Stocks Soar on Fed's 75-Point Rate Cut

Equities surged Tuesday after the central bank provided another boost to liquidity, citing concerns over growth and heightened inflation risks

The markets didn't receive exactly what they expected from the Federal Reserve on Tuesday, but investors seemed to be quite pleased with what they got.

While investors were widely looking for the Federal Reserve to cut the benchmark Federal funds target rate by a full percentage point to 2.00%, the Fed shorted Wall Street by a quarter. The policy-setting Federal Open Market Committee voted 8-2 to cut the rate by 75 basis points to 2.25%, and also effected a similar-sized cut in the discount rate, to 2.5%.

Before the Fed's announcement, major indexes were enjoying a nice rally. In the immediate aftermath of the decision, major averages gave back a small portion of their earlier gains, but they came back with force in the final hour of trading.

Investors also took some cheer Tuesday from some better than expected earnings from two big Wall Street firms.

The Dow Jones Industrial Average, after a brief 87-point dip, surged to end 420.41 points, or 3.51%, higher at 12,392.66. The S&P 500 index, which also gave back some of its early upside move, closed up 54.14 points, or 4.24%, at 1,330.74. The Nasdaq composite index did not change much in the wake of the rate cut but it too charged higher toward the end of the session, finishing 91.25 points, or 4.19%, higher at 2,268.26.

On the New York Stock Exchange, 29 stocks traded higher for every 3 that lost ground, and on the Nasdaq the ratio was 22-9 positive.

In its post-meeting statement, the policy-setting Federal Open Market Committee said that recent information indicates that the outlook for economic activity has weakened further. The Fed also noted that growth in consumer spending has slowed and labor markets have softened.

"Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters," said the FOMC.

But inflation concerns remain. "Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization."

"Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully."

The Fed said that its recent rate cuts and its measures to foster market liquidity should help to promote moderate growth over time and to mitigate the risks to economic activity.

"However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability."

The FOMC left the door open for more easing ahead, says Action Economics.

The vote was 8-2 with two dissents, Dallas Fed president Richard Fisher and Philadelphia Fed president Charles Plosser, both against the size of the cut, preferring a less aggressive action.

While the 75-point easing was disappointing in one sense, "the Fed did so much over the weekend and on Monday by opening up the discount window to broker-dealers, and with Goldman Sachs and Lehman Brothers earnings [beating estimates on Tuesday], they probably decided it was unnecessary to push it and that 75 would be enough," says Bill Stone, chief investment strategist at PNC Wealth Management in Philadelphia. "And the markets are storming back."

The U.S. central bank also left the door wide open for more easing in the future if needed, he adds.

Arun Raha, U.S. senior economist at Swiss Re, interprets the Fed's rate cut differently. In a statement, he wrote that the Fed's willingness to ease rates as much as 75 basis points "shows it doesn't believe that the action it took last week to expand its securities lending program, or its emergency measures over the weekend to increase market liquidity, are enough."

Although he sees the economy in or close to a recession, he believes if a downturn materializes it will be short and shallow. Raha bases that view on the hefty monetary stimulus that's in the pipeline, the temporary fiscal stimulus coming alter in the year, thin business inventories and the boost in exports from a weaker dollar.

The Fed's emphasis on the increasing inflation risk in its statement seems odd at a time when the focus is on reining in the effects of the financial crisis, but Stone at PNC says he thinks the Fed was probably just reminding the public about its mandate to ensure price stability as well as economic growth.

"The big thing is that the Fed is not behind the curve. It will address these problems as they come up," says Doug Roberts, chief investment strategist at Channel Capital Research in Shrewsbury, N.J. When events pose a potential risk to the financial system as a whole, as the liquidity drain at Bear Stearns did, the Fed "will address it and prevent it from spiraling out of control," he adds.

Skeptics argue that the Fed isn't reducing the moral hazard by continuing to cut rates and provide bailouts, but Roberts doesn't agree.

"They're not going to guarantee that somebody’s going to get out of this alive," he says. "With Bear Stearns, [the Fed] said, 'This is the sale, there’s no room for negotiation because there's too much risk to the system. Making sure you get a return on your investment is not our concern.'"

Citing the mixed signals from February's inflation reports, Roberts said he believes the Fed is betting that inflationary pressures will ease over time.

Whether the stock market can sustain the investor optimism seen Tuesday is anyone's guess. PNC's Stone said he'd like to hope that the financial crisis is nearing an end, with the Bear Stearns collapse serving as the requisite crescendo.

"Valuations for stocks are very inexpensive relative to safe investments, like Treasuries," he says. "It's wholly unappetizing to buy Treasuries at these levels."

With stocks in the S&P 500 Index offering an average dividend yield of 2.30%, vs. a 1.58% yield for 2-year Treasury bonds, investors seem to be getting paid for taking a risk on equities right now, he says. "So you can afford to sit in stocks. It's rare that you get stocks yielding more than 2–year Treasurys," he says.

Stone's view is a lot sunnier than the one that Massimo Tosato, vice chairman of the fund firm Schroders, expressed to Reuters on Tuesday. Speaking at a funds summit in Luxembourg, Tosato said that the credit crisis could last for the next 12 to 18 months, while retail investor appetite for risk could take up to two years to return, according to a Reuters news advisory.

