Focus Shifts to the Federal Reserve

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What with the various leaks on

Federal Reserve

policy a few weeks ago, the resurgence of the importance of economic data for the market and the stock market trading more or less lockstep with the Treasury market lately, it is not hard to determine what Wall Street's focus for the coming week will be: the

Federal Open Market Committee

meeting on Tuesday.

Not that the chance of a rate hike is anything more than slim.

"The case that I hear is that the Fed can't tighten at this time because

Greenspan

hasn't prepared us," says James Griffin, international economist and strategist at

Aeltus Investment Management

and a

TSC

contributor. "I can't argue with that, because the Fed has gone from being secretive about its practices to being fairly forthcoming." Indeed, the days when only a handful of Fed watchers could determine when rates had even been

changed

are gone, and since 1994 the FOMC has so carefully telegraphed its intentions to the market that some have dubbed it the "

Federal Open Mouth Committee

."

In recent weeks, Fed governors and district presidents have indicated that the Fed has shifted its bias back to a tightening. Greenspan, however, has been mute on the subject -- the two speeches he gave this month did nothing to move the market. The June Fed-funds futures contract closed Friday with an implied yield of 5.55%. The 2-year Treasury note had a yield of 5.61%. If the Fed tightened, raising their target rate to 5.75%, it would be, to put it lightly, something of a market shock.

It will be interesting to see the stock market's reaction to the Fed's presumed decision to leave rates unchanged. For the last half year, the FOMC meeting has had very little effect on the market. The market assumption was that the Fed's hands were tied until slowing effects of the Asian economic crisis came to light. But in the three meetings following the '97 tightening, before Asia hit Wall Street's radar screens, the news that the Fed had left rates unchanged sent stocks higher. Will Tuesday's meeting mark a return to the old pattern?

Todd Clark, head of listed trading at

Charles Schwab

, doesn't think so. He contends that the stock market has ignored so many potential problems in recent weeks, that it has so clearly discounted a non-move by the Fed, that the chances for a relief rally are slim. "The internals of the market for the last two weeks have been very poor," he says. "That doesn't really augur well for any kind of relief rally, and it basically makes me think we're going to sell off."

But the action in the stock market may ultimately depend on what happens in the bond market. Stocks have been following the bond market more closely lately, particularly on banner days -- the days when things like the

Employment Cost Index

, the

jobs report

,

retail sales

and so on come out.

That attention to the bond market is appropriate, argues Rich Bernstein,

Merrill Lynch's

chief quantitative strategist -- if anything, he wishes that the stock market had paid a little more heed to the action in the bond market recently.

"Over the next couple of weeks you want to be wary if the stock market rallies and the bond market doesn't," says Bernstein. "The reason that's not healthy is you can no longer rely on earnings to support the stock market." Bernstein's research shows that the profit cycle is going to weaken significantly and a profits recession cannot be discounted. "Profits recessions aren't bad for the stock market so long as interest rates can fall enough to make up the shortfall," he says. Citing Merrill Lynch chief economist Bruce Steinberg's belief that the yield on the long bond could fall to 5.5% this year, Bernstein remains bullish, if cautiously so.

The stock and bond markets will be also be paying close attention to the trouble in Indonesia. "On a global scale, I think obviously Asia is stubbornly coming back to the front page," says Bernstein. Indonesia has demonstrated (again) how economic turmoil can lead to social unrest and has dashed hopes for a Mexican-style, v-shaped rebound in the region. With Japan itself in economic disarray, things look dire. "We obviously feel that Japan is a very big problem," says Bernstein. "We've always viewed emerging markets as remoras that grab on to sharks. The problem in Asia is there's no shark."

The stock market has apparently reconciled itself to the fact that U.S. companies are going to see earnings growth out of Asia (though it may not have reckoned with the fact that a resurgence in Asia could be a very long way off), so it may be somewhat insulated from Asia's woes. The growing social unrest in the region does, however, raise some questions over the interest-rate picture in the U.S. -- questions the FOMC meeting may serve to focus the market on.

Let us say that the Federal Reserve would like to tighten, if not at Tuesday's meeting, at the July meeting. Will they do it given the negative effect that could have in Southeast Asia, threatening a deepening of the economic malaise and risking throwing the entire region into political uncertainty? The Federal Reserve mission is not, after all, to be the world's central banker. It is to keep inflation in the U.S. low and to strive toward full employment.

"The Fed really can't be responsible for everything in the world," says Aeltus' Griffin. "That is going to mess up their main charge, which is to keep things on a stable path."

But, it could be argued, another downturn in Asia could have a slowing effect on the U.S. economy. A rate hike could represent, in effect, a double tightening. Another argument against a Fed tightening as a result of the Asian turmoil is more political in nature. The blurring of economic borders, the transition to a world economy, has been a priority of the U.S. If Asia has become sensitized to the U.S. interest-rate environment, the U.S. bears some responsibility for that and what it means. It is, perhaps, unfair to draw the Fed into such an argument. That does not mean that the

Defense Department

and the

State Department

will not.

* * * * *

For investors dissatisfied with Federal Reserve arcana, there are a number of companies reporting earnings. Chief among them is

Dell

(DELL) - Get Report

, which will vie with the FOMC when it reports earnings on Tuesday after the close.

First Call

consensus estimates are for the company to earn 42 cents per share, but if Dell earns only that much, it will be viewed as a disappointment. Escalating whisper numbers are the rule, not the exception, with Dell.

A slew of retailers will post first-quarter earnings. Chief among them:

Home Depot

(HD) - Get Report

, reporting on Tuesday and expected to earn 42 cents per share, and

Toys R Us

(TOY)

, reporting on Wednesday and expected to earn 7 cents per share.

Intel's

(INTC) - Get Report

annual meeting will be another point of interest among investors, particularly in the wake of Merrill Lynch analyst Tom Kurlak's pronouncement of Friday that a microprocessor glut is forming and that Intel is about to begin a price war.