After worrying for weeks that growth and inflationary pressures would have the Federal Reserve tightening the monetary screws to painful levels, market players took a chill pill this week. In this altered state of mind, traders even found cause to take two out of the three major stock indices to multiyear highs.

A spate of less-than-stellar February economic data and tame inflation readings had many traders daydreaming of a gentler Fed, which might deliver two more rate hikes at most. That would leave its key rate at 5%, a nice round number.

Fear that the Fed would overshoot -- hiking rates too much and strangling economic and profit growth -- abated. How could the Fed be unsensitive to retail sales falling for the first time in six months in February, a month when consumer prices ticked up only slightly?

For those seeking more evidence, the Philadelphia Fed index of business activity was also weaker than expected, while weekly jobless claims were higher than expected.

The bond market, always the first to cheer signs of slower growth and inflation, was also the first to relax. Treasuries, which had sold off so far in March, regained some ground.

The price of a 10-year Treasury bond advanced, while its yield, which moves inversely, fell as low as 4.65% on Thursday following the tame CPI. That also helped stocks, which had felt the competitive pressure of rising bond yields.

Signs of bond bearishness returned on Friday, after news that industrial production increased 0.7% in February, after a 0.3% drop in January, while industrial capacity in use rose to 81.2% from 80.9%.

Bonds also braced for a Monday night speech by Fed Chairman Ben Bernanke to the Economic Club of New York, where former Chairman Alan Greenspan used to provide updates on the economy.

The 10-year Treasury bond price fell and its yield rose to 4.67%, but well below the 4.76% level where it stood last Friday.

Rising bond yields also revived nervous jitters in the stock market on Friday, capping gains on a day when option expiration added to volatility.

The Dow Jones Industrial Average rose 26 points, or 0.23%, to 11,279. Broad gains for blue chips helped overcome a 5% drop in the shares of General Motors ( GM), which said its 2005 loss was $2 billion worse than reported and that it will restate earnings back to 2000.

The S&P 500 advanced 0.15% to 1307. On Thursday, both the Dow and the S&P ended at their highest levels since May 2001.

The Nasdaq Composite, meanwhile, gained 0.3% to 2306 Friday as chip stocks made a comeback.

For the week, the Dow advanced 1.8%, the S&P rose 2% and the Nasdaq rose 1.9%.

Among the biggest gainers this week were housing stocks, which are seen as benefiting from the end of rate hikes. The Philadelphia housing sector index jumped a whopping 7.4% this week, led by the likes Toll Brothers ( TOLL) and Hovnanian ( HOV).

Another reason why housing stocks rallied was Thursday's news of a larger-than-expected number of housing starts in February. Also, Robert Toll, the CEO of Toll Brothers, told The Associated Press that real estate can still grow as long as mortgage rates stay near historical lows.

But wait a second. If the market thinks the housing market still has long days of growth ahead of it, then how does it reconcile this with the idea that the Fed will soon stop raising interest rates?

A big issue for the Fed remains the housing market, which has been a key driver of economic growth over the past few years. Consumers withdrew $600 billion from their home equity to finance purchases in 2005, according to former Fed chief Alan Greenspan.

Mortgage rates are benchmarked to Treasury bond yields, and these have only started to rise since February, after seemingly remaining immune to 20 months of uninterrupted rate hikes by the Fed. At 4.67%, the yield of the 10-year bond is still below where it stood when the Fed started raising rates in June 2004.

Some Fed officials also believe that credit markets remain accommodative. "Despite the removal of very accommodative Fed monetary policy, credit markets are still accommodative in my view," Atlanta Fed President Guynn said Wednesday, according to Bloomberg. Guynn votes on interest rate decisions this year.

According to John Lonski, chief economist at Moody's, what's been hitting the housing market since last summer is not so much rising mortgage rates but affordability. Home prices had soared to such levels that potential homebuyers couldn't afford to buy them and sellers have had a harder time making deals.

Should the economy and job growth stay strong, which would help potential homebuyers, Lonski doesn't rule out a second wind for housing later this year.

Part of what may help U.S. companies is a drop in the dollar, which would boost exports and make homemade goods more competitive vs. Asian imports, the economist says. A weaker dollar, however, would raise the price of imports, including oil, which doesn't bode well for inflation.

Crude oil advanced 5.7% to $63.35 per barrel this week amid continued geopolitical tensions.

Meanwhile, the dollar, which had remained supported by rising U.S. rates last year, fell 2.6% vs. the yen and 2.4% vs. the euro this week, as traders discounted a less-aggressive Fed. At the same time, the European Central Bank and the Bank of Japan both have turned more hawkish in recent weeks.

The seers at Morgan Stanley, meanwhile, predict continued U.S. growth based on surveys of the companies in their coverage universe. In these surveys, firms say they plan to boost spending, hiring and their prices -- not exactly a scenario that would take the Fed out of the equation for the rest of the year.

"Market participants and analysts hoping for an end to Fed tightening are looking for signs of lower inflation and/or softening growth," write Morgan Stanley economists Shital Patel and Richard Berner in a note.

But "especially after a rally on good inflation news, stronger-than-expected business conditions and healthy pricing power could come as a double-barreled surprise," they say.

It's hard to tell how markets will react to data in the short term. Next week, besides Bernanke's speech, the market will also get updates from housing. Economists expect that sales of both new and existing homes were weaker in February than in January. Ditto for February producer prices.

Even if this is viewed as more ammunition for the end-of-rate-hikes hopefuls, how will housing bulls react? One thing is for sure, more chill pills might be needed next week.
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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