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Fed Juggles; Stocks Run in Place

Liz Rappaport

Follow the bouncing ball, says Ben Bernanke and the Federal Reserve.

The Federal Open Market Committee completed 2006 by telling investors to follow the data just as they would follow the bouncing ball when singing along to a Christmas carol on television. That's what the Fed is doing. To wit, the central bank toed a careful line Tuesday by acknowledging slower growth, but maintained a tightening bias.

Stock, bond and currency markets staged a relatively muted response to the FOMC decision to remain on pause with the fed funds rate at 5.25%. That said, the markets took the Fed's minor addition to the accompanying policy statement as slightly more dovish.

The Fed added the word "substantial" to its assessment of the housing market. But the Fed also said that the markets shouldn't just watch housing. "Economic growth has slowed over the course of the year, partly reflecting a substantial cooling of the housing market," reads the statement.

The statement also noted that recent indicators have been "mixed," and that "on balance" the economy will expand at a moderate pace over coming quarters.

"The Fed was acknowledging the obvious," says Ethan Harris, chief economist at Lehman Brothers, who forecasts that the slowing housing market will subtract more than 1% from growth in the third and fourth quarters. "They don't want this to be a signal," says Harris.

The Fed did not change its take on inflation at all. The statement reiterated that core inflation is elevated and could remain so. As several Fed speakers and Bernanke have hammered home in recent weeks, the Fed will move rates based on the fluctuations of core inflation. Richmond Fed president Jeffrey Lacker remained a dissenting voter, arguing the Fed should be raising rates now as core personal consumption expenditures remain at 2.4% year over year and the core consumer price index is running at 2.7% year over year. The Fed's stated comfort zone is 1% to 2%, but it would likely settle for 2% to 2.5% as long as it keeps falling.

But the growth-obsessed bond market gained moderately on the Fed statement -- a sign that bond traders may be getting used to Bernanke's data-dependent message. Even three months ago, the word "substantial" would have sparked a much larger rally.

The 30-year bond rallied 8/32 to yield 4.61%, up only two basis points, while the 10-year note added 7/32 to yield 4.49%, and the two-year note added 3/32 to yield 4.61%.

Alternately, the bond market may have tempered a rally on news the trade deficit narrowed to its lowest level since August 2005, or signs in the corporate debt market that the Fed is nowhere near tight.

The shrinking trade deficit could boost fourth-quarter GDP estimates by at least 0.5%, says John Lonski, chief economist at Moody's Investors Service. The deficit narrowed to $58.9 billion in October, down from $64.3 billion in September, and it was below expectations for a $63 billion reading. The trade deficit has shrunk 14% from its record $68.5 billion in August this year. The news prompted Lonski to raise his estimate for fourth-quarter GDP to 1.5% from 1%.

Also threatening a bond market rally Tuesday was more evidence of excess liquidity in the system. How can the Treasury market really let loose on a day when Ford (F Quote) financing arm Ford Motor Credit doubled the size of its high-yield bond offering to $3 billion from $1.5 billion?

Combining Tuesday's bond offering with the upsized $5 billion convertible bond offering by Ford Motor Co. last week, the junk-rated, struggling automaker seems positively awash with funding opportunities. Reflecting the huge demand for high-yielding assets, the company increased the total size of its announced fund-raising plan to $23 billion from $18 billion in a matter of weeks. Ford's shares fell 2% on the day.

"When you see something like that, you wonder just how badly the U.S. economy needs a rate cut," says Lonski.

The stock market fluctuated throughout the day Tuesday. Stocks were weaker ahead of the FOMC statement, then rebounded, fell again, and rebounded into the closing bell.

The Dow Jones Industrial Average and S&P 500 both slipped 0.1% on the day to close at 12,315.58 and 1411.56, respectively. The Nasdaq Composite fell 0.5% to close at 2431.60.

Since the Fed got out of the way with no surprises, equities traders had one eye focused on earnings.

Goldman Sachs(GS Quote) posted its best quarter ever, but its shares fell 1.2% on the day.

Best Buy(BBY Quote) fell short of analysts' expectations, and said intense price competition took a bite out of its profits. Shares of the company fell 4.9%, as the company's faltering may foretell a weaker-than-expected holiday season. Some analysts report that shoppers are waiting for intense pre-Christmas discounts before hitting the stores in full force.

Shares of competitors Circuit City(CC Quote) fell 5.5%, while Costco(COST Quote) and Target(TGT Quote) shares fell more than 1%. Federated Department Stores (FD Quote) shed 3.8%.

The best read on the consumer and the Fed's next bouncing ball, comes Wednesday, with retail sales figures.

Meanwhile, Texas Instruments (TXN Quote) managed to rise 1.6% despite its lackluster guidance late Monday, but the broader chip sector slid. The Philadelphia Stock Exchange Semiconductor Index fell 0.7%.

With steelmaker Nucor (NUE Quote) another notable company with weak guidance, it seems a sense of "it can't get better than this" is brewing.

Or perhaps contrarians are betting against Merrill Lynch's stock strategist Rich Bernstein's turning tail. After being bearish through most of the past three years' rally, Bernstein joined the bulls on Tuesday. He upped his S&P 500 target to 1570 by the end of 2007, a 12% return.

Bernstein seemed almost surprised himself. "This is the first time in several years that the target analysis has not pointed to a single-digit return," he writes. Bernstein attributes the model's outcome to lower headline inflation readings and more price-to-earnings expansion.

Bernstein will no doubt be watching Friday's consumer price index closely, as will the still data-dependent Fed.