All E On Fed As Market Enters Second Half Interest Rate Action Will Adjust Tone On Boom Year

Bull or bear, just about every midyear market forecaster on Wall Street focuses first on the Federal Reserve.

Fed decisions to ease, or not to ease, credit conditions at its policy-setting meetings in July and August will set the tone for the remainder of what, so far, has been a blockbuster year for both stocks and bonds.

Although cryptic comments from Chairman Alan Greenspan have done little to clarify the Fed’s intentions, speculation has intensified that the central bank will push short-term interest rates lower when its policy-setting committee meets this week.

Or the action could come at the ensuing committee meeting in late August.

Fed policy has been in neutral for several months now after a yearlong series of credittightening moves in 1994.

But the stock and bond markets have forged ahead on the presumption the central bank, sooner or later, starts to nudge short-term rates lower in order to cushion a slowing economy against the risk of outright recession.

In the past, stocks and bonds have thrived in periods of easing credit conditions.

Some analysts worry, however, that the benefit may be muted this time by the sheer fact that a relaxation of policy has been so widely anticipated for so long.

The markets’ reaction from here on out may be determined more by how the Fed goes about any easing than the simple question of whether or not it decides to ease.

According to research by Mark Stumpp, chief investment officer at the investment advisory firm of PDI Strategies, past periods of aggressive cuts in short-term interest rates have been much better for stocks than gradual, tentative easings.

“Stocks could do pretty well if the Fed cuts interest rates sharply,” Stumpp says. But his data show a much less enthusiastic reaction by the markets to minor rate reductions.

At the same time, however, some observers worry that dramatic action by the central bank might scare the bond market, which is hypersensitive to any suggestion that inflation might revive.

For stocks, too, “how the Fed might lower interest rates becomes important,” says Greg Smith, market strategist at the brokerage firm of Prudential Securities.

“Do equity investors buy cyclical stocks, or do they stay with the multinational, more predictable growth companies?”

Dramatic action by the Fed, Smith says, would likely steer investors toward cyclical stocks, such as the auto group.

A very gradual approach would tend to favor growth companies not so closely linked to the ups and downs of the business cycle.