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By Jennifer Yousfi
When U.S. Federal Reserve policymakers conclude their two-day meeting today (Wednesday), investors are betting the central bank will announce a hefty reduction in interest rates for the second time in just over a week. But some analysts are concerned that with a strong durable goods report and some unexpectedly good news on the U.S. corporate earnings front yesterday (Tuesday), that a once-certain rate cut may now be open for debate.
And that wouldn't be good for stock prices, analysts say.
Faced with plunging markets abroad and intensifying recession fears here at home, the U.S. central bank's policymaking Federal Open Market Committee on Jan. 22 slashed the benchmark U.S. interest rate by three quarters of a percentage point. The surprise move was the Fed's single-biggest reduction in nearly 25 years, and took the Federal Funds Rate from 4.25% down to 3.50%. The central bank also cut the Discount Rate by a similar amount, taking it down to 4%.
The Fed Funds Rate is what banks charge one another for overnight loans. It also serves as a benchmark for the Prime Rate, the base rate that commercial banks use to price loans to their best and most creditworthy customers.
Initially, the U.S. stock market reacted favorably to the cut. But stock prices were whipsawed throughout the week, and on Friday closed with all three major U.S. indices down in the red for the day.
On Monday, weakness in the Asian markets seemed to be setting up a scenario similar to the one that had spawned last week's surprise Fed cut.
Instead, the U.S. markets reversed course again, as investors bet heavily that an additional rate cut would come out of the FOMC meeting, which started yesterday and concludes in the middle of the afternoon today.
FOMC members have a lot of data to consider, and much of it conflicts.
Consider, for instance, the weak housing report released Monday by the U.S. Department of Commerce, which said that sales of new U.S. single-family homes plummeted a record 26% in 2007. On Monday, that seemed to be the final bit of confirming evidence the FOMC needed to justify a rate reduction that would come only a week after the Jan. 22 emergency move.
With that cut, analysts reasoned, the economy would receive a badly needed boost to help it claw its way out of the worst housing slump in decades.
Anticipation that Federal Reserve Chairman Ben S. Bernanke would cut the key interest rate by as much as 50 basis points in reaction to that bearish housing report fueled strong U.S. stock price gains Monday.
That bullishness spilled over into the Asian and European markets yesterday. Japan's Nikkei 225 Index soared 390.95 points, or 2.99%, to close at 13,478.86. Hong Kong's Hang Seng Index edged up 238.19 points, or 0.99%, to finish yesterday at 24,291.80.
On Tuesday, manufacturing shares gained on the strength of better-than-anticipated durable goods orders. Aircraft-builder Boeing Co. (BA) and heavy-equipment manufacturer Caterpillar Inc. (CAT) both climbed in morning trading. And a handful of companies released strong earnings reports that were well received by the market as Dow Chemical Co. (DOW), American Electric Power Co. Inc. (AEP) and Valero Energy Corp. (VLO) all showed gains.
At yesterday's close, all three major U.S. indices had gains. The blue-chip Dow Jones Industrial Average Index rose 96.41 (0.78%) to close at 12,480.30. The tech-laden Nasdaq Composite Index was up 8.15 (0.35%) to close at 2,358.06. And the broader S&P 500 Index gained 8.33 (0.62%) to close at 1,362.30.
"When you see a durable goods number like this and then earnings outside of the financial sector doing quite well, people are beginning to realize that perhaps the contagion effect may be somewhat limited," Damon Barglow, of Boston-based Eastern Investment Advisors, said in an interview with Bloomberg Radio. "[The market] is realizing that there is a lower probability of a recession."
And there's the rub.
These new positive developments will only serve to complicate an FOMC decision that just days ago seemed a foregone conclusion.
"There was dissension to the emergency cut [last week] and the schisms at the Fed would be exacerbated by another large move," Joel Naroff, president and chief economist of Naroff Economic Advisors, Inc. said yesterday in a note to clients. "Thus, a compromise of 25 basis points should not be ruled out."
Added Naroff: "That might be coupled with a statement that hinted a move [before its next meeting] was possible."
The Fed has more than just an economic slowdown to consider, as any further rate cuts will push rates below the expected inflation rate for the year. Creating a negative real interest rate could have lasting repercussions and create new problems that will have to be addressed.
Among the potential problems that could arise from an overly ambitious rate-reduction campaign:
- Additional declines in the value of the U.S. dollar.
- Escalations in conventional price inflation, especially in such key consumer areas as food and energy prices.
- The return of so-called "stagflation," the combination of rising unemployment and spiking prices – a deadly one-two combination that first appeared in the United States in the 1970s. Before that, it was thought the two were mutually exclusive and could never appear together.
With investors anticipating a rate reduction of half a percentage point, anything less will be viewed as a disappointment by investors – even with a statement that foreshadows a possible intra-meeting rate cut.
Financials shares that have been buoyed by rate cut hopes will likely take a dive if the Fed doesn't come through.
Trading was light yesterday and will likely remain so, as the markets wait to see which way the Fed will move.
"Investors have been buying shares on the view that, with the help from lower rates, the U.S. economy can avert recession and corporate profits can rebound during the second half of 2008 – there is now a lot riding on the Fed and its announcement [today]," Frederic Ruffy, an analyst at Optionetics, told MarketWatch.
News and Related Story Links:
U.S. stocks cautiously climb ahead of Fed decision
- Money Morning:
Fed Fans Optimism and Fears With Surprise Rate Cut