Federal Reserve

had one last chance Monday to correct the markets' belief that it will not raise the fed funds rate on Aug. 8. But when St. Louis Fed President William Poole and San Francisco Janet Yellen came to the podium, they chose to let sleeping dogs lie.

In separate speeches, the Fed Presidents commented on the future of monetary policy, but neither elicited much response from the financial markets. Traders were sanguine about warnings that inflation is undesirable, and investors continue to read "pause" as "full-stop."

"The market hears 'pause' and they think 'over'," says James Bianco, president of Bianco Research. "I'm hearing from Fed officials that they say pause and mean pause."

If the market read pause as pause, they would not react as they have to recent economic data and Fedspeak, Bianco says. The markets "are locked into the growth story," and ignoring the inflation tale, he says. If the Fed were to pause and begin hiking rates again, the markets would likely be knocked on their heels.

Such concerns were far from traders' consciousness Monday, if they were present at all. After thinking over Friday's stock and bond market rallies on the heels of a weaker-than-expected 2.5% second-quarter GDP report, investors returned Monday without much buyer's remorse. The major stock indices slipped modestly as bond markets and the fed funds futures market continue to bet the Fed will not raise rates in August.

The fed funds futures market prices in a 32% chance of a rate hike at the Aug. 8 meeting, while it prices in a 38% chance of a hike at the September meeting, up slightly from 34% Friday, according to Miller Tabak. Overall, the fed funds futures market prices 52% odds of a 5.50% fed funds rate by the Oct. 24 FOMC meeting, up from 46% Friday.

The Fedspeak was not as confident. On the heels of yet another high inflation data point Friday, and ahead of the PCE core deflator index out Tuesday, St. Louis Fed President Poole said he was 50-50 on next week's rate decision, according to


. San Francisco Fed President Yellen said the Fed must take into account the lag in the effects of monetary policy and that a "gradual" and "forward-looking" approach is better. But Yellen reiterated the Fed will continue to be data-dependent, that inflation rates are above her comfort zone, and that core inflation needs to "trend in a downward direction over the medium term."

The major stock averages, like the fed funds futures market, revealed only a hint of uncertainty about the Fed's future path. Stocks fell slightly, but the bond market remained stable with the 10-year Treasury still yielding below 5%.


Dow Jones Industrial Average

fell 0.3% to 11,185.68, while the

S&P 500

fell 0.15% to 1276.66. The

Nasdaq Composite

dropped 0.13% to 2091.47. For the month, the Dow gained 0.3%, and the S&P 500 rose 0.5%, but the Nasdaq dropped 3.7%.

Despite the minor moves for major averages, the pattern of harsh punishment for companies with disappointing earnings and/or guidance continued Monday. Among the latest victims:

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The 10-year Treasury note fell 3/32 to yield 4.98%, while the five-year Treasury note fell 1/32 to yield 4.91%, and the two-year note dropped 1/32 to yield 4.96%.

Inflation in the Pipeline

Despite the bond market's lack of anxiety, the inflation situation is not ideal. The Commerce Department reported Friday that the price index for personal-consumption expenditures, excluding food and energy prices, grew 2.9% year over year in the second quarter, up from a 2.1% increase in the first quarter. Core CPI is running at 2.6% year over year, as of June, up from 2.17%, as of the end of December 2005.

If core CPI came in at 0.2% monthly increases, then year-over-year CPI would reach 2.9% to 3% by September, says Brett Gallagher, head of U.S. equities at Julius Baer Investment Management. Likewise, wage-driven inflation, measured by unit-labor costs probably reached a six-year high of 3.5% in the second quarter after revisions, says Richard Berner, economist at Morgan Stanley -- 200 basis points higher than previously thought.

"The Fed is not going to receive news of inflation any time soon that would establish a definitive top for the fed funds rate," says John Lonski, chief economist at Moody's Investors Service "Investors have to be aware that if the Fed decides to hold rates steady in August, by no means does that mean the Fed will not hike rates at some point again over the next six months."

Gallagher, like many others, has become more defensive in his strategy, moving to overweight large-cap stocks -- large diversified financial companies, in particular. In the month of July, defensive areas like health care and utilities were stellar performers, while small-caps and industrials were big losers. The Dow Transportation Average fell 11% in July.

Gallagher declined to specify individual stocks, but says the large-cap bet comes from conviction that a Fed pause will cause the dollar to fall farther. "When the dollar is weak, almost without fail, large-cap outperforms small-cap," says Gallagher.

The dollar has struggled of late, but was largely unchanged vs. the euro and the yen Monday. The euro bought $1.277 vs. $1.2751 late Friday, and the dollar bought 114.67 yen vs. 114.77.

The dollar bear case is not hard to envision. The dollar will be under pressure as central banks around the world embark on interest rate hiking campaigns just as the Fed pauses. The Bank of Japan just raised its overnight rate last month to 0.25%, and the European Central Bank is expected to hike again this week.

Indeed, a weak dollar could be a foil for the Fed ... among other uncontrollable issues. Even Yellen said to reporters after a speech on May 28 that a hypothetical dollar decline, "would appear to call for a response of tighter policy."

Broadly, Gallagher believes the market is likely to rally into a Fed pause, whether that means pause or stop. "What we saw last week was a preamble," he says. "If the market went 5% to 10% higher from here...while I don't think it is the right thing, I think it is a possibility."

The right thing would be a bit more vigilance about inflation and the economic slowdown, he says, adding that the market may not follow-through after the Fed pauses.

Merriam-Webster's online dictionary defines pause as a "temporary stop." The dictionary's third definition is more apropos: "Temporary inaction, especially as caused by uncertainty."

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


to send her an email.