Champagne Wishes, Rate Cut Dreams

The Dow soars to another record as Bernanke seemingly opens the door to a Fed rate cut.
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Breaking the record felt good on Tuesday, but putting the

Dow's

old high over 125 points in the rearview mirror feels even better. So Wednesday was the real rally, even if the underlying catalyst for the move was a tad flimsy.

Oil was up, so traders had to focus on the other market stimulant since its June lows -- falling interest rates. It is almost too greedy to wish for a rate cut when the economy is doing relatively well and the energy tax has been virtually erased. But a rate cut is exactly what traders focused on Wednesday following a speech by

Federal Reserve

Chairman Ben Bernanke at the Economic Club of Washington.

A rate cut would stimulate the economy, but Bernanke gave no explicit clues regarding that likelihood. Like virtually every other communique since June, he reiterated a belief that the housing market correction, the energy markets, and expectations for falling inflation are the keys to his economic outlook.

But Bernanke also said the housing market is experiencing a "substantial correction" and that housing is a "major drag" on the economy, comments that Wall Street took as confirmation the Fed is finished tightening, and may even ease sooner rather than later.

The Treasury market rallied on Bernanke's tacit permission to do so, driving bond yields back down after a brief jump Tuesday. Stocks followed suit, hoping that all of this stimuli ensure the so-called Goldilocks economy.

The

Dow Jones Industrial Average

was up about 40 points ahead of Bernanke's speech, but it and the other major indices took off in the afternoon. The Dow plowed ahead 123.27 points, or 1.05%, to finish the day at a new record high of 11,850.61. The S&P 500 also hit a new 5 1/2-year high, up 1.21% to 1350.22, while the Nasdaq Composite gained 2.1% to close at 2290.95.

"The market's focus should be on earnings and the quality of earnings," says Marc Pado, chief investment strategist at Cantor Fitzgerald. "The Fed isn't going to cut rates with the Fed's preferred measure of inflation

core PCE running at a 2.5% year-over-year rate." (The Fed has outlined 1% to 2% inflation as its comfort zone.)

The major averages disagree, certainly judging by Wednesday's action.

Only shares of

Pfizer

(PFE) - Get Report

,

Merck

(MRK) - Get Report

and

General Motors

(GM) - Get Report

were in the red for the Dow Wednesday.

The 27 other stocks in the Dow gained ground, with

Boeing

(BA) - Get Report

,

Citigroup

(C) - Get Report

,

Home Depot

(HD) - Get Report

and

Microsoft

(MSFT) - Get Report

adding between 1.8% and 2.7% on the day.

Exxon Mobil

(XOM) - Get Report

, which dragged the Dow down Tuesday, gained 1.8% Wednesday on higher-than-average volume as momentum traders were bottom-fishing in the energy sector. To wit, the

Energy Select Sector SPDR

(XLE) - Get Report

gained 1.5% on almost double its average volume. The

Oil Services HOLDRs Trust

(OIH) - Get Report

gained 1.7% on the day on almost double its average volume as well.

The price of oil itself gained 1.3%, to close at $59.49 per barrel, while heating oil and gasoline finished up 1.4% and 2.7%, respectively.

All said and done, the stock market had some major support from the transports and heavy buying in the beat-up energy sector. The Dow Jones Transportation Average gained 2.28% Wednesday, following a 0.8% climb Tuesday. Many traders believe the transports' participation reflects investors' belief in a relatively strong economy and is, thus, an important factor in sustaining the overall stock market rally.

The Treasury bond market has believed all summer that the economy is headed for a tougher road than the stock market sees, sending long-dated bond yields down while short-term yields remain slightly higher -- a yield-curve inversion that has many traders worrying about a recession. Ironically, bond traders' pessimistic view is part of what keeps stock traders more optimistic about a soft landing.

Bond traders took Bernanke's thoughts, combined with weakness in the ISM non-manufacturing business activity survey, to mean rate cuts are a-comin'. The 10-year note gained 13/32 in price to yield 5.56%, while the 30-year note added 17/32 to yield 4.72%.

Like lower energy prices, lower interest rates put a floor under the economic slowdown. With less to pay at the pump, consumers have more discretionary funds in their pockets. With low rates at the bank, they also have lower borrowing costs and the ability to refinance out of adjustable-rate mortgages and into affordable fixed-rate mortgages.

Odds of a rate cut in the fed funds futures market also climbed Wednesday. The market now puts 2% odds on a cut at the October FOMC meeting, 8% odds of a cut in December, and 40% odds of a cut in January, according to Miller Tabak. The eurodollar futures contracts price in a fed funds rate of 4.5% at the end of 2007.

But to make these bets on Bernanke's lack of communication is just another lag effect of monetary policy -- but this time in the personal realm. Bernanke isn't Greenspan, and he's not going to provide the Greenspan-like "tape bombs" to move markets.

"Bernanke has been pretty clear about his strategy to lower the chairman's profile," says Ethan Harris, chief economist at Lehman Brothers, adding that Bernanke wants to stick to official channels while allowing the Fed governors and regional Fed presidents to be more casual and open in their speeches.

What the Fed governors and Bernanke have said is that they want to see how the housing market downturn plays out before they take any road with rates. So, as in June, pause still means pause. The question is whether this is a pause that refreshes or a pause that leaves investors gasping for more.

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

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