Federal Reserve

Chairman Alan Greenspan showed Tuesday that he isn't one to back down in the face of a hostile crowd.

In the first half of the year, Greenspan and his colleagues on the Federal Open Market Committee laid out the case for steadily raising short-term interest rates to keep a strengthening economy from overheating and igniting inflation. In May, the Fed warned that it would undertake a series of "measured" rate hikes, and at the end of June it began doing just that.

But since then, we've witnessed skyrocketing oil prices, two months of anemic payroll growth and reduced consumer spending. Stocks acted as if the slowdown would hit profits, and bonds rallied on the theory that weakness would curb inflation and the Fed's measured campaign. After trading as high as 1144 in June, the

S&P 500

lost 7%, the

Nasdaq Composite

dropped 13%, and the yield on the 10-year Treasury note declined from 4.87% in mid-June to 4.22% on Friday.

Seeing all the same data, however, Greenspan showed no sign of wavering from his relatively rosy scenario. The FOMC

statement on Tuesday reiterated much of the same lingo that the central bank used back in June when the economy looked much stronger. The statement addressed the current weakness by cribbing from Greenspan's July 20 testimony to Congress, saying that inflationary pressures seemed "transitory" and that the economy was "poised to resume a stronger pace."

That was enough to prod bond investors to lean back towards the old view that the Fed would keep up the steady pace of quarter-point increases for the rest of the year. The yield on the two-year Treasury note, which moves in opposition to its price, gained 0.09 percentage points to 2.53% Tuesday, while the yield on the benchmark 10-year note gained 0.03 points to 4.29%. Meanwhile, fed funds futures contracts are now signaling a 70% likelihood of a rate hike in September vs. 56% on Monday.

After Tuesday's announcement, bond guru Bill Gross, manager of

(PTTAX) - Get Report

Pimco's Total Return fund, said on

CNBC

that he's been selling into the recent rally and predicted that the 10-year note yield "has no where to go but up."

Gibson Smith, manager of the

(JAHYX) - Get Report

Janus High Yield fund, remains "cautiously bearish" as well. While economic data over the next few weeks could keep Treasuries in a modest rally, he agreed that the current yield levels "are not sustainable if the economy is truly improving."

Junk bonds should be doing better than Treasuries when rates are rising because the strengthening economy helps improve corporate finances. But that hasn't happened as much as expected in 2004.

Smith said he's found that the problem is a substantial number of almost-investment grade junk issues -- so-called fallen angels that used to be investment grade but are now double-B rated -- are trading in lockstep with Treasuries. He favors true junk bond credits -- those rated single-B and triple-C -- and is long many in the fund, which is up 3% so far this year, better than two-thirds of competitors. Before Smith took the helm in December, it trailed 98% of the field.

Stocks were moving on a separate track after the Fed's announcement. A slight selloff was quickly erased and the major indices finished at their highs for the day.

The moves came off of lows for the year on the Nasdaq and near the year low for the S&P 500, so it may simply reflect an oversold bounce. The

Dow Jones Industrial Average

and S&P gained 1.3% each while the Nasdaq jumped 1.9%.

Despite the Fed rate hike and in contrast to Treasuries, companies sensitive to higher interest rates appreciated too.

Lehman Brothers

(LEH)

gained 2.7% to $70.84,

Citigroup

(C) - Get Report

added 1.6% to $44.18 and

Wells Fargo

(WFC) - Get Report

rose 1.1% to $57 on Tuesday.

Before Tuesday, interest-rate-sensitive stocks had traded down since the spring as the Fed signaled its move to raise rates. Absent more evidence of economic weakness, such names have to be considered vulnerable to additional Fed rate hikes.

To be sure, a September rate hike isn't an absolute certainty, though I think the Fed is full speed ahead

as of now

for a September hike. If the August payroll report comes in next month showing job losses or oil makes another prolonged move higher, the Fed might put off the September move. But absent those changes from the status quo, given what we know today, the Fed is signaling that it remains on course for another 25-basis-point increase in the fed funds rate at the Sept. 21 meeting.

A few of the indicators to keep an eye on before the next big August payrolls number: this Friday's release of the University of Michigan's consumer sentiment survey for August, which is expected to show a slight rise from July's reading of 96.7, and the release of the consumer price index for July on Aug. 17, which is projected to rise by 0.2% from 0.3% in June.

Both could give an early snapshot of where the economy is heading. Lower confidence and/or lower inflation would weaken the case for a Fed hike in September.

But absent such signs, expect Greenspan to stick to his convictions and measure out another tightening.