2.4%.

Rising defaults and delinquencies among so-called subprime and Alt-A borrowers -- those with poor credit histories or without full income documentation -- have routed the mortgage sector this year.

Big lenders such as New Century (NEWCQ Quote - Cramer on NEWCQ - Stock Picks) and American Home Mortgage (AHM Quote - Cramer on AHM - Stock Picks) have filed for Chapter 11 bankruptcy protection, and others such as NovaStar (NFI Quote - Cramer on NFI - Stock Picks) and Accredited Home Lenders (LEND Quote - Cramer on LEND - Stock Picks) have been forced to seek outside capital.

With Citadel clones popping up and institutions like Prudential and Fannie Mae looking for "opportunities," perhaps the market is realizing there's more than enough capital to stave off a crisis.