As rate-cut odds are dwindling, some observers say rate hikes may be back on the horizon.

But until hikes are a confirmed threat, stocks can continue on their golden path.

The

Dow Jones Industrial Average

hit another all-time high Monday, nearly crossing the 12,000 mark. The blue-chip index reached an intraday high of 11,997.09 and closed up 0.2% at 11,980.60. The

S&P 500

added 0.25% to close at 1369.05, and the

Nasdaq Composite

finished up 0.28% to close at 2363.84.

The critical financial sector took a blow Monday when

Wachovia Securities

(WB) - Get Report

disappointed investors with its third-quarter revenues.

Shares of Wachovia fell 2.16%, and competitors

Citigroup

(C) - Get Report

,

JPMorgan Chase

(JPM) - Get Report

and

Bank of America

(BAC) - Get Report

fell in concert. The Philadelphia Stock Exchange/KBW Bank Index fell 0.6%.

The financials have been one of the structural support beams of the stock market even through these months of high short-term interest rates and bets on economic weakness. Some say the financials have to simply not fail in order to remain supportive to the overall market. Others, like two of the three bearish strategists highlighted in

The Wall Street Journal

Monday, say the financials are a sell as soon as next year arrives.

Whatever next year brings, Wachovia broke the ice on the damage caused by the inverted yield curve, the phenomenon of short-term Treasury yields being higher than their long-term counterparts. The inversion, which has persisted since the springtime, is a direct result of the

Fed's

tightening campaign, which only just ended in August.

Financials, which comprise over 22% of the S&P 500, led the rally off the summer lows as optimism about a potential rate cut took hold of investor sentiment. But the fed funds futures market has recently pushed the odds of an ease out to the June 2007 meeting vs. March, and even January, during the past two months.

Pretty soon, odds of an ease will move to August, and then the market will "push the ease so far out that it gets pushed off the board," says James Bianco, president of Bianco Research.

Unlike earlier this year, when the Fed signaled a pause as evidence of higher inflation mounted, the Fed has been hawkish of late, signaling it is "still on pause, no ease," even as evidence of lower inflation gathers. The fed funds futures market and the Treasury market have dutifully responded to the rhetoric, but the future of Fed policy is still up in the air. The scales of growth and inflation remain unsettled, even as a strong earnings season, low energy prices and a strong consumer fuel the stock market to new highs.

"It wouldn't take much to get rate hikes back on the table," says Bianco. "The Fed has already stated that the current level of inflation is too high."

Fed Chairman Ben Bernanke was mum on the subject of monetary policy in a speech Monday, but Fed-speak of late has repeated that inflation can't run forever over the Fed's "comfort zone" for inflation, or 1% to 2%. The tough talk is hardly a news flash, as inflation rates haven't neared that range since 2004. The Fed's favored measure, the core personal-consumption expenditures index, puts inflation at a 2.5% year-over-year pace -- the highest since April 1995. The core consumer price index measure puts inflation at 2.8% year over year -- the highest since January 1996.

While the Fed has said it is tolerating higher inflation through 2008 in order to allow time for the impact of its 17 rate hikes, those rate hikes are not having the effect the Fed had hoped for thus far. The Fed posited when it paused in August that the economic slowdown would stamp out inflation. But the Fed admitted in the September FOMC minutes, released last week, this forecast is not coming to bear as quickly as hoped. This sent the bond market reeling. Yields on the 10-year Treasury note have widened nearly 23 basis points in about eight days. (On Monday, the 10-year rose 5/32, and its yield dipped to 4.78%.)

New readings of the consumer price index and the producer price index come in this week, but "rate hikes would have to come from upside surprises to growth," says T.J. Marta, chief fixed-income strategist at RBC Capital Markets.

The economy has moderated, says the Fed, but there are still signs of robust activity both in the business and consumer parts of the economy. Indeed, one upside surprise came Monday in the form of the New York Empire State Index, which beat consensus expectations by nearly two times, reaching its highest level since June. The data reveal strong levels of manufacturing activity in the New York area.

Investors and the Fed expected the weak housing market to slow growth enough to sharply weaken the economy. The irony is that the weak housing market itself props up inflation data, which gets the Fed nervous about its credibility and the path of policy.

Collecting inflation data is not even remotely a science. Consensus estimates say both the producer price index and the consumer price index headline numbers out Tuesday and Wednesday will be soft due to lower energy prices over the past month. But the core inflation reading of CPI, in particular, will not come down as much this month or in the near future, in part due to how shelter is factored into the data.

"Housing is contra-cyclical," says Bianco. Even as house prices weaken, rents have been going up, which means that the data collectors record higher prices for all housing in the CPI report. Adding to the confusion, the government also subtracts utility costs from owner-equivalent-rent readings (OER). So, when gas and heating oil prices fall, owner-equivalent rent readings also get higher.

"In a weak-housing, falling-energy-price environment, you get a big push to OER," says Bianco, adding that OER alone is likely to keep inflation running above the Fed's comfort zone.

Either way, the inverted yield curve is not likely to go away as fears remain that the economy could still have more slowing to come. Even the stock market rally is focused on large-cap, relatively safe stocks such as

Exxon Mobil

(XOM) - Get Report

, which rallied over 2% Monday as crude prices rose for the third-straight session.

So don't count that spot on the horizon as a rate hike just yet.

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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