Good news is bad news again, which means normalcy has returned on Wall Street.
Something seemed out of whack back on Jan. 17 when
Chairman Ben Bernanke stood before Congress offering a grim economic outlook and promising rate cuts, and the stock market responded with a heavy selloff. Since when was bad news for the economy viewed as bad news for investors?
One staple of the stock market's latest bull run has been Wall Street's laser-focus on the central bank's punch bowl. Any sign of a sluggish economy was usually embraced by investors as a harbinger of more easy money from the Fed and a reason to buy. Little wonder then that the five-year bull market appears to have ended in a nasty credit crunch.
When the promise of lower rates was finally overshadowed by the threat of recession in mid-January, it seemed like the markets had given up at long last on the notion that cheap credit could keep the party rolling forever.
Cramer: Fed Cut Helped, but We Need More
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Not so fast. In the wake of Bernanke's historic 75-basis-point rate cut -- a surprise move in response to widespread panic in the global financial markets last week -- investors are now banking on an extra 50-basis-point cut after the Federal Open Markets Committee meeting ends on Wednesday. Stocks -- particularly rate-sensitive financial stocks like
Bank of America
-- have responded by moving higher since the emergency cut on Tuesday.
"The Fed needs to do a 50-basis-point cut or the markets will be very disappointed," says Gail Dudack, chief investment strategist with Dudack Research Group. "I think it would be a huge risk to disappoint the market."
With ugly data from the U.S. housing market flooding the airwaves, markets are pricing in a strong likelihood of a half-point cut from the Fed. If the market is right, that means the Fed will have moved 125 basis points lower in little more than a week, which would amount to the fastest move of that size in the modern history of the Fed. Does the drama of such a move match the gravity of the threats to the U.S. economy?
Some investors appeared to have second thoughts on Tuesday, after the Commerce Department reported a 5.2% increase in orders for durable goods in December -- the largest gain for that key measure of economic activity since July. Fed funds futures that were pricing in an 82% chance of a half-point rate cut from the Fed on Wednesday retreated to a 65% chance and stocks pulled back as well.
Despite gloomier news from the residential real estate market, where home prices are in decline and home foreclosures are spiking, the durable goods data at least raised the possibility that the government's first report on economic growth, due out Wednesday morning, will be higher than expected.
A growing chorus of market-watchers says the U.S. economy has already entered recession, but economists on Wall Street are currently expecting the Commerce Department to report that GDP rose 1.2% in the fourth quarter. If that figure comes in higher, investors may start wondering if things are really that bad.
"We're talking ourselves into a recession," says Paul Mendelsohn, chief investment strategist with Windham Financial Markets. "What we think may be happening may be a lot worse than what's really happening. I can't imagine an economy here that would immediately need more than 100 basis points in one shot."
Mendelsohn predicts the market will be disappointed with the Fed again, and he's not alone. Paul Kasriel, chief U.S. economist with Northern Trust Company of Chicago, says the U.S. probably is in a recession, but he says the Fed will only ease by a quarter-point if it eases at all.
"The yield on 10-year treasuries is now above the current fed funds rate, and that means monetary policy has caught up with the markets," says Kasriel. "The stock market might throw another temper tantrum, but I don't see how the Fed can manage monetary policy and be pulled around by the stock market every time. There could be some disappointment
Adding to the Fed's unwillingness to appease the markets, Kasriel points out that two new voting members will be joining the committee this year. Dallas Fed Governor Richard Fisher will be voting this year, along with Philadelphia Fed Governor Charles Plosser -- both men, says Kasriel, have shown an inclination to be "hawkish."
That said, St. Louis Fed Governor William Poole, the lone dissenter on the Fed's historic decision to step in last week, will no longer be voting. He wanted the central bank to wait and take action at Wednesday's meeting.
Lehman Brothers senior economist Ethan Harris forecasts a quarter-point rate cut.
Cramer: Banks Need a Fed Cut to Survive
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"The Fed viewed last week's emergency rate cut as a major down-payment on the cut they were already planning to make at this week's meeting, so they may be less willing to go along with the markets now," says Harris.
Meanwhile, news of massive trading fraud at Société Générale, one of France's largest banks, came out after the Fed move last week. Investors say the bank's quiet unwinding of $7 billion in fraudulent trades may have been the catalyst for huge selloffs in Asia and Europe.
"The Fed was responding to a market collapse when they threw 75 basis points out there last week, and now they have a better understanding of what the situation really was," says Mendelsohn. "They may be re-thinking this whole thing, and they might decide they want to keep some bullets in the chamber and see how things pan out."
Harris says that a 25-basis-point cut by the Fed on Wednesday would likely result in a down day for stocks, but he doesn't think it would result in serious instability for the financial markets.
"On a longer-term basis, a quarter-point move on Wednesday could signal to the market that the Fed is not panicked and that there are no skeletons in the closet," says Harris. "Also, a smaller move makes it easier for the Fed to keep its bias towards further easing in its policy statement. If they keep trying to meet or exceed the market's expectations with monetary policy, they're also going to have to start managing expectations against more rate cuts."
What's the risk of the Fed going too far? More easy credit could inspire more spending from a U.S. population that desperately needs to start saving.
"The Fed may wind up creating another asset bubble," says Mendelsohn.