Rally Gets Senate Hearing

What Ben Bernanke says in his confirmation hearing has big implication for stocks.
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The recent rally in stocks -- particularly bank stocks -- gets a key test Tuesday when

Federal Reserve

nominee Ben Bernanke appears for his Senate confirmation hearing.

While Bernanke's nomination doesn't face significant opposition, his views on issues like inflation are sure to be probed when the hearing begins at 10 a.m. EST in Washington. And since Bernanke must establish his inflation-fighting credentials early, it's possible his answers will redound to the hawks.

Indeed, how Bernanke handles the challenge could have implications for the current rally in stocks, which has been led by the financial sector. As of Friday's close, the Philadelphia/KBW Bank Index was up 7% for the fourth quarter, making financials the best-performing sector of the

S&P 500

. But the index pulled back Monday and bonds plunged as anxiety rose about what Bernanke will say.

According to Merrill Lynch market strategist Richard Bernstein, investors -- and especially those long in financials -- "should listen carefully" to Bernanke's hearing, which will present his "first chance to jawbone."

The market, Bernstein says, has once again begun to assume that the end of the Fed's tightening cycle may be in sight, something that might explain the resurgence of the financial sector in the fourth quarter. But there could be a bad surprise during Tuesday's hearing.

"The Fed has given no indication at all that they are considering ending the current tightening cycle," Bernstein says. "We suspect that the financial sector might quickly start to underperform again if Bernanke indicates that Wall Street's expectations are incorrect."

Furthermore, signals that the Fed is finished raising rates aren't enough to justify the rally in financials. For the financial sector as a whole -- but especially for banks -- there also needs to be a steepening in the yield curve, which plots the yields of short- and long-term bonds.

Banks make money by borrowing shorter term and lending for the longer term, usually at higher rates. A flat (or inverted) yield curve can dramatically decrease or eliminate this profit center and the recent rise in long-term yields is one reason for the sector's upside flurry.

With inflation expectations rising over the past two months, long-term rates have indeed been rising -- but so have short-term rates, as the Fed has signaled more rate hikes.

On Monday, the spread between the yield of the two-year note -- at 4.48% -- and that of the 10-year Treasury -- at 4.61% -- stood at a mere 13 basis points. And that thin spread followed an even thinner spread last week as the 10-year rallied, and its yield fell after a successful auction Thursday.

Not only has the Fed not signaled that it's done, but the yield curve is still flattening, Bernstein says.

According to the Merrill Lynch strategist, the recent surge in financials has taken the sector's valuations to levels not seen since 1997-98.

That's not altogether reassuring, given that the period coincided with the Asian and Russian financial crises and the infamous collapse of the hedge fund Long-Term Capital Management. Neither is it reassuring to consider that these valuations come after 12 sequential rate hikes by the Federal Reserve and promises of more to come.

Over the years, traders have come to rely on outgoing Fed Chairman Alan Greenspan's supposed willingness to bail out financial markets in times of strife. They've gone so far as to dub the phenomenon the "Greenspan put," a reference to bearish option plays used to hedge against losses.

Now, with Greenspan heading into the sunset, the market needs a new friend. It might be a while before Ben Bernanke feels comfortable enough to assume that role.

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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