When Federal Reserve Chairman Alan Greenspan delivers his semiannual monetary policy report to Congress at 10 a.m. EDT on Wednesday, he is more likely to validate the view that the Fed will continue to raise interest rates than to endorse the view that a pause is imminent.

Such can be surmised from recent economic news, which appears to indicate that the economy is snapping back from a short and shallow soft patch. In addition, there are some in Washington who are saying that the neutral fed funds rate may be higher than the market thinks and that the fed funds rate will have to be raised above the neutral rate -- a new concept the bond market is not priced for.

As was the case in February when Greenspan delivered his previous semiannual monetary policy report, the chairman faces the risk of causing further cannibalization of the Federal Reserve's previous interest rate hikes. Any indication of a pause would almost certainly cause an economy-stimulating loosening of financial conditions via gains in stock and bond prices, for example, and via a tightening of credit spreads and a decline in the value of the dollar. Given this risk, Greenspan must ask himself the same question that he asked himself in February: Does the economy need new stimulus?

If he believes that the answer is no, then he has no choice but to deliver a testimony that is consistent with the Fed's rate-hike campaign and to avoid language that would result in giving the economy a boost it does not need.

If, on the other hand, Greenspan sees a need for economic stimulus, or if he feels that inflation risks have abated enough that a bit more stimulus would do no harm, then he could hint at a pause. This would stir optimism in the financial markets, which would likely be accompanied by loosening financial conditions. But this scenario seems less likely to occur in light of recent economic news.

Letter Hints at Greenspan's Economic Outlook

Greenspan almost certainly will take note of the fact that the economy has remained resilient despite the recent surge in energy prices. Hints of this can be found in the July 11 letter he wrote to Congress, wherein the chairman said that aside from some "headwinds" resulting from the energy surge, the U.S. economy was coping pretty well.

Giving Greenspan such optimism on the economy is the recent surge in income growth, now up 6.7% vs. a year ago, or about 1.5 percentage points above the long-term average. That's enough in dollar terms to pay the net increase in the nation's energy tab. His continued optimism on productivity gains and the effect that it will have on both personal and corporate income will almost certainly be another central theme.

Low business inventories, a strong banking and credit system, and relatively low inflation are other factors Greenspan will likely cite in delivering sanguine views about the economic outlook. He's also likely to show mild concern about the housing market, with an emphasis on "mild" in the macro picture.

The discussion over interest rates will gain a significant amount of attention Wednesday, as Greenspan will likely discuss both the "conundrum" of low long-term interest rates and the notion of "neutral" policy. Greenspan is likely to discuss these topics at greater length than he did on June 9, when he last delivered testimony on the economy and the markets.

With respect to the neutral rate, Greenspan will likely reiterate that the Fed will know that it has reached neutrality when it reaches it. A growing risk is that Greenspan and or his colleagues will begin to say that a restrictive stance on monetary policy might eventually be needed. While there's no urgent need to warn the markets of such just yet, the Fed will want to prepare the markets by describing scenarios in which it might be possible and letting the economic news dictate whether such should be discounted.

As for the so-called conundrum, the greater the angst that Greenspan shows, the more likely it is that the markets will perceive that there are more rate hikes on the way. Perceptions of a fed funds rate of higher than 4.0% would nudge interest rates higher, as maturities beyond two years rarely trade at yields below the fed funds rate.

For example, over the past 16 years, the two-year T-note has traded below the fed funds rate on only six occasions. On each occasion the Fed cut rates within six months, with most hikes occurring much sooner than that. The point is that Treasuries tend to trade above the fed funds rate unless the market expects an interest rate cut from the Fed. A rate cut does not appear likely at present. In my eyes the so-called conundrum is due to the lowering of inflation expectations.

Past Market Responses to Greenspan Have Been Large

Over the past 12 years, on the first day of Greenspan's semiannual reports to Congress, the average absolute price change in the front-month T-bond future has been roughly 33/32 (see table below). That there have been sharp reactions should not be too surprising. But what stands out, and what is the most tradable, is the follow-through. The market usually continues to move in the same direction as it did on the first day of testimony for several more weeks, and the cumulative reaction after the first week is usually double that of the initial reaction. And it goes on: One month later the reaction nearly doubles again (also in the same direction).

Key Levels on the 10-Year

With the yield on the 10-year T-note having breached its 200-day moving average of 4.20%, even mildly hawkish Greenspan testimony will likely cause a further rise in market interest rates. The next target for the 10-year is 4.3%, followed by 4.4%, which was has been a key support and resistance level many times over the past two years, during which the 10-year has been largely confined to a trading range of 4% to 4.5%.

The break of the 200-day combined with hawkish Greenspan testimony would justify moving to at least the middle of this range. With very hawkish testimony, a move toward the upper end of the yield range is possible, but a break higher would require increased perceptions of the possibility of a move toward a restrictive policy stance, which would be the most bearish thing that Greenspan could say on Wednesday.

Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of

The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback;

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