Stock Drop After Fed Rate Cut

Bernanke & Co. trimmed the Fed funds rate target to 2.0%, but lack of clarity about future moves caused confusion in the markets

The Federal Reserve delivered what Wall Street expected Wednesday afternoon by cutting the key interest rate by a quarter percentage point to 2.0%. But its murky statement dampened the enthusiasm and the early rally in stocks, leaving investors confused about what to expect next.

At the start of the session Wednesday, stocks were buoyed by a preliminary report showing that first-quarter U.S. gross domestic product rose by a better than expected 0.6%, and ADP's private employment index that showed a 10,000 rise in payrolls in April.

Then at 2:15 pm ET, the policy-setting Federal Open Market committee lowered its target on the federal funds rate by 25 basis points to 2.0%, as well as the discount rate by 25 basis points to 2.25%.

The lack of clarity in the Fed's statement about whether or not Bernanke and his crew plan to take a breather in their monetary easing campaign and a less fervent than expected stance toward inflation spurred confusion in the markets. Even more importantly, it sent a signal to currency traders that the firming of the dollar seen in recent weeks wasn't justified. The dollar promptly dropped, while bonds rallied on expectations that interest rates will remain depressed.

By the close at 4 pm ET, the blue-chip Dow Jones industrial average gave back a 168-point gain -- which had propelled it back above 13,000 -- to close 11.81 points, or 0.09%, lower at 12,820.13. The broader S&P 500 index pulled back from the 1,400 mark to end down 5.35 points, or 0.38%, at 1,385.59. The tech-heavy Nasdaq composite index lost 13.30 points, or 0.55%, to close at 2,412.80.

The Fed's mixed message about the economic and inflation outlook left investors wondering what the Fed will do next. In its press release, the Fed said that recent information "indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further." The Fed also noted that financial markets "remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters."

The market's confusion over the Fed's stance toward inflation was understandable given its statement: "Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The FOMC expects inflation to moderate in coming quarters, as energy and other commodity prices level out and pressures on resource utilization ease. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

"The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity", the Fed said. "The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability."

Board members Richard Fisher and Charles Plosser voted against the Fed funds cut, preferring no change in the target.

The drop in the dollar re-ignited inflation fears around the price of oil, and that's likely to undermine the intended effect of the tax rebates, which the Bush administration hopes will stimulate consumer spending.

"A large part of [the rebate checks] is going to be used to pay for gasoline," says Diane Dercher, chief economist at Waddell & Reed Financial in Overland Park, Kan., noting how much energy prices have risen just in the past month.

That only exacerbates the damaging effect that the declines in financial wealth and home values and the weakening in real wages are having on consumers, she says. And with scant hope for "a huge, more permanent fiscal stimulus package out there like we saw in the early 2000s," she says it's hard for her to see anything that will drive consumer spending.

Renewed concerns about inflation hurting consumers' purchasing power were clearly reflected in shares of Procter & Gamble (PG), which had been up nearly 4.0% on a strong earnings report but slid back to close just 1.8% higher.

There need to be signs of stability in the housing market and lower mortgage rates to stimulate mortgage loans before any meaningful turn in the economy, says Jill King, senior portfolio manager at Horizon Cash Management in Chicago.

"We have seen some indicators that lead us to believe there's a return to normalcy, she says, citing tightening of credit spreads and higher dermand for corporate bonds on the Street. The substantial sell-off in 2-year Treasury bonds has pushed the yield on those bonds above the fed funds rate, which is a sign the market thinks the Fed, after Wednesday's action, is done cutting rates for a while, she says.

Arun Raha, senior economist at Swiss Re, said in a note that he believes the Fed will be reluctant to cut any further, since inflation remains elevated, and the central bank doesn't want inflationary expectations to increase. The substantial monetary easing in the pipeline and a further boost from the fiscal stimulus package coming this summer will cushion the downturn, making any recession, if is occurs, moderate, he said.

Rajeev Dhawan, director of the Economic Forecasting Center at Georgia State University in Atlanta, disagrees, saying he doesn't see a return to normalcy from recession-like conditions for a year or two, compared with the one to two quarters it typically takes for the economy to bounce back.

The economy is in the middle of what Dhawan terms a "recessionary zone which will last until the end of this year." assuming that home prices stop declining by that time. "We will have a tough time characterizing this as a recession by the standard definition. Sectorally, some [sectors] are clearly in recession or even depression," he says. "This is going to be a flat U. We don’t come out of the funk for a while."

