During the question-and-answer period of Ben Bernanke's testimony before Congress on Wednesday, Sen. Jim Bunning (R., Ky.) accused the Fed chairman of general incompetence and of leading the stock market into the basement. But Bunning must have overlooked Bernanke's hand in spurring some huge stock market rallies over the last month.

Wednesday marked the third such occurrence, as the Dow Jones Industrial Average jumped back above its 200-day moving average, gained 210 points, or 1.9%, and closed at 11,009.26 in the wake of Bernanke's testimony. The S&P 500 added 1.8% to 1259.43, and the Nasdaq Composite climbed 1.8% to close at 2079.50.

Altria ( MO) was the only Dow component to end in the red, with Boeing ( BA), Home Depot ( HD) and JPMorgan Chase ( JPM) at the vanguard of the advance, the latter after posting strong quarterly results.

Treasury prices and gold also rallied sharply while the dollar stumbled.

Bunning may be at the extreme -- he opposed Bernanke's nomination in the first place. But the financial markets haven't exactly given the chairman high marks since he took office, either. Bernanke's flip-flops contributed to a consensus that the new Fed chairman had communication and credibility problems.

Like bickering spouses, both the markets and Bernanke may be making strides toward better understanding. But a successful marriage is built on follow-through; if the markets and Bernanke can't build on the good days, there are bound to be more bad ones.

Both times Bernanke sparked massive rallies prior to Wednesday's, the follow-through was weak.

After hitting its intraday low for the year on June 14, the Dow rallied nearly 200 points on June 15 following comments on energy prices by Bernanke that were perceived as dovish, or less hawkish than anticipated.

Prior to the June 29 FOMC meeting, the markets were gripped by the possibility of a 50-basis-point rate hike. The Dow rallied 216 points that day as the Fed statement was (again) deemed dovish, or less hawkish than feared. As with June 15, June 29 featured more than 90% upside volume, a bullish signal.

But the June jobs report created stagflation fears, sparking selling that intensified as earnings season got off to a lackluster start and tensions escalated in the Middle East. (Wednesday's postclose earnings included strong results from Motorola ( MOT) and Apple ( AAPL) but mixed guidance from Intel ( INTC) and eBay ( EBAY).)

The failure to extend the June rally was hugely disappointing to traders, says John Bollinger, president of Bollinger Capital, and the market sank into negative sentiment territory. "The bears were crowing at maximum volume," a sign the market was "well set up to receive some good news" Wednesday, he says.

Indeed, the market's were set up to receive mixed news as neither higher-than-expected CPI data, weaker-than-expected housing starts nor some warnings about inflation from Bernanke could keep major averages from their appointment with higher prices.

Up volume was just shy of 90% on the NYSE, where 2.7 billion shares traded, but 75% of Nasdaq trading, where 2.3 billion shares changed hands. Still, the big upside action means "the bulls have the ball for the third time, and it is fourth and goal," says Bollinger.

Translation: Another failure to extend a rally on the back of these bullish days could suggest an ugly fate for the stock market.

The Current Threat

Wednesday's stunning rally centers on the belief that Bernanke signaled a possible pause in his rate-hiking campaign.

The chairman's remarks were "largely consistent with the tone of the June 29 FOMC policy statement, indicating optimism that the economy is moderating, that inflation expectations remain largely in check, and that the recent bulge in inflation will dissipate 'over the medium term,' " writes Peter Kretzmer, senior economist at Bank of America. "Bernanke continued to emphasize the lags in the impact of Fed monetary policy actions, suggesting that he is concerned about over-tightening."

With traders again uttering the "one and done" mantra, the fed funds futures ratcheted down the likelihood of another 25-basis-point fed funds-rate hike in August to 71%, down from 90% Tuesday, according to Miller Tabak. In a new show of conviction about its interpretation of Bernanke, the fed funds futures market suggests an August hike would be the last for 2006. The odds of 5.75% by the Oct. 24 FOMC meeting dropped to 0% after Bernanke's testimony was released.

Traders read Bernanke's testimony as a dovish confirmation of the June 29 FOMC statement. Bernanke repeated that slowing growth would weaken inflation, and that monetary policy must be based on "the longer-term outlook for both inflation and economic growth."

Regardless of the Fed's blue-sky-no-clouds forecast, Bernanke didn't telegraph a pause in August. Indeed, he devoted much time in his testimony and in the Q&A to inflation -- repeating that inflation is the greatest current threat to the economy. His comments were peppered with hawkish statements, such as: "We have to take into account the risks as well as the expected path ... the chance a bad outcome could occur," adding, "You need to lean a bit against that bad outcome."

Bernanke defensively answered comments about mortgage rates rising and the weak stock market by noting that both markets do much worse in inflationary periods. In the testimony, he said "some inflation risks remain," and they are largely centered around unpredictable prices for energy and other commodities. "If the pattern of elevated readings on inflation is more protracted or more intense than is currently expected, this higher level of inflation could become embedded in the public's inflation expectations and in price-setting behavior."

At best, Bernanke gave himself the flexibility to pause if economic data surprises to the downside, and the credibility to hike again if inflation continues to edge upward. Bernanke said he's "very aware" of concerns about overshooting, but said the situation of addressing higher or more persistent inflation later means "perhaps more interest rate increases. We have to balance those risks in two directions." Bernanke said that at some point the "Fed will have to get off of this 25-basis-point escalator."

Other markets reacted similarly to stocks. Treasury bonds rallied sharply as the 10-year gained 19/32 to yield 5.05%. The dollar sank 0.38% on the news to 116.75 yen from above 117 Tuesday, and the euro gained 0.74% to $1.2602.

Only time will tell if Bernanke and the market's relationship has grown closer. If not, investors will once again be all dressed up with nowhere to go.
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.

If you liked this article you might like

Fed Chief Endorses Stimulus

Fed Chief Endorses Stimulus

Beige Book Depicts Sluggish Economy

Beige Book Depicts Sluggish Economy

Watch for a Different Kind of Merger in 2008

Watch for a Different Kind of Merger in 2008

Clarity Coming to Wall Street

Clarity Coming to Wall Street

Recession Naysayers Hold Out

Recession Naysayers Hold Out