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'Goldilocks' Report on China Lifts Stocks

Treasury takes a hard, but not too hard, line on currencies; shares rally in reaction.
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The major indices rebounded into positive territory Tuesday, setting aside previous inflation concerns, after the U.S. government heightened pressures on China to revalue its currency. The move was greeted by investors as meaning that U.S. products would be more competitive against their Chinese counterparts.

In a semiannual currency report, the Treasury Department warned China that it would be labeled a currency manipulator if it does not let the yuan float more freely against other currencies by the time of the next report. But the report did not find China guilty of manipulating its currency currently, providing relief to traders worried that a more combative stance could trigger a trade war.

Following the Treasury report, which also gave the dollar a boost, the

Dow Jones Industrial Average

bounced from an intraday low of 10,213.14, closing up 79.59 points, or 0.8%, to 10,331.88. The

S&P 500

rose 8.11 points, or 0.7%, to 1173.80, off an intraday low of 1159.96. An analyst upgrade of

Exxon Mobil

(XOM) - Get Report

and the higher price of crude oil helped energy stocks recover from recent losses, further boosting the blue-chip averages.

The

Nasdaq Composite

gained 9.27 points, or 0.5%, to a one-month high of 2004.15, after touching an intraday low of 1980.94. The performance of the tech-heavy index could hinge on the reaction to

Hewlett-Packard's

(HWP)

after-the-bell report. The PC giant

posted better-than-expected fiscal second-quarter results and raised its revenue guidance but warned that its third-quarter earnings won't meet expectations. H-P shares were recently up 3.7% in after-hours trading.

The market headed south early Tuesday as news of stronger-than-expected producer price index report for April fueled concerns about inflation. In conjunction with a strong report on housing starts, the PPI data were seen as boosting the case for sustained

Fed

rate hikes.

The producer price index rose 0.6% in April, above market forecasts for a 0.4% rise. Excluding food and energy, prices increased 0.3%, above expectations of a 0.2% gain. The PPI was seen as a bad omen for the much more important release of the consumer price index on Wednesday.

Separately, news that industrial production fell 0.2% last month, against expectations for a 0.2% gain, revived the specter of mild stagflation that haunted markets during March and April.

But the decline in industrial production -- mostly due to waning production of automobiles -- did little to offset the impact of a series of recent key economic reports, at least in equity investors' minds. Strong April employment and retail sales, as well as the narrowing trade deficit, have eased previous concerns of a significant slowdown in economic growth. But now investors are grappling with the inflationary implications of the stronger data.

"Inflation is accelerating," says Joel Naroff, president of Naroff Economic Advisors (NEA). "It is not doing so rapidly, but the direction is clear." So far, he says, price pressures are enough to keep the Fed in tightening mode, but are contained enough to let the central bank maintain a measured pace.

TheStreet Recommends

"The

industrial production and PPI data doesn't change anything," says Larry Berman, fixed-income strategist at CIBC World Markets. He expects Wednesday's CPI to also surprise on the upside. "That will keep the pressure on the Fed to keep raising rates, but it's not material enough to change its measured pace."

The market's current expectations, as measured by Fed funds futures, are for close to 100% chance of a quarter-point hike at the Fed's next rate-setting meeting in June. Another two quarter-point hikes are almost fully priced in at the remaining four Fed meetings this year.

Of course, there are risks to these expectations. A recent sharp pullback in commodity prices -- including crude oil, which ticked up 34 cents to $48.95 Tuesday -- has helped reduce concerns over inflation going forward. Yet that drop may have at least been partly fueled by fears of a slowdown in U.S. economic growth. If growth expectations fully return, high commodity prices may come back up as well.

Another big question is what impact the sustained rate hikes over the past year are having on economic growth. Typically, the impact of rate hikes can take between 10 months to a year to impact growth, which should be about now since the Fed began raising rates in June 2004.

The main impact to date has been felt on the aggregate measure of the money supply, which has shrunk noticeably now that the interest rate in money markets has been raised from 1% to 3%, notes Goldman Sachs chief U.S. economist Bill Dudley.

But this is largely irrelevant in terms of its implications on credit availability and growth, he says. Capital markets have now taken over the banking system in spurring monetary impulses. And according to Goldman's indicators of the financial conditions from capital markets, credit growth is still very strong. "So far, there is no evidence of a slowdown," says Dudley.

The so-far limited impact of the Fed's existing rate hikes therefore appears to be another onus on the Fed to keep raising rates. That's especially true as the Fed's hikes and inflation warnings have had little impact on the yield of the 10-year Treasury, which slipped to 4.12% Tuesday. The continued strength of Treasury prices, which move in opposition to yields, is helping sustain the red-hot housing market; that, in turn, is helping sustain consumption, and the inexorable link between the two was a key factor behind the economic growth of the past few years.

On Tuesday, the Commerce Department reported that housing starts rose 11% in April, after dropping 17.6% in March. The report spurred the first increase in copper prices in a week in trading on the New York Mercantile Exchange. Copper had been hit recently amid fears of slower growth.

Strong housing trends also keep girding retail sales. That's at least true for the likes of

Lowe's

(LOW) - Get Report

, and

Home Depot

(HD) - Get Report

, which rose 3.9% Tuesday after posting

better-than-expected quarterly results.

"Equity investors should enjoy the

housing number," says NEA's Naroff. "But they shouldn't celebrate too much. For the Fed, it's just another reason to go to 3.25% on June 30."

To view Aaron Task's video take on today's market, click here

.

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

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