Bonds Reassess Wisdom of Fed Neutrality

Stocks hold up well as Treasuries rethink the FOMC's stance given the inflation backdrop.
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A day after the

FOMC

meeting, the

euphoric haze lifted. Stocks were mixed Thursday while Treasury yields rose as the context of the Fed's change in rhetoric started to sink in. Upon second glance, Wednesday's statement leaves investors wondering if the presumed move to neutral may be about attempting to stop a runaway train headed for a major crash. The shift definitely isn't about having slain the inflation dragon.

Cutting rates "is like putting back the punch bowl," says T.J. Marta, senior fixed-income strategist at RBC Capital Markets. "It's easy money that got us into the current predicament...and the only way to keep things from spiraling out of control may be to ease a little to ameliorate the bubble bursting."

Also weighing on the market's mood was a dismal earnings warning from

Motorola

(MOT)

, which sent its stock down 6.6%. The warning comes on the heels of a warning from

Halliburton

(HAL) - Get Report

and lackluster outlook from

FedEx

(FDX) - Get Report

earlier this week. Halliburton added 0.2% Thursday while FedEx slid 0.3%.

Warnings from such large household names do not bode well for profits. It makes you wonder if a parade of warnings is about to begin as the next reporting season approaches.

Meanwhile,

Palm

(PALM)

fell 8.8% as Motorola's weakness undermined swirling takeover talk. (After the close, Palm reported earnings that were

better than expected, and its shares were recently up 1.4% in after-hours trading.)

That said, and given the preceding gains, major averages performed admirably. The

Dow Jones Industrial Average

added 0.1% to close at 12,461.14, while the

S&P 500

lost a fraction to close at 1434.54. The

Nasdaq Composite

slid 0.2% to close 2451.74.

Profit issues notwithstanding, the macroeconomic story dominated Thursday. Traders came to the realization that the Fed's shifting gears to neutral likely means "stuck in neutral," not "in neutral with the easy choice to slam on the breaks or hit the accelerator."

Fed Zigs, Treasuries Zag

In summary, the Fed simultaneously said in its statement Wednesday that it is very worried about inflation and that economic growth is slowing. By removing the notion that further "firming" may be at hand, the central bank implicitly agreed that the home price deflation problem occurring in the U.S. could spill into the broad economy. That kind of bleeding necessitates a breath of life into the system -- even though prices for most things besides homes are nowhere near deflating.

So a rate cut at the cost of higher inflation would only reignite the credit creation that fueled the housing bubble. And the central bank would likely end up with higher rates further down the road -- when the crisis is averted but inflation is higher.

Voila

, a Fed stuck in neutral.

"We have stagflation," says Paul Kasriel, chief U.S. economist at Northern Trust Co. of Chicago, who is concerned about the possibility of a recession. "We always have stagflation at this point in the cycle because inflation is a lagging indicator. We almost always see the economy slow down, and then we continue to see inflation move up a little bit."

Inflation eventually turns down if the economy continues to weaken, he says.

For now, the whiff of a Fed sacrificing some of its inflation watchfulness to add to its recession worry was enough to bring the bond vigilantes out of hibernation. Bond vigilantes would argue that yields of longer-duration bonds provide too little reward for the risk associated with the stubbornly high inflation readings that the market has seen of late. In other words, they're not compensated enough for the risk of holding the bond for such a long time if the value of the dollar is going to decline. Vigilantism in the bond market is a far cry from the recession-fear sentiment that has dominated over the past several months.

So within the parameters of remaining on pause, the Fed managed to make a de facto rate cut -- in the eyes of the bond market, at least. The yield curve normalized Wednesday as the short-duration bond yields fell. That trend continued Thursday: The 30-year bond fell 26/32 to yield 4.77%, the 10-year fell 11/32 to yield 4.58%, and the two-year Treasury note fell 3/32 to yield 4.59%.

Wednesday saw banks and the financial sector surge in particular, as the smell of punch grew stronger yet again. The financials didn't continue their rally Thursday, perhaps because the prospect of regulation or government intervention in the mortgage and banking industry looms. Capitol Hill heard testimony of bank regulators and lenders on the extent of potential damage from the subprime mortgage catastrophe. Fed Chairman Ben Bernanke will testify before the Joint Economic Committee on the subprime mortgage market next Wednesday.

If the market has misinterpreted the FOMC's statement, Bernanke will surely let us know. The last time the Fed neared a transition point, in the spring of 2006, Bernanke harshly put the breaks on the notion that the Fed was dovish, in a speech on June 5. The Dow fell 199 points and sparked the second leg of the stock market's downturn that ended in July.

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

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