Stocks Evade Fed Hawks

The FOMC minutes point to more rate hikes, but stocks end a miserable month on an up note.
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Looking for certainty from the

Federal Reserve

these days is like waiting for Godot. You can talk and talk and talk about it, but it never comes.

The minutes of the May 10 FOMC meeting offered little guidance on the state of inflation or the economy. But it did provide clues to the depth and breadth of the Fed's concerns about inflation, and the

elephant in the room finally broke enough glass to get noticed. The FOMC members even discussed a 50-basis-point rate hike. In the end, of course, the Fed raised rates 25 basis points in May and set the stage to hike again in June.

But the markets focused on the tone, which tilted toward unison with the market's increased anxieties over inflation.

"The center of gravity in the FOMC is shifting to another rate hike here," says Ethan Harris, chief economist at Lehman Brothers. The fed funds futures market puts the likelihood of a June rate hike at 74% Wednesday afternoon, up from 56% before the minutes were released. The likelihood of another hike at the August meeting also climbed slightly to 25%, according to Miller Tabak.

The markets reacted accordingly. Stocks sold off when the headlines ran, and the focus was on the Fed's inflation jitters. The Treasury market sold off with the 10-year note falling 12/32, its yield rising to 5.13% vs. 5.08% Tuesday. The dollar rallied on hopes for more Fed rate hikes, which helped send

gold prices lower.

Stock proxies climbed back in the final hour, however, and closed near their highs of the day. The

Dow Jones Industrial Average

closed up 0.7% at 11168.31, while the

S&P 500

gained 0.8% to close at 1270.09, and the

Nasdaq Composite

closed up 0.65% to 2178.88.

A day after all 30 of its components fell, the Dow's gain was broad based, with


(MSFT) - Get Report

a notable laggard. Major averages were led by chip stocks such as

Micron Technology

(MU) - Get Report

and energy stocks such as


(CVX) - Get Report


NRG Energy

(NRG) - Get Report

despite weakness in crude prices.

Absent more data to chew on Wednesday, it is telling that the stock market performed so well on the heels of the hawkish Fed minutes, says Marc Pado, U.S. market strategist at Cantor Fitzgerald.

John Bollinger, president of Bollinger Capital Management, says the stock market is trying to "put together a short-term W," and the market is in the middle of the pattern, with Tuesday marking the small dip in the middle. A continuation of the pattern would suggest that stocks are on their way back to the top of the W and beyond -- back toward all-time highs for the Dow, at least.

Even if this proves too good to be true, just about anything would be better than the month of May, where clouds prevailed and flowers didn't bloom. For the month, the Dow fell 1.8%, the S&P lost 3.1%, its poorest May since 1984, the Nasdaq fell 6.2%, its worst monthly decline since July 2004, and the Russell 2000 lost 5.7%.

Hawks Take Flight

The FOMC minutes confirmed fears that Chicago Fed President Moskow is not the rogue hawk in the Fed, says Pado, recalling that Moskow's hawkish comments were responsible for a lot of

Tuesday's heavy selling.

The minutes "shows that concern over further hikes and inflation is not just Moskow, it is deep-seated," Pado says.

The minutes revealed concern among members that growth had not moderated as expected while inflation risks had increased since the March meeting. And this was before the May CPI report, which showed that core CPI is up 2.3% year over year. The FOMC also didn't have the luxury of knowing that core inflation as measured by the personal consumption expenditure price index is up 2.1% year over year, as reported last week.

By both measures, inflation has broken past the Fed's 1% to 2% comfort zone. And like major league pitchers hoping for strikeouts, the Fed can't aim for the edges without risking being outside the strike zone more often than not, as outlined by Moskow on Tuesday.

The Fed's mention of

a 50-basis-point hike may call to mind the end of tightening cycles past, when the Fed would end a move on a dramatic note.

But that kind of finale is not at hand, says Harris, adding that the Fed wanted to indicate to the markets that it needs the utmost flexibility. The ends of tightening cycles come with "a sense of confidence that they're done," says Harris. "Here you have total uncertainty. But by discussing 50 basis points, they change the center point to 25 basis points."

As a result, "with one stroke of the pen,

the FOMC changed the whole picture" away from the "pause camp,

which dominated the airwaves" in recent months, he adds.

The data still fuel both sides of the argument, and the "one and done" crowd isn't likely to go quietly into that good night. The Fed did not say much this time about the lags of monetary policy, but Merrill Lynch's North American economist David Rosenberg still believes that inflation is a lagging indicator and that the Fed is on the verge of over-tightening. The Fed will be cutting rates and contending with deflation by 2007 if it isn't careful, says Rosenberg.

The Fed reiterated its data-dependency in the minutes, and data they shall have. Friday's May non-farm payrolls report could easily swing expectations for the June Fed rate hike back to lower levels. The jobs report offers insight into the labor market and into inflation. The market and the Fed also have another PPI and a CPI report between now and the June FOMC meeting.

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


to send her an email.