If there's any doubt that the Federal Reserve will raise rates at a "measured" pace this year, Fed Chief Alan Greenspan is likely to quash it when he delivers his semiannual testimony to Congress on Tuesday.

After a batch of weaker-than-expected economic data and recent commentary from various Fed officials, somewhat dovish comments shouldn't come as a surprise to the markets, but they probably will. Many bond investors are still worried about aggressive rate hikes this year and are calling for bond prices to retreat over the near term.

The number of short positions (bets that bond prices will decline) established in the 10-year note future hit a record 216,000 contracts in the week ended last Tuesday, up from 192,000 during the prior week.

In his speech before the U.S. Senate, Greenspan is likely to justify the recent hike in interest rates by saying that the economy has strengthened and that the risks of deflation have diminished. But he also could acknowledge the recent moderation in the economy and reiterate that rate hikes should be gradually going forward.

Last month, retail sales, employment growth and manufacturing activity all came in well below economists' estimates. And while regional manufacturing surveys in early July have been encouraging, the four-week moving average of jobless claims has increased and consumer sentiment has risen less than expected.

There are other reasons for Greenspan to remain cautious. Wages are still lagging behind prices and real average weekly earnings are down 1.4% from last year, the softest pace since 1995. Although the job market has improved since August, those age 60 and over have snapped up about one-third of the jobs, according to Merrill Lynch. Meanwhile, the labor force participation rate for those people in their prime earnings years (those age 25 to 54) is the lowest in 17 years.

With tax relief no longer working its way through the economy, and oil prices stubbornly high despite strong production from the Organization of Petroleum Exporting Countries, there are plenty of reasons to be concerned about consumer spending in the second half of the year.

Meanwhile, some economists are questioning just how strong business spending will be, particularly after Intel ( INTC) said inventories rose 15% in the second quarter.

"We hope the Fed chairman also acknowledges that economic growth is moderating and that the sustainability of the recovery is not without risk," said Vincent Malanga, senior economist at Investor's Economic Resources.

Malanga said Greenspan should note that the threat of terrorism continues to weigh on the economy and that excess debt and financial leverage are risks to the outlook. "As a result, he should say that there is no timetable for interest rate increases and that there is no pre-established level of interest rates that represents neutrality."

In reality, Greenspan probably will be more nuanced than that, saying the Fed is willing to take quicker and more drastic action if inflation flares up, while also acknowledging that inflation isn't a problem right now.

The latest consumer and producer price indices have validated the Fed's view that the run-up in inflation earlier this year was due to "transitory" factors, and it's possible Greenspan will repeat a line from his June 15 Senate Confirmation hearing that "inflationary pressures are not likely to be a serious concern in the period ahead."

If the threat of inflation is played down, bonds could move up sharply. The 10-year note has rallied over the past five weeks amid signs of softening growth, but sentiment among bond investors remains overwhelmingly bearish, and any dovish comments could trigger a wave of short covering.

Ried, Thunberg & Co.'s index on the outlook for Treasuries stood at 43 on Friday. (A reading below 50 indicates that investors expect bond prices to fall over the next two months.) On Monday, the yield on the 10-year note was sitting at 4.35%, down from 4.87% on June 14.

Midyear testimonies often elicit a big same-day reaction from bond investors. Over the past decade, the average and median move in the 10-year note has been 10 basis points, according to Merrill Lynch, which noted that this can "make or break someone's quarter." After four of the past six speeches, bonds have rallied on the session.

For equities, the reaction has been less severe, with the median move in the Dow at just 46 points. "But in 11 of the past 16 testimonies, the equity market was lower on the day," according to Merrill.

While Greenspan's comments likely will set the tone for the market, the Fed's forecasts for growth, employment and inflation also will be closely watched. In February, the Fed said it expected growth this year of between 4.5% and 5% but that prediction might prove optimistic.

"The GDP forecast should certainly be lowered from the lofty 4.75%, as growth in the first half of the year is poised to come in south of 4%," said Merrill economist David Rosenberg.

The economy grew at just 3.9% in the first quarter and is expected to grow by 3.8% in the second. The Fed also has predicted that inflation would hit 1% to 1.25% this year, as measured by the personal consumption expenditures index. In addition, it has called for the unemployment rate to fall to between 5.25% and 5.5% this year. Rosenberg said both the average unemployment rate and the inflation rate could be revised up slightly on Tuesday.

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