Edge to Stocks in Rate Debate

The averages get a lift as the latest data come in cool.
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Wall Street was beaming with high hopes Monday as more evidence of subpar growth on the eve of a Federal Open Market Committee meeting fueled optimism that official interest rates are about to level off.

While nobody doubts that the

Fed

will raise rates by another quarter-point Tuesday, a debate is raging among economists and Fed watchers about the central bank's next move.

After eight rate hikes at this so-called "measured pace," a slowdown in U.S. growth has fueled concerns that more tightening could push the economy into recession. With investors still on inflation-watch after the Fed rang alarm bells at its last meeting, parsing Fed speak will again be the name of the game Tuesday afternoon.

This time, the question is simple. Will the Fed abandon its vow to enact further tightening at a "measured" pace?

On Monday, the

Dow Jones Industrial Average

gained 59.19 points, or 0.58%, to 10,251.70. The

S&P 500

added 5.31 points, or 0.46%, to 1162.16, and the

Nasdaq Composite

gained 7 points, or 0.36%, to 1928.65.

A morning slide in crude prices led early gains in the major indices. But prices went back above $50 a barrel later on Nymex. And with caution dominating the session ahead of the Fed meeting, trading was light: 1.6 billion shares traded on both the

NYSE

and the Nasdaq. Advancers beat decliners 2 to 1 on the NYSE while decliners beat advancers 8 to 7 on the Nasdaq.

The main catalyst for stocks was economic news depicting an economy growing at a slower pace.

Manufacturing activity, as measured by the Institute for Supply Management's monthly survey, lost steam for the fifth month in a row. The ISM said its index fell to 53.3 in April, down from 55.2 in March and below market expectations for the index to drop to 54.6.

Faced with mounting evidence of slower growth, some are now predicting that after the widely expected 25-basis-point rate hike on Tuesday, the Fed is going to leave fed funds at that nice, round level of 3%.

"This week could mark the Fed's last rate hike of this cycle," writes Morgan Stanley's chief economist Stephen Roach.

While Wall Street economists have been debating whether recent evidence of slower growth constitutes a "soft patch" or something more serious, it appears that the bond market has made up its mind for a while.

After the weak employment report released in late March, the yield of the benchmark 10-year Treasury bond began falling from a peak of 4.61%.

The yield now currently trades at around 4.20%, as weak retail sales, a soaring trade deficit and the first-quarter GDP confirmed not only that growth had slowed but that it may slow further in coming months.

The bond market clearly thinks that inflation will be under control. Job growth -- the key to higher wages, price pressures and eventually inflation -- has remained tepid. And the employment cost index rose 0.7% in the first quarter, its smallest gain in six years.

But what does the Fed think? The Fed's favored inflation monitor, the personal consumption expenditure index, rose 0.5% in April, bringing its year-on-year increase to 1.7%, near the top of the 1.5%-1.75% range the Fed considers "tolerable." But most of the April gain was related to higher energy prices.

At least some at the Fed seem to find that worrisome. On the same day the weak March employment report was released, Fed president Michael Moskow, one of the moderately hawkish voting members of the FOMC, cited energy prices and import prices as particular areas of concern.

But other Fed members have expressed a much more sanguine read of the inflationary impact of commodity prices. According to several veteran analysts, the Fed is not really concerned about these price pressures.

But it is in a bind because it must move interest rates higher from their exceptionally low level of the past few years, especially as speculative bubbles have appeared in different corners of the investment spectrum. Besides the obvious housing bubble, speculators still appear to be playing the carry trade (borrowing with still-low U.S. rates to finance riskier investments elsewhere).

And so the Fed must convince markets that rates will move higher while it waits several more months to see if the "soft patch" turns into a more serious slowdown, according to Bank of America market strategist Tom McManus.

The Fed's saber-rattling, he says, is aimed at "yield curve arbitragers, AKA 'carry traders,' not to become overly confident in their ability to predict the precise path of financing costs for their leveraged investments," McManus said.

McManus therefore remains cautious on the outlook for the 10-year Treasury bond, expecting that its yield will eventually move higher as normal credit conditions return.

MG Financial Group currency strategist Ashraf Laidi, meanwhile, also thinks that the Fed needs to convince the market of its intent to keep a tightening bias. Why, the Fed needs to keep the weak dollar afloat. The greenback remains supported by weak growth and political uncertainty both in Europe and in Asia.

But should the market feel that U.S. yields won't move much higher, "there could be a sharp drop in the dollar." That's especially true if China also gives into political pressures to drop the yuan's peg to the dollar, however unlikely that scenario may be.

Given the huge trade deficit, the inflationary impact of a weak dollar is certainly not ignored by the Fed, the currency strategist says. While he expects the Fed to stop raising rates after hiking them to 3.25% in June, Laidi expects the Fed to keep its measured pace language at Tuesday's meeting and to keep the markets guessing for a while longer. "In the meantime, the Fed hopes the market will do the tightening for them."

Of course, nothing is less certain. The bond market appears to prefer the softer economic outlook, while the Fed buys more time to wait and see.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send

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