Inflation Down, Stocks Up

All the ingredients were in place for stocks to rally Wednesday and the market responded in kind.
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Stocks rallied sharply Wednesday as sliding oil prices and news of tamer-than-expected core consumer prices signaled the

Fed

won't have to deliver more aggressive rate hikes to stay on top of inflation.

The

Dow Jones Industrial Average

surged 132.57 points, or 1.3%, to 10,464.45, lifted by sharp gains in the likes of

Hewlett-Packard

(HPQ) - Get Report

,

Exxon Mobil

(XOM) - Get Report

,

Alcoa

(AA) - Get Report

and

Citigroup

(C) - Get Report

.

The

S&P 500

added 11.76 points, or 1%, to 1185.56. The

Nasdaq Composite

also posted very strong gains, adding 26.76 points, or 1.3%, to 2,030.65 after H-P's strong earnings and restructuring news and as Merrill Lynch upgraded the tech sector.

Wednesday marked the third straight day of gains for the major indices, and the biggest three-day advance since November. Advancers bested declining stocks 25 to 7 in

NYSE

trading and 21 to 9 in Nasdaq activity. Volume was also up smartly from recent trends, with 2.3 billion shares traded on the Big Board and 2 billion over the counter.

Government bonds rallied and the dollar fell on the consumer price index report. Core consumer prices, which exclude food and energy, were unchanged in April against expectations they would rise 0.2%. The year-on-year gain in core prices, which averages out temporary blips, fell back to 2.2% in April after trending up at 2.4% in March.

Amid news the Bush administration has identified four more categories of Chinese textile imports subject to quotas, Joel Naroff of Naroff Economics, mused that the biggest reason for a tame core index in April was a drop in clothing and computer prices. "Don't you just love that flood of cheap Chinese imports? Just wait until quotas get reinstated," he presciently wrote to clients.

Overall, the consumer price index rose 0.5% in April, above expectations of a 0.4% gain. But the gain in the headline number was driven by soaring gasoline prices.

While the increase in energy prices was the highest in two years, the Fed has signaled that it is not much concerned by what it considers to be a transitory trend. And it seems that events are going the Fed's way. Gasoline prices have fallen the past five weeks, bringing their current level down 2.7% from their April average, according to the economics group at Wachovia.

Many economists view the April report as offsetting an unexpected surge in core consumer prices back in March. The surge, they say, was caused by the early timing of the Easter holiday this year, which boosted rental and clothing costs in March instead of April.

Just as the March CPI had raised the possibility in investors' minds that the Fed could move to a more aggressive stance, the April CPI was seen as giving fewer reasons for the central bank to abandon its measured pace in returning rates to a neutral stance.

"The Fed now has no reason to switch from 25 basis points to 50 basis points

increments to keep raising rates," says Moody's economist John Lonski.

The benchmark 10-year Treasury rose 11/32 while its yield fell to 4.07%, its lowest level since early February. Adding to the bond madness, Bill Gross, chairman of bond titan

Pimco

, said the 10-year's yield may fall as low as 3% within five years due to low inflation and should remain in the 3% to 4.50% range.

Interest-rate sensitive issues rose sharply; the Philadelphia Stock Exchange/KBW Bank Index rose 1.4% and the Amex Broker/Dealer Index jumped 2.5%.

Crude oil prices also did their share to ease inflationary fears Wednesday, falling sharply on news that U.S. stockpiles rose four times more than expected. Crude for June delivery fell below $48 a barrel, and closed near a three-month low of $47.25.

To make the day's bullish scenario perfect, even oil shares rose in spite of falling oil prices. The energy and materials sector rose as a weaker dollar sparked renewed interest in commodities and on news that China's industrial production rose more than expected.

Now, the Bad News

Still, few economists, if any, expect the Fed to be done tightening anytime soon. First of all, inflation pressures have been creeping higher over the past year, and strong April employment report and retail sales confirmed that above-trend economic growth continues.

Second, if growth resumes too strongly, in the U.S. and in China for starters, higher energy and commodity prices also may make a comeback. The narrower-than-expected U.S. trade deficit in March already has most economists upwardly revising their first-quarter growth forecasts. According to Wachovia energy analyst Jason Schenker, "downward pressure

on energy could be countered in the near term by a strong upward revision in U.S. GDP next week."

Third, there's the now perennially low long-term yields of Treasury issues, which keep fueling the housing boom and consumption. No matter what Fed Chairman Alan Greenspan does or says, the yield on the 10-year Treasury note remains closer to 4% than to 5%, which is where economists say it should move toward as the Fed lifts its key rate toward 4%.

Finally, Greenspan is due to retire from the Fed in January and he does not want to leave any doubt he may have fallen behind the curve on inflation, especially if housing prices keep spinning out of control, says Michael Gregory, economist at BMO Nesbitt Burns.

"As a parting gift, Greenspan would prefer to have a 50-basis point hike and an inverted yield to impose discipline in the bond market," he says.

An inverted yield curve may signify a recession, or a sharp slowdown next year, although this could be limited to the manufacturing sector, and hit already downtrodden industries such as automobiles, airlines and clothing, Gregory says.

Before that happens, Greenspan actually may prefer to see energy prices -- whose rise the Fed sees as "transitory" -- make a comeback and further cut the spending appetite of consumers.

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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