Traders were encouraged Tuesday by better than expected earnings from Goldman Sachs (GS) and Lehman Brothers (LEH). The market largely ignored a larger than expected rise in the February core producer price index and a dip in February housing starts.

On Monday, investors digested news of JPMorgan Chase (JPM) acquiring Bear Stearns (BSC) for $2 per share, and the Federal Reserve cutting the discount rate and taking steps to expand lending to big financial firms.

The Fed has been unusually active in the run-up to the FOMC meeting, to say the least. The Fed basically brokered the JPMorgan-Bear deal over the weekend, and took some remarkable steps to ease the stress on financial markets -- its first weekend move in nearly 30 years. The U.S. central bank cut the discount rate on Sunday to 3.25% from 3.5%, and announced that it will lend to the 20 primary dealers that buy Treasury securities directly from it -- a tool not used since the Great Depression. The Fed will also provide up to $30 billion to JPMorgan to help it finance the purchase of Bear Stearns.

Goldman Sachs said its fiscal first-quarter net income dropped 53% on $2 billion in losses on residential mortgages, credit products and investments, interrupting 10 quarters in a row of higher year-over-year earnings. But results still topped the expectations of Wall Street analysts.

"Market conditions are clearly very difficult," said Goldman CEO Lloyd C. Blankfein. "But we saw strong customer activity across many of our franchise businesses in the first quarter. Although market conditions present many challenges at the moment, they also offer considerable opportunities." Goldman shares rose 24.6% to close at $175.59.

Meanwhile, Lehman Brothers reported a 57% drop in fiscal first-quarter net income amid weakness in its fixed-income business, but like Goldman its results also topped analysts' expectations. The firm has been the subject of much market speculation about its financial health in the wake of Bear’s collapse. Lehman CEO Richard S. Fuld Jr. said, "our results reflect the value of our continued commitment to building a diversified platform and our focus on managing risk and maintaining a strong capital and liquidity position." Lehman shares traded 46.4% higher at $46.49.

Treasury Secretary Henry Paulson said the U.S. economy had turned down sharply but declined to label the situation a recession. "We know we're in a sharp downclimb and there's no doubt that the American people know that the economy has turned down sharply. So to me, much less important is the label that's placed on it today. Much more important is what we do about it," he told NBC's Today Show.

In a separate interview on ABC's Good Morning America, he described the economy as being in a "sharp decline."

The U.S. producer price index rose 0.3% in February, lower than the 0.4% that markets had expected. However, the core rate, excluding food and fuel, was up 0.5%, much hotter than the 0.2% expected. The numbers follow January's 1.0% gain on the headline, and 0.4% on the core. The headline pace is now running at 6.4% year-over-year, vs. 7.4% in January. The core rate is up 2.4% from a year earlier, vs. 2.3% the month before.

U.S. housing starts slipped 0.6% to a 1.065 million unit annual pace in February, but bigger than the 0.990 rate that markets had expected. Moreover, it follows a large upward revision in January to a 1.071 million rate (1.012 million before). However, starts are still down 28.4% over last year (from -27.9% previously).

April NYMEX crude futures settled $3.74 higher at $109.42 per barrel on Tuesday.

Gold prices gave back earlier gains and reversed lower as the dollar index climbed after the Fed announcement. April gold futures fell $24.10 to $978.50 per ounce. The support above $1,000 earlier in the session had been bolstered by reports that South African electric utility Eskom said power may have to be cut to the gold and platinum mines if more generators fail because of bad weather.

Among Tuesday’s stocks in the news, Yahoo! (YHOO) filed an investor presentation that details its three-year financial plan and strategic initiatives which are expected to roughly double operating cash flow over the next three years from $1.9 billion to $3.7 billion and generate $8.8 billion in revenue excluding traffic acquisition costs in 2010. The presentation supports a unanimous determination by Yahoo's board of directors that Microsoft’s (MSFT) Jan. 31 unsolicited acquisition proposal "substantially undervalues Yahoo!." Yahoo shares rose 7.0% to $27.66.

Pilots at Delta Air Lines (DAL) notified company officials they remain unable to reach agreement with their counterparts at Northwest Airlines (NWA) on how to integrate pilot ranks if the two airlines combined -- a deadlock that could scuttle the merger sought by the two carriers, according to a Wall Street Journal report. Delta shares were up 9.3% at $10.09.

NYSE Euronext (NYX) set a $1 billion share buyback and raised its annual dividend 20%, to $1.20.

European stock markets recovered some of Monday’s big losses. In London, the FTSE 100 index gained 3.54% to trade at 5,605.80. In Paris, the CAC 40 index rose 3.42% to 4,582.59. Germany’s DAX index advanced 3.41% to 6,393.39.

Asian markets posted gains overnight. Japan’s Nikkei 225 index rose 1.5% to 11,964.16. The Hang Seng index in Hong Kong climbed 1.42% to 21,384.61.

Treasury market

Treasury yields rose, and prices fell, as traders digested the Fed's rate cut decision, which will put more pressure on bonds. The 10-year note was 1-04/32 lower at 100-15/32 for a yield of 3.44%, while the 30-year bond fell 29/32 to 100-24/32 for a yield of 4.33%.

Before it's here, it's on the Bloomberg Terminal.