The financial world went down Alice's rabbit hole Thursday, as nothing behaved the way it usually does.

Consummate dove and San Francisco Federal Reserve Bank President Janet Yellen made hawkish comments about monetary policy. Yet, the Treasuries market rallied. The proverbial book was thrown at the housing market, as more homebuilders lowered their earnings expectations, but the sector gained even though the overall market declined.

The major averages continued to rescind their August rally and ended near the lows of the day, albeit on low volume. And some surprises lurked behind the red flashes. The

Dow Jones Industrial Average

fell 0.7% on the day to close at 11,331.44, and the

S&P 500

added 0.5% to close at 1294.02. The

Nasdaq Composite

shed 0.6% Thursday to close at 2155.29.

The Cheshire cat was smiling on the notoriously ugly housing sector Thursday -- the epicenter of concern about the waning economy. Late Wednesday,

KB Home

(KBH) - Get Report

cut its earnings estimate for the fiscal year 2006, and

Hovnanian

(HOV) - Get Report

reported weak earnings. Early Thursday,

Beazer Homes

(BZN)

cut its earnings forecast, adding that its net home sales fell 49% in the two months ending Aug. 31.

But "the homebuilders' cut to earnings expectations weren't as bad as the market expected," says Marc Pado, chief investment strategist at Cantor Fitzgerald.

Hovnanian, whose results did beat expectations, rose 6%, while KB Homes ended up a penny at $40.40 after trading as low as $38.66 intraday. Beazer lost 2.7% to $37.33, but was up vs. its intraday low of $35.96. The

SPDR Homebuilders Exchange-Traded Fund

(XHB) - Get Report

added 1.46%.

The Treasury market, meanwhile, seems to believe there is no bottom for the housing market -- or the economy for that matter. The bond market is still betting that the

Fed's

next move would be a rate cut. The 10-year Treasury note gained some traction Thursday, adding 3/32 to yield 4.78%, even amid hawkish comments from Yellen. And this just one day after the market weakened on fears of wage inflation.

"Our traders are really bear-ed up on the economy, thinking the next Fed move is an ease," says TJ Marta, fixed-income strategist at Royal Bank of Canada Capital Markets, adding traders are anticipating a steeper yield curve "as soon as the market is sure the Fed's next move is an ease."

But an ease is a dangerous bet given Yellen's speech in Boise, Idaho, where she said: "With inflation too high, policy must have a bias toward further firming."

Yellen weighed in on wage inflation as well. "I must admit that I'm also less sanguine than I was a month ago about one particular factor in the inflation process, namely, labor compensation," she says. Yellen's hawkish mood oddly countered St. Louis Fed President William Poole's comments Tuesday, when he unexpectedly emphasized the Fed's data-dependent approach. He's was wearing the giant top hat that day.

As it stands, the fed funds futures market continues to price in a 16% chance of another rate hike to 5.5% sometime this year, as well as 16%, odds of a rate cut at the FOMC's January meeting as well, according to Miller Tabak.

But even if the Treasury market's pessimism about the economy is overblown, and inflation is a greater threat than bond traders acknowledge, a Fed hike would shock the markets. Ben Bernanke's open-communication philosophy and short history suggests there would be a lot more hawkish rhetoric from the mouths of Fed members if the policy makers were really leaning toward tightening.

Without that rhetoric on the table, inflation expectations would have to climb for the Fed to put a hike in play. The TIPS spread, which reveals expectations for inflation using the market for inflation-protected securities, is trading at 235 basis points, near the low end of the 220-basis-point to 290-basis-point range since 2004.

So while the Treasury market's recent rally may seem extraordinary, there are two forces meeting to drive yields lower. A bearish bet on the economy is accompanied by foreign central banks' buying of U.S. Treasuries. According to RBC's Marta, Thursday's rally can in part be attributed to a large bid in the Treasury market by an Asian central bank.

He says that "rumor" started in Europe and transferred to North American trading desks. He says the so-called rumors are usually true. "Given nothing else to note, you tend to believe it."

True or not, the ever-present rumors reiterate that foreign buying is keeping long-term interest rates down -- which arguably supports the U.S. consumer, helps Asian exporters, keeps a floor on the housing market's decline, and helps corporations keep costs down and growth prospects attractive.

To wit, commercial banks' residential real estate charge-offs are still below 10% this week, according to RBC research. That is historically low, says Marta, though up from bottoming at 6% to 7% late in 2005. Also, the Labor Department reported that unemployment claims fell by 9,000 last week, more than the expected 5,000 decrease.

At the very least, the economy's strength combined with a cloudy inflation picture could be starting to rattle the markets' belief that the Fed's pause was really a stop. And don't forget, September is still the worst month for stocks ... and hurricanes. A big bad storm could shake things up in Wonderland.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

here

to send her an email.