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Rebound Hangs on Jobs Data

Rate-cut hopes and the fate of the two-day bounce face a big challenge from payrolls.

The stock market's two-day rebound faces a crucial test Friday as traders brace for the Labor Department's employment report for July.

Economists expect the report will show about 130,000 new jobs added in the month, and unemployment will remain steady at 4.5%. But the report carries some extra weight now that the rate-cut theory is being priced back into the markets.

The yield on the 10-year Treasury bond edged lower to 4.75% Thursday from 4.76% Wednesday. Equity investors also expect credit market turmoil, and rising defaults and mortgage delinquencies will engender some intervention from the

Federal Reserve

. The fed funds futures market now puts 100% odds on a rate cut by year-end.

Hopes for a rate cut have climbed this week amid upheaval in mortgage lenders

American Home Mortgage



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, problems with a number of hedge funds exposed to mortgage-backed securities, as well as (refuted) rumors about

Beazer Homes'

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Rate-cut dreams helped traders overcome housing angst Thursday as the

Dow Jones Industrial Average

closed up 0.8% to 13,463.33. The

S&P 500

rose 0.4% to 1472.20 and the

Nasdaq Composite

gained 0.9% to 2575.98.

"After what we've seen in subprime and high-yield and stocks, people think the Fed needs to cut rates," says William Hornbarger, fixed-income strategist at A.G. Edwards. Hornbarger believes the Fed is likely to cut in December, but not to rescue the markets. He believes core inflation will continue to fall into the Fed's 1% to 2% comfort zone, and that will elicit a rate cut.

But recent comments from Fed Chairman Ben Bernanke and other Fed speakers suggest the central bank may remain on hold for an extended period, i.e., the "Greenspan put" may prove to be a relic of a bygone era.

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If a rate cut prophecy were to come true, the Fed would likely start hinting at it soon. The Fed often hints at policy changes in one meeting, indicates what's coming at the next, and only then makes the move at the third meeting in the sequence. Including next week's FOMC meeting, there are four left in 2007.

As far as employment goes, the Fed has been rather clear that it would need to see unemployment higher than 4.5% before it would consider a rate cut. In his recent testimony to Congress, Bernanke said he would need to see a convincing string of improving core inflation reports and a softening in the labor market to accept that inflation is genuinely tamed. The cost of labor, and rising food and energy prices are inflation pressures the Fed remains concerned about.

Some analysts believe there will be some softening in the July payrolls data, due to the ADP National Employment report's weak 48,000 new-job count for the month, as reported Wednesday. But others point to indicators of no slackening in the labor market.

John Lonski, chief economist at Moody's Investors Service, points to higher reports of consumer confidence as a key sign that the labor market remains strong and that household debt problems may be contained.

The Conference Board reported Tuesday that its index of consumer confidence rose to its highest level in almost six years.

Also, the weekly reports of jobless claims have "been hovering at levels associated with private payroll growth of 184,000," writes Michael Darda, MKM Partners' chief economist, who estimates payrolls grew 116,000 in July. "A blowout

number on either side

of expectations would likely be interpreted negatively" by the markets.

Indeed, too weak and we're headed for recession. Too strong, and the Fed stays on the sidelines.

Bespoke Investment Group analyzed the S&P 500's performance after the jobs report has been announced. Cutting the data to focus on conditions similar to today's, in which interest rates are falling and the S&P 500 is oversold, Bespoke found that when nonfarm payrolls are released into such an environment, the S&P 500 falls 0.52% on average on the day of the release "regardless of the report's outcome."

As for the idea of a Fed cut to "rescue" the financial markets, both Lonski and James Bianco, president of Bianco Research, are quick to point out that while credit spreads have risen to 434 basis points over Treasuries from record lows around 260 basis points in June, they are now at historically more normal levels vs. being truly extreme.

Also, credit crunches and market weakness do not have to lead to dire economic weakness, and that doesn't have to require the Fed to unleash liquidity into the system, the economists say.

Bianco recalls that the Fed hiked rates from 2.75% to 3% in the spring of 2005, when high-yield bond spreads widened dramatically and stressed the credit system after

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debt rating was cut to junk status.

Lonski recalls that after the WorldCom bankruptcy in 2002, investors lost total confidence in financial statements, and credit spreads widened to 1,000 basis points over Treasuries, even as profits improved and the default rate declined. He also notes that in 1998 through 1999, defaults did rise from a low of 2.2% to 6% by the end of 1999, all while quarterly GDP growth averaged over 4%.

As for the idea of a "Greenspan put" -- the notion the Fed will come to the rescue of financial markets -- it's important to note that Greenspan is no longer the Fed chairman.

It's ironic, says Bianco, that market players nicknamed Bernanke "helicopter Ben" when he became chairman in February 2006, based on the idea he would be quick to drop liquidity into the system. "He's nowhere near a helicopter."

Neither are his deputies. Two bankers nominated to serve on the Fed's Board of Governors underwent confirmation hearings in Washington on Wednesday, and both Fed Governor Randall Kroszner and Elizabeth Duke reiterated the Fed's role in staving off inflation and maintaining maximum employment. There were comments about subprime problems getting worse, but no indication that the Fed should cut rates or rescue the credit markets.

"Not that the Fed won't react, but it has to get a lot worse," says Bianco, suggesting the Dow would have to drop thousands of points, not just hundreds. "If there is a 'Bernanke put', the strike price is a lot higher than with Greenspan," he says.

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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