Riding a wave of buying interest for most commodities, steel stocks surged Wednesday as the dollar dropped a day after the Federal Reserve's latest rate hike.

The Fed hinted at further monetary tightening on Tuesday, sparking a selloff in bonds and stocks, and a surge in the dollar. Bonds continued to dip Wednesday, with the yield of the benchmark 10-year Treasury rising to a 21-month high of 4.81% following an unsuccessful auction of five-year notes.

But the dollar and stocks reversed the previous day's action.

The Nasdaq Composite, which had been lagging the other major indices in recent weeks, jumped 1.45% to 2337, a five-year high. The rally was led by semiconductor shares and fueled by a positive note on Sun Microsystems ( SUNW).

The S&P 500 rose 0.75% to 1302.

The Dow Jones Industrial Average gained 61 points, or 0.55%, to 11,215. 3M ( MMM) rose 1.7% after Merrill Lynch upgraded the stock. The blue-chip average, however, was restrained by Caterpillar ( CAT), which fell 1.6% after a downgrade by UBS.

General Motors ( GM) also weighed on the Dow, losing 2.6%, after the company said late Tuesday that its accounting woes extend to its financing arm, GM Acceptance Corp.

Here's more bad news for GM: The price of steel is making a comeback after weakness late last year.

It's next to impossible to obtain an average daily price given the fragmentation of the steel market. But according to Forbes, the price of a hot-rolled band has increased to $570 per ton from $540 just in the last three months.

That's good news for steelmakers and distributors, whose stocks also have surged in the first three months of 2006.

On Wednesday, shares of Steel Dynamics ( STLD) jumped 7.3% after KeyBank upgraded the stock, expecting upward earnings revisions.

Among the larger players, US Steel ( X) gained 3%, Nucor ( NUE) rose 2.7%, and AK Steel ( AKS) gained 4.7%.

Concerns that China might turn from one of the largest consumers of steel to a net exporter this year, as it said in February , had kept a lid on steel prices. But these concerns have largely been overblown, according to Morningstar analyst Scott Burns.

Indications that China is now trying to boost its internal consumption more than its exports are likely to continue fueling, or at least support, steel prices, he says.

The Smelting Pot

Amid those conditions, a multiyear wave of consolidation is resuming and is leaving no stones unturned.

On Wednesday, Japanese steel companies Nippon Steel, Sumitomo and Kobe Steel agreed to take joint "counter-measures" in the event of a hostile bid. While few expected cross-border targeting of these firms, given Japan's protectionist tendencies, the fact the three felt compelled to take these measures speaks volumes about the global consolidating trend of the industry, says Burns.

Steel's advance, thanks to strong demand from the likes of China and India, has encouraged the large players to get even larger in what remains mostly a fragmented industry. The Netherlands' Mittal Steel ( MT), one of the top three players, is trying to acquire Luxembourg-based Arcelor. Should the deal go through -- it is meeting with resistance in Luxembourg and France -- the combined entity would represent only 10% of global production.

Mittal and Arcelor, along with the other top global players, such as the U.S.' Nucor and U.S. Steel, all are looking for global partners to grow.

But as seen with the Japanese firms and the Arcelor deal, cross-border transactions are no easy task. Arcelor CEO Guy Dolle told U.S. Steel counterpart John Surma earlier in March that Arcelor was not seeking to buy U.S. Steel, according to Forbes. This put an end to rumors that such a deal might be a good way for Arcelor to fend off Mittal's bid.

The name of the game for steel players remains domestic consolidation to create regional juggernauts. And there, the rumor mill has not stopped. Earlier in March, the Pittsburgh Post Gazette reported that U.S. Steel was in talks to acquire AK Steel.

"They haven't flat out denied the talks," says Burns. "All we know is that AK Steel is still negotiating with its union, but they really need an infusion of equity and they're looking for a white knight." Expectations of such a deal certainly seemed alive Wednesday, given AK Steel's 4.7% advance.

While merger speculation will likely keep steel stocks hot for a while, Burns notes that the sector already has advanced substantially. For instance, at $14.40 per share on Wednesday, AK Steel's stock is up 80% since the start of the year. It's well above Burns' fair value estimate of $9.50 and above the $12 level at which he would advise selling the stock.

A surge of broker upgrades into the sector recently -- and the so-called fast money pouring in as the market looks for the next hot sector -- will likely continue boosting steel stocks for a while. But at these levels, wild cards -- such as a bigger-than-expected upswing in Chinese production -- could very well reverse the trend.
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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