The tug of war between a slowly deflating housing bubble, underlying economic strength and inflation will be showcased in key economic reports on Thursday.

Based on Thursday's data alone, it would be tempting to bet that, thanks to a slowing housing market and tame inflation pressures, the Federal Reserve will soon stop raising interest rates.

Construction is expected to have started on 2.030 million new homes in February, down 11% from 2.276 million in January, according to a Reuters survey.

At the same time, the consumer price index is expected to have risen 0.1% in February, slower than its 0.7% increase in January. Excluding food and energy, the core CPI is seen rising 0.2%, matching January's gain.

In another key report, jobless claims are expected to have increased 298,000 in the latest week, slightly down from 303,000 the previous week, but slightly above the four-week average of 294,000.

Combined with signs of weakness in retail sales in February, these reports would bode well for those hoping that the Fed will soon end its 20-month long campaign of monetary tightening.

Such hopes were on display Wednesday, reflected in strength in stocks following the release of the Fed's beige book report, which said the economy continued to expand at a healthy clip in the first two months of the year, while cost pressures were little changed.

Stocks took off after the report, boosting both the Dow Jones Industrial Average and the S&P 500 to their highest finishes since May 2001.

The Dow rose 58.43 points, or 0.5%, to 11,209.77. Blue chips were helped by DuPont ( DD), which lifted its first-quarter guidance. General Motors ( GM) also advanced amid reports of a bid for its financing arm GMAC.

The S&P 500 gained 0.4% to 1303. The Nasdaq Composite advanced 0.7% to 2311, moving higher despite a big drop in tech leaders Apple ( AAPL) and Google ( GOOG).

But strangely enough, the bond market didn't hear the same tune. The benchmark 10-year Treasury bond fell 10/32, while its yield, which moves inversely, rose to 4.73%.

The rise of bond yields in recent weeks was partly based on January's strong economic data, itself a rebound from weakness seen in the fourth quarter. But so far, February's data are proving to be less stellar than January's.

"The February numbers are more tepid than January, which was inflated by unusually warm weather that month," says David Watt, senior economist at BMO Nesbitt Burns.

Since Tuesday, the market has already been scaling back expectations of future rate hikes by the Fed. Futures are still pricing in two more hikes, which would take the fed funds rate to 5.0% by May 10.

But expectations of another move to 5.25% fell from 22% to 0% on Tuesday after research firm Medley Global Advisors suggested the Fed would stop at 5.0%, according to Miller Tabak.

Such an outcome would reduce risks that the Fed would "overshoot" -- i.e. lift interest rates too much and push the U.S. economy into a recession. This overhanging threat on future profits has been cited as a cap on stocks in recent weeks.

Reversed Conundrum

Since the Fed began raising rates in June 2004, the bond market witnessed a strange phenomenon: Long bond yields were refusing to move higher and offer investors higher premiums for parking their money for a longer period of time.

This "conundrum," as former Fed Chairman Alan Greenspan coined it, was explained by current Fed Chairman Ben Bernanke as a symptom of too much money sloshing around the global financial system.

But this "savings glut," whether it came from Japan, China or petroleum-exporting countries, is showing signs of ebbing.

The main thing that brought the bond market down on Wednesday was a report showing that net foreign purchases of U.S. Treasuries slowed to $4.4 billion in January, their lowest level in three years.

Additionally, Japan, the largest holder of Treasuries in the world, sold a net $16.6 billion worth of Treasuries, its largest sale ever.

The global economy is picking up some steam and that's putting pressure on global bond yields at the same time that the world's central banks are lifting their key rates, notes the JPMorgan economics team.

With better investment opportunities at home, competitive pressures are rising for U.S. bonds, whose yields need to at least stay at high levels to still attract global investors.

Should the Fed stops lifting rates, these pressures will be even more felt on Treasuries. This might create a reverse conundrum: Even if the Fed stops raising rates, U.S. bond yields would continue to rise.
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; click here to send him an email.

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