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WALL STREET INSIGHT – Mixed signals point to uncertainty

Investors focus on Tuesday’s Fed meeting: will it be 25 or 50 pt cut?

A RECESSION or simply a period of slow economic growth in which the economy glides gently to a soft landing before lifting off again? A modest 25 basis point cut in short-term interest rates, or a hefty 50 basis point reduction?

Considering the debates raging through the stock market over the outcome of the turmoil in the credit markets, the severe housing slump and the huge losses being suffered by the banks and investment houses due to their holdings in mortgage-backed securities, investors are left with those two essential, and closely related questions, and a high degree of uncertainty over their outcomes that’s likely to keep stocks volatile and range-bound.

The fate of the US economy is a long-term question, one which will only be answered over the next three or four months. But the question over how the Fed will choose to deal with the liquidity crunch and the threat to the economy will be answered tomorrow when the Federal Open Market Committee meets to decide on whether and by how much to cut the target interest rate for short-term loans.

‘This market is in dire need of help and reassurance right now, and we got some of that on Friday from Treasury Secretary (Henry) Paulson’s plan for sub-prime mortgage borrowers, and now Wall Street is waiting on pins and needles to see what the Fed is going to do for it on Tuesday,’ said Joe Kalinowski, chief investment strategist at Grace Financial.

The Fed is widely expected to trim at least a quarter point from its 4.50 per cent target Fed funds rate, but the market believes that a half point cut is needed to ease the liquidity problems besetting the economy and help stave off a recession. Some Wall Street economists believe that Fed chairman Ben Bernanke and the other members of the FOMC will agree.

‘The risk of a recession is better than 50 (per cent) at this point, with jobs growth slowing, businesses having trouble getting credit, and home prices continuing to fall,’ said David Rosenberg, Merrill Lynch’s chief economist.

‘While the inflation hawks on the committee will not make this an easy decision, I think there’s a better than 50 (per cent) chance that the Fed will choose to cut 50 basis points in order to stave off a recession and send the right signal to the market,’ he said.

But after the release of the November jobs report last Friday, showing moderate jobs gains and strong wage increases, Joel Naroff, president of Naroff Economic Advisors, said he believes the Fed will have a hard time making the case for a half percentage point cut in the Fed funds rate.

‘The economic data is sending us mixed signals over the health of the economy, and that should result in a fierce debate within the FOMC over how much to cut. It is likely we will get a rate cut, but that will probably be 25 basis points at best,’ he said.

Stocks in New York closed little changed on Friday after the latest mixed signal – an employment report that showed that job growth fell precipitously from 170,000 in October, but still came in at fairly robust 94,000 last month.

While the Dow Jones Industrial Average gained 5.69 points at 13,625.58, the S&P 500 slipped 2.68 points, or 0.2 per cent, to 1,504.66. The Nasdaq too closed the day down, by 2.87 points, or 0.1 per cent, to 2,706.16.

For the week, the Dow gained 1.8 per cent, the S&P 1.6 per cent and the Nasdaq 1.7 per cent.

With the Federal funds futures market on the Chicago Board of Trade reflecting a 40 per cent chance of a 50 basis point cut, an interest rate cut of half a percentage point will likely be greeted with a strong celebratory rally tomorrow, traders said.

‘Even if the Fed only gives us a 25 point cut, we could see a rally if the FOMC says in its statement that it’s prepared to cut more if the conditions warrant,’ said Bruce Bittles, chief investment strategist at Robert W Baird & Co.

While the Fed meeting is expected to be the climactic event of the week, there will still be three days of trading left for investors to consider and reconsider their positions. Traders said they are braced for more of the same volatility that has defined the stock market for more than a month now.

Indeed, the durability of any gains will hinge on what the news of the week tells investors about another big short term uncertainty vexing the market, namely how the financial sector is weathering the sub-prime shakeout. That begins on Thursday with Lehman’s fourth quarter earnings report.

Goldman Sachs and Morgan Stanley report the following week. Brokerage reports will be watched very closely for signs of more sub-prime related credit writedowns. During the third quarter, Lehman wrote off more than US$1 billion of loans.

Investors won’t lose their focus on the economy, as inflation data, in the form of both producer and consumer prices, are reported on Thursday and Friday, respectively. Another big item is retail sales for November, also released on Thursday.

 

Source: Business Times 10 Dec 07

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