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Treasury Bulls Battle Bernanke's Hawks

Stocks are a sidebar in the debate over whether inflation or growth is of primary importance.

The Treasury market has been out of sync with the

Federal Reserve

for months now, with bond traders seemingly obsessed with growth stats even as the Fed continues to stress the importance of inflation. This curious divergence was evident again Tuesday, while the stock market avoided taking sides.

Chairman Bernanke said twice in his speech Tuesday that inflation is "uncomfortably high," and he said twice that the risks to his inflation forecast "seem primarily to the upside."

Even after a much weaker-than-expected durable goods report, Bernanke (and other Fed speakers) was much more sanguine in his comments on growth, painting a relatively rosy picture of the economy. He noted the steep decline in home prices and rise in inventories, but -- on the day existing-home sales had their first upturn since February -- added that the market shows signs of stability.

Furthermore, "outside of the housing and motor-vehicle sectors, economic activity has, on balance, been expanding at a solid pace," Bernanke said, while predicting that the economy in the coming year will "return to a rate that is roughly in line with the growth rate of the economy's underlying productive capacity."

When the durable-goods number came out, the Treasury bond market rallied sharply, sending the 10-year yield below 4.5%, a threshold that suggests bond investors believe the Fed not only will ease next year, but ease two or three times.

Bernanke's hawkish talk on inflation jogged the Treasury market away from a fierce early-morning rally. But Treasury prices still ended the day higher as investors are still focused on growth data rather than inflation rhetoric. The 10-year ended the day up 8/32 in price to yield 4.5%, while the 30-year bond rallied 11/32 to yield 4.59%. The two-year note gained 2/32 to yield 4.68%.

The market action reinforces the need for Treasury traders to tame their rate-cut fever.

"Memo to the markets: 'Alan Greenspan is no longer the Fed chairman,' " says James Bianco, president of Bianco Research, adding that Greenspan's focus in setting policy was real economic growth, and "he dismissed inflation."

With Bernanke, "Fed policy starts and stops with inflation," says Bianco. "I still think the markets just don't get that yet."

That said, the Fed may have confused the bond market by repeatedly stating that slowing growth will do the work of bringing down inflation. This rhetoric put investors' focus on growth. But what they may have misunderstood is that the slow growth is just the optimal means to the ultimate end -- lower inflation. Growth is not the driving force of monetary policy.

Indeed, Bernanke surprised investors who knew him as an inflation-targeter when he started to focus his forecast for inflation on slowing growth. Bernanke and other officials' recent speeches show that the Fed is backtracking somewhat on that forecast. They have insisted they do prioritize inflation over growth, even if it takes more rate hikes to get there. The challenge for the Fed is to reorient the market to the same order of priorities without making any drastic pronouncements about rate hikes.

"The Fed is super-glued to its seat," says Ethan Harris, chief economist at Lehman Brothers. "Their consistent message is that they're on hold for a long time, and if anything, they may be hiking."

Indeed, just about every Fed speaker in recent weeks, including Bernanke on Tuesday, remind the market that the bias is toward hiking the fed funds rate, not easing.

St. Louis Fed President William Poole, now a voting member of on the FOMC, said Tuesday in an interview with

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Market News International

that U.S. policy is mildly restrictive, but that slower growth is not sufficient for the Fed to consider easing policy.

Any Fed easing "is going to depend entirely on what's happening to the inflation rate," Poole said in the interview. "I know I would find it very difficult myself to vote to decrease the federal funds rate if it appeared that the inflation rate is hanging at its current level or is headed higher."

Philadelphia Fed President Charles Plosser also highlighted inflation as a significant problem in a speech Tuesday at the University of Rochester's Simon Graduate School of Business. "There remains some risk that policy is not yet firm enough to ensure a return to price stability over a reasonable time horizon," he said. Plosser acknowledged that inflation readings have "looked more encouraging, but we should not read too much into these figures." Plosser believes that GDP growth will accelerate to 3% next year, he said.

Wednesday, the government will release its revised estimate of third-quarter GDP growth. The initial estimate put growth at 1.6%.

A weaker-than-expected reading of consumer confidence and the largest price drop in existing-home sales on record contributed to the bond market's rally. Some noted, however, that embedded in the existing home sales data, are signs of a housing market bottom. Inventories are stabilizing and overall sales rose amid the price drop. "Isn't that the definition of a bottom?" quips Bianco. "When the prices drop far enough to find their floor and sales go up?"

Hopes for a housing market bottom were part of what gave the stock market bulls the upper hand Tuesday, as buyers jumped into the market after the home sales data came out at about 10 a.m. The

Dow Jones Industrial Average

added 0.1% to close at 12,136.45, while the

S&P 500

gained 0.4% to close at 1286.72. The

Nasdaq Composite

gained 0.3% to close at 2412.61.

Major averages were aided by

Cisco Systems

(CSCO) - Get Cisco Systems, Inc. Report

, which rebounded from Monday's shellacking, and

Exxon Mobil

(XOM) - Get Exxon Mobil Corporation Report

, which rallied in concert with crude prices. Notable laggards included



, which tumbled 7.7% after slashing its second-quarter forecast.

Housing bottom or not, if Bernanke is all about inflation and the bond market is all about growth, investors can continue to misunderstand without damage only as long as the Fed remains on pause. The risks, therefore, are that inflation surprises to the upside, and the market suddenly realizes that the Fed really meant it when it took a tightening bias.

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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