Fed Game Set

Wednesday's FOMC meeting will determine if Bernanke & Co. can regain control of the conversation.
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In their financial chess match with the Federal Reserve, the markets have been directing the game of late. New Fed chairman Ben Bernanke could go a long way toward establishing himself as a worthy opponent Wednesday with the statement accompanying the FOMC's May meeting. Or, it could be checkmate for the global economy.

As it stands, large-cap stocks are rallying, while Treasury bond yields and the dollar are displaying concern about both inflation and the weight of global imbalances. Commodities prices, in particular gold (which

breached $700 per ounce on Tuesday) and oil, continue to be fueled by speculative fervor, as well as supply/demand issues. These market indicators are in a maelstrom of two major transitions -- the move away from clearly telegraphed monetary policy to a "data dependent" Fed and the shift to a new chairman after 18 years with Alan Greenspan guiding the ship.

Fed members and Bernanke have indicated that the FOMC is likely to pause to collect data after hiking the fed funds rate to 5% Wednesday. At a time when the new chairman is finding his voice, the market's reaction to any minute deviation from the FOMC's prior script is sure to be hyperbolic.

"Current market expectations could be violated in two ways -- the extent to which they

the FOMC hint at a stronger probability of a June hike, or the stronger probability of completely stopping its tightening campaign," says Anirvan Banerji, director of research at The Economic Cycle Research Institute.

Fed funds futures are pricing in 100% odds the FOMC will raise rates for the 16th straight time Wednesday to 5%. Futures are predicting 38% odds of a June tightening, but 80% certainty that fed funds will reach 5.25% by August.

In terms of the subtleties, FOMC members are doubtlessly debating again whether to include the phrase "some further policy firming may be needed" in the statement. The FOMC is also sure to tell the market it is ever more dependent on data, but it is the bias with which it portrays the current economy and how it may interpret the next six weeks' worth of data that may upset the applecart.

"If Bernanke makes clear a pause, rather than an end

to tightening, it will probably take a little bit of steam out of stocks," says Jason Trennert, chief investment strategist for International Strategy & Investment.

Then again, if the Fed hints that Wednesday's hike is the end of its tightening campaign, stocks could soar, as they did on

April 18 in response to dovish comments in the minutes of the March FOMC meeting.

Waiting for a Pause

The stock market has been hoping for an end to Fed tightening for a year now. But pausing to assess effectiveness of its actions is not unusual in the Fed's history. Its last tightening campaign ended in May 2000, with a pause until January 2001, when it began to ease. The Fed eased at each subsequent meeting through January 2002, when it paused and then eased again in November; then it paused and eased again in June 2003. After that, the Fed paused until it began its current string of hikes starting in June 2004.

"We remain of the view that the Fed will do what a normal central bank does and begin to pause and reflect before making another move," says David Rosenberg, economist at Merrill Lynch, adding that this is the norm for the central banks around the world. "For some strange reason, only the Fed is supposed to hike and never stop until something breaks. By the time something breaks, it is usually too late."

Well, the Federal Reserve does have a history of tightening until something breaks -- think Penn Central, Orange County, Calif., Long-Term Capital Management, the New Economy, etc. -- and the Fed itself keeps saying the risks of overdoing its tightening are high. But the only evidence that the 15 rate hikes thus far have worked to restrain anything is in the residential housing market, as

detailed here. The 375 basis points of tightening arguably should have created more restraint, but all signs point to a roaring fire.

Business spending is up; manufacturing is strong; unemployment is at 4.7%; and companies have huge cash balances to spend on M&A, shareholder dividends, stock buybacks and capital expenditures -- each of which is on the rise. The consumer is still shopping, even though median wages have stagnated and home prices peaked. In financial markets, the riskiest assets are the most overpriced, while safer assets like large-cap stocks are only now making any strides commensurate with the economy's strength.

With this fire burning, inflationary pressure has mounted. Indeed, several Fed speakers have indicated that the Fed's preferred inflation metric -- core PCE (personal consumption expenditures) index -- is riding at the top end of the Fed's comfort zone at 2%. Friday's payrolls report also included the disturbing third-straight monthly increase in hourly wages, which was higher than expected. Combined with high energy and raw-material prices, corporate profits are likely to suffer eventually, or the costs passed through to consumers.

"The medium-term challenge will be to decide whether inflation risks are tame or not," says Richard Berner, economist at Morgan Stanley, who this week upped his year-end forecast for the fed funds rate to 5.5% from 5.25%.

Indeed, several economists have read the most recent data as increasing the likelihood that the fed funds rate moves beyond Wednesday's presumptive 5% by the end of the year. "Not hiking requires tame core inflation releases


clear signs that consumer spending is appreciably slowing this quarter," says Mickey Levy, economist at Bank of America, who last week increased his expectations for another fed funds rate hike at the FOMC's June 28-29 meeting to greater than 50%.

It's a Small World After All

Further complicating the Fed's release Wednesday is the focus on the U.S. Treasury Department's semiannual report on foreign exchange, which may name China as a currency manipulator. Protectionist sentiment in Washington is mounting as China has not responded to requests that it allow its yuan currency to appreciate, which would help correct the U.S.' $202 billion trade deficit with China.

Even if the report does not name China as a manipulator, many expect strong language to be in it, which could also spark further protectionist moves in Washington and a reaction abroad. As it stands, about 70% of the global currency reserves are in the hands of developing countries, according to

The Wall Street Journal


Speaking of the global economy and complications to the Fed's efforts, the European Central Bank and the Bank of Japan are at the onset of tightening campaigns while the U.S. possibly moves toward easing -- or at least no more tightening. The resulting change in yield differentials -- actually, the expectation thereof -- has led to broad-based selling of the dollar, which may go some way to correct trade imbalances, but will eventually lead toward domestic inflation as well.

Perhaps a tailwind for the Fed, however, is the potential that synchronized tightening among other central banks will "likely result in the revaluation of risk," said ISI's Trennert. "As the tide of global liquidity goes out, people will focus on safe assets, most especially large-cap U.S. stocks."

Indeed, the

Dow Jones Industrial Average

rose 0.5% to 11,639 Tuesday, behind strength in

General Motors

(GM) - Get Report



(DIS) - Get Report

, which offset weakness in


(HPQ) - Get Report

, down in sympathy with


(DELL) - Get Report


The Dow is now only 83 points away from its Jan. 14, 2000, all-time high of 11,722, while the Dow Transports hit another all-time high Tuesday, rising 0.8% to 4998.95. The

S&P 500

closed up fractionally at 1325, and the

Nasdaq Composite

closed down 0.3% to 2338. The S&P remains more than 15% below and the Nasdaq still down a whopping 119% from their respective all-time highs reached in March 2000.

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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