Wall Street rebounded strongly on Monday, and in volatile trade the financials sector staged a stunning turnaround ahead of the Federal Reserve’s policy meeting on Tuesday.

The S&P 500 index rose 2.4 per cent to close at 1,467.67. The Nasdaq Composite rallied 1.4 per cent to 2,547.33 and the Dow Jones Industrial Average rose 2.2 per cent to close at 13,468.78.

As stocks rallied, equity volatility, as measured by the Chicago Board Options Exchange’s Vix index, retreated from a new high for the year. The Vix closed nearly 9 per cent lower at 22.93, but had earlier traded at a peak of 26.47, its highest reading since April 2003. The index has risen from a reading of below 10 earlier this year.

The Russell 2000 index of smaller companies pared early weakness and rose 1.5 per cent to 766.35. Earlier in the day, the benchmark fell to its lowest level since October 2006. The prospect of less deal activity and tighter credit conditions has hurt small stocks and the Russell 2000 remains 2.7 per cent lower so far this year.

Financials were lower in early trade on Monday, and then rallied strongly, led by mortgage giants Fannie Mae up 10.4 per cent at $62.50, and Freddie Mac, up 7.7 per cent at $60.

Talk that the government sponsored enterprises might be allowed to expand their mortgage balance sheets boosted their stock prices.

Analysts also said the sharp decline in the price of mortgage securities in recent weeks should entail higher profits for the GSE’s as their cost of funding has not risen sharply.

The rebound in financials was reflected in the S&P Investment Bank Index surging 5 per cent. That trimmed its decline for 2007 to 13.1 per cent. The broader S&P financials index rallied 4.7 per cent, but is still down 8.7 per cent for the year.

A debate over whether tightening conditions in the credit market and weak financials would harm the broad economy remained the main topic for investors.

“Many investors believe that the weakness in financials is signalling the beginning of a bear market,” said Tobias Levkovich, chief US equity strategist at Citigroup. “The capital markets-sensitive diversified financials industry group is a coincident indicator, not a lead indicator,” Mr Levkovich added.

In recent weeks, cyclical stocks have also fallen in line with the general retreat in financials. This suggests worries that the economy may suffer from tighter credit conditions are building, analysts warned.

Against that backdrop, the Federal Reserve’s Open Market Committee meets on Tuesday. The central bank is expected to leave rates unchanged.

Some economists say the Fed may acknowledge the recent turmoil in financial markets, but also maintain a tough stand on inflation.

It is a stance that lessens the chance of any near-term easing in policy, but amid the present credit market turmoil, the odds of a quarter percentage point easing at the FOMC’s meeting in October have risen to around 80 per cent.

“The consensus is for a less hawkish stance on inflation pressures with an acknowledgment of the recent turmoil in the financial markets,” said David Ader, bond strategist at RBS Greenwich Capital. “The wildcard is how the FOMC skews the balance of risks and if they highlight any downside risks to growth from the credit/mortgage situation.”

Other financial stocks sharply higher on Monday included Wells Fargo, which rose 5.9 per cent to close at $34.76, as the bank announced it would buy back an additional 50m shares. Merrill Lynch gained 6.4 per cent to $74.55 after an analyst upgrade.

Also in the spotlight was Bear Stearns, which closed up 5 per cent at $113.81. The stock recovered from a 7.9 per cent decline to $99.75 earlier on Monday. Warren Spector resigned as co-president of Bear Stearns on Sunday, after S&P placed the brokerage on negative rating watch late last week.

Other financials that reversed early declines on Monday included Lehman Brothers, which closed up 4.5 per cent at $58.27, after setting a low of $52.63. Countrywide, the largest US mortgage lender, rallied 7 per cent to $26.75.

Monday’s rebound in the S&P leaves the benchmark around 5.5 per cent below its record close of 1,553.08, set in mid-July. Traders say a fall in the region of 10 per cent has in the past helped clear speculative excesses from a bull market and sowed the seeds for a renewed rally that ultimately propels the market to new highs.

The jitters over credit and financials have overshadowed second-quarter earnings that have so far beaten estimates.“Equity markets have been unable to shake off the liquidity fears that are now prevalent and dominant,” said Mr Levkovich.

According to Thomson Financial, 409 of the S&P 500 companies have reported results so far and 66 per cent of them have exceeded estimates. The annual growth in earnings for the second quarter is 7 per cent, above a 4.1 per cent estimate at the start of July.

Among other stocks in the news on Monday, UnitedHealth was up 2.1 per cent at $48.50 after the health insurer raised its earnings forecast for 2007.

Cooper Tire & Rubber rose 5.1 per cent to $22.25, after the tyre maker swung to a second-quarter profit, beating expectations.

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