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Data Could Trump FOMC

Liz Rappaport

An Fed Open-Market Committee meeting typically creates more anxiety in the markets than Tuesday's trade would suggest.

Ahead of Wednesday's policy decision, major averages were resilient in the face of a massive rebound in oil and natural gas prices, as well as some disappointing earnings guidance from economic bellwethers UPSUPS and 3MMMM. Bonds reversed course and gained ground Tuesday, bucking a strong consumer confidence report and potential data land mines ahead, including Wednesday's advanced fourth-quarter GDP report.

The Dow Jones Industrial Average added 0.3% to close at 12,523.31, while the S&P 500 jumped 0.6% to close at 1428.82. The Nasdaq Composite gained 0.3%, to close at 2448.64.

UPS spent most of the day down, trading as low as $70.38 intraday, but finished well off of its lows, down 1.3% at $72.70. The company's full-year outlook fell short of analysts' expectations, and the company blamed a slowing U.S. economy for the glum view. 3M fell 5.4% after its CEO said moderating global economic growth is responsible for its soft earnings guidance.

Procter & GamblePG gave the market a strong earnings report and boosted is 2007 guidance, but its shares slipped 0.5% on the day. On the flip side, disability insurer UnumProvident'sUNM shares climbed 10.5% Tuesday on its strong earnings report and healthy guidance.

The government will release its fourth-quarter GDP estimate at 8:30 a.m. Wednesday. The consensus expectation is for growth of 3%. The markets will also digest the fourth-quarter employment cost index Wednesday morning. Analysts expect a 1% increase from the third quarter, when wages were rising at the strongest annual rate since the second quarter of 2002.

As for the Fed, no change in rates is expected, but traders expect the policy statement will be more hawkish than those of recent meetings, mostly to acknowledge stronger fourth-quarter growth and signs of strength in the housing market.

Indeed, "if you take housing out of the equation, you have a booming economy, inflation running higher than the Fed's 'comfort zone,' a strong consumer, wages pushing higher and unemployment running at full employment," says Marc Pado, chief market analyst at Cantor Fitzgerald. "Under those circumstances, the Fed will be scratching their head to find a reason not to raise rates."

But raising the rhetoric won't mean much to the markets unless the data also shock to the upside. A much-stronger-than-expected GDP or wage inflation report might suddenly make the Fed's tone more meaningful.

As it stands, the market is not contemplating any move by the Fed through most of 2007. Just a month ago, traders were debating whether the Fed would cut rates in March or May. As of late Tuesday, the fed funds futures market prices in less than 50% odds of a single rate cut by the end of the year, according to Miller Tabak. Even minor odds of a rate hike -- 4% in May -- have crept into the market to really confuse things.

RBC Capital Market's chief fixed-income strategist T.J. Marta says the Treasury market may have a "sell the rumor, buy the news" reaction to the Fed's statement Wednesday. Last week, Treasury yields rose sharply as traders removed the "oh my God, we're doing down view" from the table, he says. Rumors of a report in the market claiming inside information about a more hawkish FOMC statement means the market has already priced in the more aggressive statement, he adds.

The 10-year Treasury note ended the day up 5/32 to yield 4.87%. The 30-year bond rose 10/32 to yield 4.97%. Bond prices move inversely to yields.

Indeed, the Fed is still likely to reference worries about the housing market to justify its pause, even as it acknowledges some stabilization. Fears of what higher interest rates and adjustable-rate mortgage resets might do to the overall economy are still good enough reason for the Fed to tolerate a strong economy and slightly higher inflation.

"The Fed is on hold for the year," says James Bianco, president of Bianco Research.

Housing and manufacturing were the weakest spots in the economy, and Bernanke and the Fed sees signs of stabilization in both.

The minutes from the Dec. 12 Fed meeting acknowledged that "there were some indications that home sales might be starting to stabilize," and that "the adjustment of activity and prices in the housing market did not appear to have spilled over significantly to consumer spending." Also, the only thing Bernanke said about the economy when he testified before the Senate Budget Committee earlier this month was that manufacturing is not hollowing out, particularly given the most recent industrial production data.

Fed officials of late have repeatedly mentioned the heightened threat of wage inflation, with unemployment at 4.50% and showing no signs of slipping. As San Francisco Fed President Janet Yellen says, the labor market is "gangbusters."

The FOMC statement Wednesday afternoon is likely to reflect these revelations, but the morning's data are really where the potential surprises lie.