The September rally paused Monday as oil and gas bounced off of their recent lows.

Oil rose above $64 in intraday trading before ending up 0.73% to $63.79 per barrel. Gasoline gained 0.7% to close at $1.58 per gallon, and heating oil jumped 1.51% to close at $1.72 per barrel.

Major averages were relatively flat Monday, but signs of anxiety emerged after the recent rally and ahead of a hefty week of economic data and a Federal Reserve policy meeting.

"We reset the bar of tolerance every week," says Art Hogan, chief market strategist at Jefferies & Co. For a while, $70 per barrel was tolerance, then $75, and now that oil dipped below $63, $64 is a little disquieting, he says.

"Non-traditional investors are fueling the market, and in energy in particular," says Hogan. "Momentum came into the space, and these cowboys get in and out at the same time. We're seeing some of that now."

Indeed, news emerged Monday that the large hedge fund Amaranth's returns were in the red by 35% because of its bad bets in natural gas. Last week, The Wall Street Journal highlighted several large hedge funds that were sporting returns not even matching the S&P 500's 5.8% year-to-date return.

The FOMC meeting Wednesday is not expected to bring any surprises (read: the Fed leaves the funds rate at 5.25%). But news on housing and inflation could always challenge the market's self-assurance about an economic soft landing. The Labor Department reports the producer price index Tuesday, and the Census Bureau reports on housing starts.

The Dow Jones Industrial Average slipped 0.05% to close at 11,555.00 Monday, while the S&P 500 added 0.10% to close at 1321.18, and the Nasdaq Composite gained 0.16% to close at 2235.75.

Some technical factors also have traders concerned about the market running out of steam, which could mean the recent rally needs a pullback. One trader points out small signals, such as the S&P 500 making another rally high Monday while the S&P 500 futures did not; that the S&P 500 futures have had seven straight days of gains; and that sentiment seems to have shifted to the bullish side, giving contrarians a reason to short.

To wit, Prudential Equity Group's investment strategist Ed Keon, who has been bullish through most of the year, aggressively raised to 90% his allocation to stocks, from 80% Monday.

Beneath the relative calm, there was more fast-money bottom-fishing going on in recently battered energy sectors. The Philadelphia Oil Service Sector Index gained 3.15%, while exchange-traded funds, the Oil Service HOLDRs Trust ( OIH) and the Energy Select Sector SPDR ( XLE), gained 3.14% and 2.33%, respectively.

Among stocks in the news, Premium Standard Farms ( PORK) jumped 12.75% after agreeing to a $693 million buyout offer from Smithfield Foods ( SFD), which slid 3.5%.

In other M&A news Freescale Semiconductor ( FSL) rose 5.7% after agreeing to a $17.6 billion offer from a private equity consortium led by Blackstone Group. Separately, Symbol Technologies ( SBL) jumped 15.4% on reports it may be a takeover target.

Among notable losers, First Data ( FDC) tumbled 7.6% after the company provided disappointing guidance for its Western Union unit.

Bonds Back Down

The Treasury market weakened Monday amid a record-setting budget account deficit and weak foreign demand for U.S. assets. But rather than reacting to backward-looking economic news, traders say the bond market was more likely just positioning itself ahead of Wednesday's Fed meeting.

The 10-year benchmark note ended down 4/32, its yield jumping to 4.81%, from about 4.78% Friday. The 10-year yield had reached 4.83% in intra-day trade. The 30-year was down 6/32, its yield rising to 4.92% from 4.91% Friday.

"This is more about trying to push yields up ahead of the FOMC meeting," says Bill Hornbarger chief fixed-income strategist at A.G. Edwards in St. Louis. The bond market is ever so slightly unnerved by the Fed's upcoming decision, as the phrase "close call" reverberated on trading floors. The August FOMC minutes revealed that members felt the decision to pause was not easy. That said, the bond market is still pricing in the soft-landing scenario, with no inflation and no more rate hikes.

In economic news Monday, the Commerce Department reported that the current account deficit grew to $218.4 billion in the second quarter of 2006, from $213.2 billion in the first quarter, and above economists' expectations for $213.5 billion. On the eve of Treasury Secretary Henry Paulson's visit to China, the U.S. deficit with China grew to $54.5 billion, from $49.3 billion in the first quarter. The second-quarter deficit amounted to 6.6% of U.S. GDP.

While the U.S. trade imbalance expanded, foreign investment in U.S. assets shrank. The Treasury International Capital system (TIC) data for July showed that net capital flows into U.S. assets fell to $32.9 billion in July from $75.1 billion in June. The flows are the weakest since 2005 and fall short of covering the $68 billion trade deficit for July.

While the current account deficit looks ugly on the surface, it was really "a last gasp" stemming from high oil prices during the second quarter, says T.J. Marta, senior fixed-income strategist at RBC Capital Markets. Marta believes the current account deficit is likely to "bottom out" here and moderate along with the slowing U.S. economy.

The TIC data revealed a virtual collapse in July among private foreign investors into U.S. assets. The only increase was foreign investment into U.S. equities. But TIC data, like the deficit, are very backward-looking, and appetite for U.S. Treasury bonds clearly picked up again in August as yields fell across the board.

The FOMC decision Wednesday also weighed on Treasuries. While odds are only about 20% that the Fed raises rates again this cycle, the odds of a rate cut have fallen off the radar screen.

"There is a little profit-taking going on," says Marta, adding that U.S. Treasury Secretary Henry Paulson also reassured the international community that the U.S. economy is strong despite some weakness in the housing market. "The market should have more two-way risk," says Marta.

So bond and stock markets alike are finding their sprints upward are meeting with some hilly terrain as the rallies become winded.
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.