Markets Mull Zen Ben

Bernanke is a soothing visage but markets have a restrained reaction.
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Ben Bernanke must be doing yoga. His testimony before the Joint Economic Committee Thursday indicated that the Federal Reserve won't hike one more time and finish, but hike one more time and breathe. But the Zen attitude may just be a precursor to a more aggressive posture later this year if the inflation elephant stirs.

The FOMC has raised its fed funds rate 25 basis points for 15 consecutive meetings, bringing it to 4.75% currently from 1% in June 2004. U.S. financial markets have spent the past year betting on when the Fed will be "done," and they heard Bernanke's words about a potential pause loud and clear Thursday:

At some point in the future the Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook. Of course, a decision to take no action at a particular meeting does not preclude actions at subsequent meetings, and the Committee will not hesitate to act when it determines that doing so is needed to foster the achievement of the Federal Reserve's mandated objectives.

Stocks rallied somewhat on Zen Ben's testimony, as the dollar dropped and U.S. Treasury bonds saw a decent bid. These moves reversed earlier action based on China's raising its one-year lending rate to 5.85% from 5.58%. But the lack of an all-out rally on the dovish news points to lingering inflation jitters, and deservedly so.

"In the Greenspan days, if he said that we're done, we'd be at 5% odds of fed funds hike in June by now," said James Bianco, president of Bianco Research LLC. The odds that the Fed will hike in June did drop sharply Thursday to 36% from 64% yesterday, but not enough to indicate a real sense of security in the markets.

The

Dow Jones Industrial Average

closed at another new six-year high Thursday, up 28.02 points, or 0.25%, to 11,382.51. The

S&P 500

rose 4.31 points, or 0.33%, to 1309.72, while the

Nasdaq Composite

gained 11.32 points, or 0.49%, to 2344.95. Maybe the stock market needs some time to get comfortable with Bernanke but it was a comparatively weak response after its 200-point gain on

April 18 following similar dovish words from more familiar speakers like Janet Yellen, and the minutes of the March FOMC meeting.

"The market reacted with enthusiasm over the headline statements, but when they heard the caveats, inflation concerns are still there," said Marc Pado, U.S. market strategist at Cantor Fitzgerald. Even this much market enthusiasm could soon go out the window. Without the strong earnings fueling stocks -- and mega-caps

Exxon Mobil

(XOM) - Get Report

and

Microsoft

(MSFT) - Get Report

posted disappointments, respectively, before and after the bell Thursday -- we are left with things that generally aren't good for stocks, such as inflationary data, rates over 5%, Iran, Iraq ... the list goes on.

But it was clear from his testimony that Bernanke wants to pause in June.

The lagging effects of the Fed's deep tightening need time to sink in, says Bernanke, adding in true academic fashion that the Fed need to collect more data before taking a stance on inflation. Bernanke is looking for productivity levels to stay ahead of inflation data, which keeps everything a-OK.

First-quarter productivity is expected to be strong, but neither the Fed nor the markets are sure it can keep up with the high cost of commodities and rising rates as the year progresses. GDP, to be reported Friday, is expected around 5% for the first quarter, and productivity is expected to remain ahead of the 3.5% annualized inflation rate. Bernanke also pointed to the germs of restraint in the U.S. residential housing market -- a slowdown the Fed wants to be gentle and easy.

The Dating Game

Most first dates let you know during the first course exactly why you'll probably break up three months later. The same could be said for Bernanke on Thursday when he mentioned high energy prices as a key inflation concern. It is hard to imagine that steady servings of oil over $70 a barrel and inflated prices of metals and other raw materials will never be passed through to consumers.

"By June you may have $700 gold, $80 oil and the Dow at 12,000," says Bianco. "The market may be saying, 'I hear you Ben, you want to stop, but when push comes to shove, you may not get the opportunity to.' "

Even Bernanke called into question the Fed's own logic when he admitted during the Q&A session that the core consumer price index is not necessarily a perfect statistic to measure inflation.

Indeed, some companies have mentioned the high cost of raw materials in this round of first-quarter earnings, but most have said they've been able to pass through the costs, including

Alcoa

(AA) - Get Report

,

Caterpillar

(CAT) - Get Report

and others, as reported

here. Some, like

DuPont

(DD) - Get Report

, however, have indicated they've had trouble doing so. This kind of difficulty could eventually hurt earnings and profit margins.

The June FOMC meeting is relatively far away. The Fed admitted it doesn't really know what the reversal of near Depression-level interest rates might ultimately mean for inflation. Still, Bernanke forecasts the economy "downshifts from the first-quarter spurt."

The U.S. Treasury bond market expressed displeasure over the recent economic data by sending yields higher Wednesday. Some of that selling reversed Thursday, given the expected pause in fed fund rate hikes. But inflationary jitters are still in play. The 10-year Treasury bond ended up 6/32 to yield 5.08%, and the two-year ended at 99 30/32 to yield 4.9%. But, Treasury Inflation Protected Securities (TIPS) that mature in eight months show a break-even rate of 3.6%, higher than the 3.5% annualized CPI.

With gold at $638.20 an ounce, and oil at $70.97 for the June contract, Bernanke may not be breathing as easy come the end of the second quarter. And without earnings to mask all the data, markets may take a downward dog position.

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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