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As equity investors hunted for a tradeable bottom Tuesday, the corporate color-by-numbers Fed communication strategy is starting to form a clear picture of another rate hike in June.

It seems the Fed wants to be very clear now that it is probably going to raise the fed funds rate again in June by at least 25 basis points. "Team Fed" spent Tuesday mostly hammering home

Chariman Ben Bernanke's hawkish points from Monday. Three Fed presidents came out with varying degrees of anti-inflation rhetoric, with the most hawkish out first and the most dovish a whimper late in the day.

First, St. Louis Fed President William Poole punctuated Bernanke's comments Monday in a solidly hawkish interview with the online edition of

The Wall Street Journal

. It is "precisely to prevent the increase in expected inflation in my mind that we need to have an upside bias to our setting of the federal funds rate," he said in the interview. "And I think it would be a lot safer strategy to err on the side of going a little too far, in the expectation that when that became clear, you could back off."

Midday, Fed Governor Susan Bies came out to say she's "uncomfortable" with the current level of inflation. But, she added, the Fed is in a period of transition, and it doesn't know exactly when it will stop raising the fed funds rate. Lastly, Kansas City Fed President cautioned that inflation is only nearing the outer reaches of the Fed's comfort zone, and that monetary policy has moved to a neutral range.

The rhetoric sent the Treasury yield curve to near-inverted status, reflecting confidence that the Fed will hike again in June. The Fed has raised the fed funds rate 16 times since mid-June 2004. The two-year Treasury note yield rose to 4.99% and the 10-year hovered at 5.00%. The dollar, in part due to the rate picture, was firm Tuesday. The dollar index gained 0.70% to $84.73.

The stock market groped for a bottom Tuesday afternoon as the

Dow Jones Industrial Average

spent much of its day below the psychologically important 11,000 level before rebounding in the last hour of trading to close down 0.42% to 11,002.14. The Dow was weighed down by two of its previously best-performing components,


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General Motors

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S&P 500

fell 0.11% to 1263.85 after trading as low as 1,254.46 intraday, and the

Nasdaq Composite

fell 0.32% to 2162.78 vs. its low of 2,144.20.

The homebuilding sector fared particularly poorly Tuesday on the heels of a Wachovia Securities downgrade of several companies, including

Pulte Homes

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DR Horton

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KB Home

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Also, the National Association of Realtors' chief economist called for a Fed pause Tuesday, citing certain interest rate-sensitive markets' vulnerability. The Philadelphia Stock Exchange Housing Sector Index fell 2.8% to a 52-week low of 213.15.

Further reflecting concerns the Fed may overtighten and tip the economy into recession, defensive stocks such as


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Johnson & Johnson

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fared better.

The declines to begin this week show that the short-term "W formation" that started to form

last week didn't pan out, says John Bollinger, president of Bollinger Capital. "Now we'll go down and put in a proper intermediate bottom," he says, declining to put a number on where such a bottom is likely to emerge.

But a buying opportunity may be near, says Gail Dudack, president of Dudack Research Group. "When corrections happen, the buying opportunity happens at or below a 200-day moving average."

The Dow is still above its 200-day moving average, which is around 10,870, she notes. The S&P 500 is hovering around its 200-day average of about 1260, and the Nasdaq is below its 200-day moving average of about 2220.

This picture of the market Tuesday reflects what Dudack says is the overarching story about investors shifting from risky to less risky assets due to a pullback of global liquidity. Any incremental bad news like Bernanke's speech Monday exacerbates the direction, she says.

To add insult to injury, the credit cycle may have peaked. The global speculative-grade default rate has made a modest, but important tick upwards, rising to 1.7% in May from 1.6% in April, according to Moody's Investors Service.

Coming Credit Crunch

The number of bond defaults was the highest in five months, according to Moody's. Three Moody's-rated companies defaulted in May, compared with four in the entire year through April. And, the first European default in 15 months happened in May by French Global Automotive Logistics S.A.S. Auto sector and auto-related industries account for 63% of the total $2.7 billion of defaults thus far this year.

If the credit cycle is beginning to turn, the question becomes: How far will the downturn go?

Moody's predicts the default rate will climb to 3% by the end of May 2007. At a briefing last week, Moody's chief economist John Lonski said he expects the cycle to top out without doing much damage. The fed funds rate may well be less than 5.25% by the same time, he says. "Fed easing in 2007 could allow for a dip in the high-yield default rate and a continuation of the credit cycle upturn," he said, adding that the cushion of corporate cash balances also mitigates an ugly bottom.

But Martin Fridson, president and publisher of high-yield strategy report

Leverage World

, says the default rate could top the 10.89% rate reached in January 2002 at the low point in the last credit cycle.

Fridson's examination of the ratings mix of all outstanding high-yield bonds, the ratings of new issues over the past few years prior to the peak in credit quality, and the economic conditions surrounding the peak, leads him to believe the credit-quality downturn may me much more severe than Moody's suggests.

The ratings mix of new issuance has persistently declined since the last credit cycle. In 2005, 17.5% of new high-yield bonds were rated triple-C or below, compared with 7% in 1996 -- the peak of the last credit cycle, or the last year that the default rate declined before climbing again to its 2002 high, writes Fridson. In 2005, triple-C-bonds comprised 5.9% of the high-yield universe, compared with 2.3% in 1996, he writes. The economic overlay is unpredictable, but certainly a slowdown of some magnitude is in store.

Fridson says that using his model brings the default-rate peak to about 14% in the current cycle.

Rosier perspectives on the future of this credit cycle have some standard arguments, writes Fridson. Some argue that the credit-ratings-agencies' standards have tightened since the last cycle, but that is yet unproven. Perhaps the lack of a single industry to point the finger at is part of the problem, he adds, noting that the telecommunications default parade of the early 2000s was an easy scapegoat for a credit downturn that was actually much broader.

He adds, a lot of the conventional thinking on the default rate has to do with hope, traditionally a poor determinant for making financial bets. It's a lesson the "one and done" crowd is relearning again this week.

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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