Stocks Like Bernanke Banter

The Federal Reserve chief's comments lift both stocks and bonds as rate-hike worries diminish.
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Updated from 2:49 p.m. EST

The markets asked

Fed

Chairman Ben Bernanke to be their Valentine Wednesday, and he accepted, though perhaps somewhat unwittingly.

As soon as the headlines on Bernanke's semiannual testimony to Congress hit the tape at 10 a.m. EST, the

Dow Jones Industrial Average

quickly jumped into record territory. The

S&P 500

and the

Nasdaq Composite

also surged, and stayed well in the green throughout Bernanke's question-and-answer session on Capitol Hill.

The rally came despite uninspiring, flat January retail sales and business inventories for January and December, respectively. The DJIA finished up 0.7% to close at a new high of 12,741.86. The S&P climbed 0.8% to close at 1455.29, and the Nasdaq surged 1.2% to 2488.38.

The Dow Jones Transportation Average also reached a new all-time high, jumping 2.1% -- once again "confirming" the market's rally. Likewise, the Dow Jones Utilities Index also closed at record levels.

Bonds also rallied on Bernanke's testimony, sending the 10-year yield down to 4.73% from 4.81% at the end of the day Tuesday.

Bernanke's speech didn't stray from recent Fed portrayals of a strong and resilient economy, somewhat moderating inflation, but remaining risks that inflation could resurge. Basically, the chairman portrayed a Fed still on hold with a bias to tighten, but the markets saw doves flying.

On the economy, Bernanke said that "the resilience of consumer spending is all the more striking given the backdrop of the substantial correction in the housing market." On housing, Bernanke noted that while the decline in residential construction likely would drag down GDP growth in future quarters, "some tentative signs of stabilization have recently appeared in the housing market."

He gave a nod to increasing defaults in the subprime mortgage market, but noted that the "healthy labor market" and rising real incomes should help keep household finances in decent shape.

The cyclically sensitive elements of the market reflected Bernanke's upbeat outlook for economic growth. The Morgan Stanley Cyclical Index closed at a new high, up 1.2% on the day. Components

Caterpillar

(CAT) - Get Report

,

FedEx

(FDX) - Get Report

,

United Technologies

, and

Honeywell

(HON) - Get Report

all advanced at least 2%.

Deere

(DE) - Get Report

jumped 10% on its strong earnings report.

As for inflation, Bernanke was his usual vigilant but data-dependent self. Traders honed in on: "As I noted earlier, there are some indications that inflation pressures are beginning to diminish." But, he added that "the monthly data are noisy," and "it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated."

While most analysts would say that Bernanke toed the Fed's now almost boiler-plate message, his comments managed to please both the stock and the bond markets.

Indeed, the argument between stock and bond markets about the future of Fed policy may be kicking up again. The pessimistic bond market saw a green light to price in rate cuts, while the stock market saw pure gold -- Goldilocks, that is.

Throughout much of the seven-and-a-half-month-long stock market rally, the Treasury bond market was pricing in several rate cuts, betting that the economy might even slip into a recession.

As traders rang in the new year and strong fourth-quarter data rolled in, the markets unwound their rate-cut hopes, and bond yields rose to reflect faith in a more resilient economy. Several Fed speakers helped bond yields along with hawkish talk that put the specter of rate hikes back on the table.

The bond market took Bernanke's testimony as a signal that rate cuts are once again on the way, says T.J. Marta, fixed-income strategist at RBC Capital Markets. He added that bond traders also are extremely anxious about the subprime mortgage market sinking the economy.

The subprime market has garnered many headlines lately amid warnings from big players

New Century Financial

(NEW) - Get Report

and

HSBC

(HBC)

, which have been hurt after several years of low rates and loose lending standards.

Stock-traders had a different take on the testimony. They wouldn't go so far as to call it dovish, but they said it was "Goldilocks" and "status quo."

"Last week, fears crept up that the Fed would be raising rates, so this is about relief that there won't be more rate hikes, not about expectations for rate cuts," says Todd Leone, head of listed trading at Cowen & Co.

Interest rate-sensitive financial companies rallied with relief about no more rate hikes.

Goldman Sachs

(GS) - Get Report

,

Citigroup

(C) - Get Report

and

JPMorgan Chase

(JPM) - Get Report

jumped more than 1%.

Whatever traders make of Bernanke, little was actually new in his testimony.

"What I saw today was that the Fed doesn't have a message here," says Ethan Harris, chief economist at Lehman Brothers. "We're on hold."

Bernanke did include more than his usual commentary on energy prices, notes Harris. Giving credit where credit is due, the chairman acknowledged that oil prices cooperated through the second half of 2006 to help reduce inflation and spur consumer spending. He also revealed that he believes energy prices "will probably help foster a continued edging down of core inflation."

He added: "In particular, futures quotes imply that oil prices are expected to remain well below last year's peak. If actual prices follow the path currently indicated by futures prices, inflation pressures would be reduced further."

By the same token, if oil prices were to spike, the opposite outcome could occur. Bernanke even said, "they

energy prices remain a key source of uncertainty to the inflation outlook."

Bernanke's comments on energy prices reveal perhaps the biggest weakness in the Fed's forecast. Unpredictable energy markets could upend growth and spark inflation, which might test Ben's attachment to his inflation 'comfort zone,' says Harris.

Bernanke also highlighted the tight labor market as a threat to inflation through rising wages. But, he noted that if productivity keeps up with the pace of employment and compensation, the risk to inflation will be contained.

The tight labor market surely was not on the minds of autoworkers, who face more layoffs.

DaimlerChrysler

(DCX)

unveiled a

restructuring plan that includes cutting 13,000 jobs in the next two years. Its shares soared 8.3%, and

General Motors

(GM) - Get Report

and

Ford

(F) - Get Report

got a small 0.4% and 0.7% boost respectively as well.

So the markets took Bernanke's testimony as a Valentine's Day gift, but the true test of a relationship comes amid regular every-day scenarios. The rest of the week brings data on housing, producer prices, industrial production and consumer sentiment. Investors would do well to remember that with many Bernanke-sparked rallies, the follow-through can be iffy.

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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