Good news emerged from the depths of one of the market's most tortured sectors Tuesday, helping the broader market rebound from its recent malaise.

In the wake of upbeat news from chip company KLA-Tencor ( KLAC) the beleaguered semiconductor sector made a come-from-behind surge to lead the broader market's comeback.

At an annual semiconductor industry conference in San Francisco, KLA-Tencor CEO Rick Wallace said the company had "a very good quarter," adding the company beat its bookings target for the second quarter. The company's shares increased 8.21%, helping the Semiconductor HOLDRs ( SMH) gain 3.1%. (Heading into Tuesday's session, the SMH was down nearly 14% since Dec. 31, as chip stocks paced the Nasdaq's underperformance.)

Led by the chips, "the market held critical areas of support and turned higher, and that is bullish" for the near term, writes Alexander Grace, trader and hedge fund consultant.

Notably, the S&P 500 bounced after trading below its 200-day moving average of 1263.73; the index closed up 0.4% to 1,272.52 vs. its intraday low below 1260. Following similar patterns, the Dow Industrial Average closed up 0.28% to 11,134.77 after trading as low as 11,027.99, while the Nasdaq gained 0.6% to 2,128.86 vs. its nadir of 2095.69.

Prior to the chip-led comeback, the market was punishing companies with any hint of negativity in their earnings releases. Most notably, Alcoa ( AA) shed 4.9% after it posted slightly weaker-than-expected revenue Monday evening Also, Lucent ( LU) tumbled 6.4% after it lowered guidance.

In Alcoa-like fashion, shares of biotech concern Genentech ( DNA) were falling in post-market trading after it reported earnings that beat analyst expectations. The whisper of bad news in Genentech's report was weaker-than-expected sales figures for Avastin.

Inflation Is Out Of Fashion

Tuesday's early losses seemed to be an extension of recent weakness triggered by Friday's weaker-than-expected payroll data. Perhaps the one positive coming out of the report -- and other recent data points -- is that it's no longer fashionable to worry about inflation on Wall Street. Instead, the slowing U.S. economy has officially taken its place as the current fad.

Nowhere is that concern more clear than in the U.S. Treasury bond market, which is rallying based on its reliance on a few basic assumptions: that the economy is on shaky footing due to a weaker housing market, the Federal Reserve may pause, and inflation won't continue to increase. If these assumptions are disproved, these bond investors could be in for a rude awakening.

The U.S. Treasury bond yield curve has inverted several times this year, but the current inversion has some economists ringing warning sirens about a possible recession or dire financial strain. As of the end of the day Tuesday, the two-year gained 1/32 to yield 5.10%, the 10-year Treasury gained 6/32 to yield 5.10%, and the 30-year bond added 10/32 to yield 5.15%.

Crucially, all those maturities have yields lower than the fed funds current target rate of 5.25%.

This condition has only happened four other times in the past 25 years, writes David Rosenberg, chief North American Economist at Merrill Lynch. Each time the Treasury yield curve traded below the fed funds rate, it preceded an economic horror story, a bond market rally, a decline in commodity prices and defensive-sector outperformance in the stock market, he reports. Rosenberg asserts that the big economic slide is also foretold by sharp declines in the housing stocks, the Nasdaq and the semiconductor indices.

It's hard to argue that buying 10-year Treasury bonds is a flight to safety, although the bombings in Mumbai were cited as aiding the Treasury market, as well as precious metals Tuesday. Relative to some risky asset classes, Treasuries might be a bit safer, but buying longer-dated maturities is a bet that shorter-dated Treasury yields will decline. That, in turn, suggests that inflation won't be a problem, the economy will hit the brakes, and that the Fed will stop raising interest rates.

"I think all of these assumptions will be shattered," says Michael Darda, chief economist at MKM Partners, who believes the economy will surprise to the upside. "Recessions are always preceded by an inversion, but every inversion doesn't portend a recession."

Housing is cooling, but not crashing, and while the billions of adjustable-rate mortgages convert to higher rates this year and next, more of the mortgage market is based on the long-end of the yield curve. Higher long-term interest rates could really crimp the housing market and the consumer, says James Bianco, president of Bianco Research LLC. But that is not happening. Housing measures, like commodities prices, have come down from incredibly inflated levels, which may just be a normal adjustment, not a collapse.

Inflation is likely to surprise the bond bulls as well. Three core CPI readings at the higher end of the Fed's "comfort zone," oil prices that remain at or near record levels and a still relatively tight labor market show that inflation pressures won't just disappear because the economy is slowing a bit. Core inflation lags headline inflation by six to 22 months, notes Darda, adding the inflation beast has not yet jumped out of the cake.

In terms of jobs, the breadth of job creation, despite a couple of weak payroll reports of late, has been improving since 2005, writes Thomas McManus, chief investment strategist at Bank of America. In the past six months, he notes, 63% of industries reported job gains, according to the Bureau of Labor Statistics. This has buoyed retail sales and individual income growth over the same period.

And as for the Fed, the fed funds futures market has a near-perfect track record of predicting what the Fed will do 20 days ahead of the FOMC meeting, writes Bianco. Tuesday being 20 days out, the 70% likelihood of an August hike is a safe bet that the Fed isn't going to stop this summer.

In other words, all those bond and stock traders betting on a Fed pause may be proven wrong ... again.
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 here to send her an email.