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S&P Lags, but Breakouts Arrive

The Russell 2000 hits a record; Secretary Paulson moves Treasuries and housing stocks.

It is amazing that on a day with no marquee economic data, traders seemed to be reassessing their economic outlook.

As the

S&P 500

failed to grasp the brass ring a second time around the carousel Tuesday, the Russell 2000 marked a record high, as homebuilders and subprime lenders rallied sharply.

Meanwhile, the bond market sold off, pushing the 10-year Treasury yield to its highest level since early February.

Treasury yields are moving along with global bond yields, which have risen in recent weeks on expectations for foreign central bank-tightening amid strong growth and inflation worries. But some of the move also may be a fundamental trade away from a gloom and doom economic assessment, says T.J. Marta, fixed-income strategist at RBC Capital Markets.

"The housing story is wearing thin as nothing has collapsed and the bond market is beginning to notice that," says Marta.

Odds of a fed funds rate-cut have diminished amid signs of an improving economy. Low initial jobless-claims numbers, some stronger-than-expected manufacturing reports and a solid first-quarter earnings season have started to eat away at the rate-cut expectations, says Marta.

Also Tuesday, Richmond Fed President Jeffrey Lacker, who had been a lone dissenter arguing for rate hikes on the


last year, spoke out Tuesday, reiterating that the Fed is committed to keeping inflation below the 2% level. In an interview with


, he said the recent moderation in inflation was not statistically significant.

The probability of a fed funds rate-cut at the June 28 meeting of the Federal Open Market Committee fell to just 2% Tuesday, down from 4% Monday, according to Miller Tabak.

But more significant is the falling odds of any rate-cut in 2007. Through the end of 2007, the fed funds futures market puts odds of one cut at about 50% for the first time since last summer, according to the firm.

Even Joe Lavorgna, Deutsche Bank's chief U.S. economist and a longtime believer that the Fed would cut rates sooner rather than later, wrote Tuesday that the Fed is likely to remain on pause into the fourth quarter of 2007.

That is a change from his call for a rate-cut in the third quarter. The single reason for his change of heart is unemployment, which he says may fall back to 4.4% in May due to recent readings below 300,000 on weekly initial jobless claims.

It seems the stock market, and even the most growth-sensitive portions, aren't bothered by a Fed on pause for the remainder of the year. Indeed, the housing stocks and the cyclically sensitive small-cap and technology stocks outperformed the blue chips Tuesday even as rate-cut odds fade away.

The Russell 2000 added 0.7% to mark a new all-time high at 839.75, while the

Nasdaq Composite

gained 0.4% to close at 2588.02. The S&P 500 finished down 0.1% to close at 1524.12, while the

Dow Jones Industrial Average

slipped a fraction to end the day at 13,539.95.

The S&P and Dow were held back by weakness in energy stocks as crude oil declined $1.30 to $64.97. The Nasdaq got a boost from big-cap tech names


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Many attributed a 2% climb in the Philadelphia housing sector index to U.S. Treasury Secretary Henry Paulson's comments Tuesday morning that the housing market correction "is largely behind us" and "contained."

As Paulson attempted to improve Chinese-U.S. trade relations while staving off protectionist sentiment in Congress, he managed to influence the stock and bond markets Tuesday.

It has been some time since a Treasury secretary's reassurance about the economy moved the markets, but perhaps Paulson's voice is more convincing than recent inhabitants of his office.

Surely the raw capitalism of investors buying up the ruins of the subprime mortgage calamity is also reassuring, says Marta.

The subprime mortgage lenders caught a bid in the stock market as well Tuesday on news that

Fremont General (FMT)

will sell off its commercial loan business for $1.9 billion to

iStar Financial


. Shares of Fremont gained 41% as the notion that those subprime lenders left standing may have a chance to reinvent themselves.

iStar gained 3.9%,

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added 5%, and

IndyMac Bancorp


gained 7.1%.

The strong parts of the stock market Tuesday in the face of rising global interest rates and diminishing Fed rate-cut hopes at home suggest that stocks could weather even higher rates than 4.8% to 4.9% if the story at home is economic strength, not higher inflation. Thursday brings the next hard data with April's report of durable goods orders, expected to rise 0.9% in the month.

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


to send her an email.