Eyes Open Ahead of Fed

If a quarter-point hike bores you, keep an eye on oil.
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Updated from Aug. 8

Traders settling in for a snooze ahead of Tuesday afternoon's

Fed

decision might want to consider another cup of coffee.

On Monday, sleeping bulls who lazily bid up stocks early in the session were caught leaning when surging oil knocked the indices back down. While oil futures backed down early Tuesday, the commodity's recent volatility should keep things interesting ahead of the Fed's 10th consecutive quarter-point hike.

Recently, crude for September delivery was down 26 cents to $63.68 in electronic Nymex trading. Meanwhile, index futures suggested a respectable open in the

S&P 500

and Nasdaq 100.

Oil was it for the excitement Monday and beyond yawns of boredom, there were some more signs of fatigue Monday. The

Dow Jones Industrial Average

finished down 21.10 points, or 0.2%, to 10,536.93, and the

S&P 500 index

fell 3.29 points, or 0.3%, to 1223.13. The

Nasdaq Composite

lost 13.52 points, or 0.6%, to 2164.39.

Trading volume was 1.5 billion shares on the Big Board, and with only 1.7 billion shares trading, the Nasdaq saw its lightest volume in almost one month. Nor was selling pressure very heavy, with declining issues beating advancers 5 to 3 on the

New York Stock Exchange

and 3 to 2 on the Nasdaq.

Fatigue was already evident last week when the major indices dipped, ending four straight weeks of gains that saw the S&P 500 and Nasdaq breach four-year highs. In what increasingly appears to be an overextended rally, investors are using both bad and good news to take some chips off of the table.

To Neutral and Beyond

Along with boredom and fatigue, there's also real nervousness in a market that's looking for new direction. Beyond the wild card of soaring oil prices, a series of stronger-than-expected economic data -- including Friday's strong July employment report -- has Wall Street economists boosting not only their growth estimates for the year, but their interest rate forecasts as well.

Some are now saying that the Fed will have to go beyond simply bringing short-term interest rates back to a "neutral level" after several years with rates at historically low levels. Monetary policy may have to turn restrictive.

On Monday, economists at Bank of America, Barclays Bank and Lehman Brothers all revised upwards their growth and rate forecasts. Those at Goldman Sachs and Morgan Stanley went further.

Because of faster growth, slower productivity and a tighter labor market, "neutral is higher than previously thought and the Fed will likely have to go slightly to tight, not just to neutral," wrote Bill Dudley, chief economist at Goldman Sachs.

Dudley now expects the Federal Reserve to boost its key fed funds rate to 4.25% by year-end, compared with his previous 4% forecast. And by the middle of 2006, Dudley expects the fed funds rate to stand at 5%, compared with 4.50% previously.

That's one of the highest rate forecasts among Wall Street economists, but others aren't far behind.

If the higher-rate prognostics hold true, the implications for the stock market aren't cheerful. It's certainly bad news for interest rate-sensitive sectors like real estate investment trusts (REITs), financials and utilities. REITs, for one, already have taken a beating since last week, as the bond market is continuing to price in a more aggressive Fed.

On Monday, the 10-year Treasury bond fell another 10/32, while its yield, used to set mortgage rates, rose to 4.43%.

It's now well a year after the Fed began raising rates, and the impact of tighter monetary policy on the economy should start being felt, at the same time that the end of rate hikes seems to be in the distant future.

"As it's becoming clearer the Fed is going to continue gradually raising rates, investors will have to be on the lookout for the monetary-induced effects on growth," says Peter Kretzmer, senior economist with Bank of America.

The fear that the Fed may overshoot (as it did in previous tightening cycles) can't be validated until after the fact. But the concern that it may happen is likely to start weighing on stock prices in the meantime.

According to Richard Berner, analyst at Morgan Stanley, "a stronger growth path is in the price, but markets haven't yet discounted a scenario of rising inflation and a Fed move towards restraint in 2006."

And while economists are boosting their growth forecasts for the balance of the year, few equity strategists appear willing to make a case for stronger corporate profits.

Higher growth forecasts, it seems, are more the result of a reassessment of the impact of the energy-induced soft patch in the spring, than of new life being infused into the economy and therefore higher profits.

Consumer spending has remained buoyed through the second quarter but that was largely due to still-rising home-equity and of sales incentives by the auto industry.

"This trend cannot continue, however, since robust spending has brought the U.S. savings rate to close to zero, and consumers will have to curb their spending eventually, which would help cool economic growth," says Bob Doll, chief investment officer with Merrill Lynch.

While this likely won't soften Fed policy until at least next year (as the Fed continues to fight inflation and the delayed impact of home-equity wealth), corporate earnings growth would still suffer the brunt of it. Add to this, the impact of rising interest rates, energy prices and a strong dollar, and Doll makes a strong case that current consensus market expectations for earnings growth are "overly optimistic."

And so if the market were to take a breather, it may be just what the doctor ordered to cure boredom, fatigue and nervousness -- and, at the very least, make those yawns dissipate.

To view Gregg Greenberg's video take on today's market, click here

.

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 appreciates your feedback;

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