King at Horizon believes there could be more credit problems ahead, but she says "we’ve seen the worst of losses in the major financial institutions" and doesn't think there's a bigger shoe left to drop. But she hopes that any return to normalcy is measured so it doesn't ignite inflation, which so far has been mostly limited to food and energy prices.

In economic news, advance first-quarter GDP rose 0.6%, vs. consensus expectations for a 0.5% rise. The deflator was up 2.6%, vs. consensus for a 3.0% reading. Elsewhere, the first-quarter headline PCE price index was at 3.4%, unchanged from the prior-quarter reading, while the core figure, which excludes food and energy prices, came in at 2.0%, versus the fourth quarter's 2.1%.

The U.S. employment cost index (ECI) slowed to a 0.7% rate in the first quarter, from 0.8% in the preceding quarter. Wages and salaries were steady at a 0.8% pace, while benefits slowed to 0.6%. On a year-over-year basis, ECI held at a 3.3% rate, the same as the prior three quarters. Wages and salaries slowed to a 3.2% rate, from 3.4% previously, while benefit costs accelerated to a 3.5% rate, from 3.1% previously.

The U.S. ADP private payroll survey showed jobs rose 10,000 in April, from a revised 3,000 increase in March (8,000 previously). The data are nevertheless stronger than expected and should weigh on Treasuries and support further gains in the dollar, says Action Economics.

The U.S. MBA mortgage market index sank 11.1% for the April 25 week, while the purchase index fell 4.8% and the refinance index plunged 16.2%. Average mortgage rates actually retreated slightly after a big jump the week prior, with the 30-year fixed rate down 3 basis points to 6.01%, the 15-year fixed off 7 basis points to 5.53% and the 1-year ARM down 7 basis points to 6.86%.

The Chicago Purchasing Managers' Index held steady at 48.3 in April, above the median, vs. March's 48.2 reading, but its employment component fell to 35.3 (similar to February's figure), from 44.6 in March. New orders were down slightly at 53.0, vs. 53.9 in March.

June NYMEX crude gave up early gains to trade $2.17 per barrel lower at $113.46 after the release of weekly data showing a larger-than-expected increase in crude inventories. The Energy Information Administration reported a 3.8 million barrel rise in crude stocks, vs. the half-million barrel build that traders expected. Meanwhile, gasoline supplies, seen down 0.5 million barrels, actually fell 1.5 million barrels, while distillate stocks climbed 1.1 million barrels, versus expectations for an unchanged reading.

Among the stocks in the news on Wednesday, shares of automaker General Motors (GM) rose 9.4% after the company beat analysts' expectations of a $1.60-per-share loss with an adjusted loss from continuing operations of 62 cents per share in the first quarter, vs. a one-cent loss one year earlier, on a 1.7% revenue drop. The auto maker noted improved adjusted automotive operating performance, rapid growth in emerging markets, continued cost performance in GM North America, and liquidity of nearly $24 billion, despite the impact of the American Axle strike on North American operations and weakness in the U.S. auto industry.

Citigroup (C) shares dropped 4.0% after the company announced the pricing of its offering of $4.5 billion, or 178,076,770 shares, of common stock. The offering was priced at $25.27 per share. S&P maintains hold.

Procter & Gamble posted third-quarter EPS of 82 cents, vs. 74 cents one year earlier, on a 9% sales rise. The company sees 76-78 cents fourth-quarter EPS. P&G raised its 2008 EPS forecast to $3.48-$3.50 from $3.46-$3.50 due to its strong January-March quarter results. Shares rose 3.2%.

Time Warner (TWX) shares fell 2.8% after the company reported a 36% decline in first-quarter profits Wednesday following an asset sale a year ago and said it would spin off the rest of its cable business. Revenues rose 2% to $11.42 billion from $11.18 billion.

Chicago Bridge & Iron (CBI) shares fell 17.5% after the engineering and construction company posted lower-than-expected first-quarter earnings of 43 cents per share, vs. 38 cents a year ago, despite a 68% revenue rise.

European stock indexes were trading mostly higher Wednesday. In London, the FTSE 100 index edged down 0.03% to 6,087.30. In Paris, the CAC 40 index gained 0.39% to 4,996.54. Germany's DAX index advanced 0.92% to 6,948.82.

Asian indexes finished lower. Japan's Nikkei 225 index declined 0.32% to 13,849.99. In Hong Kong, the Hang Seng index fell 0.61% to 25,755.35.

Treasury Market

The 10-year bond rose 24/32 to 98-04/32 while the yield dropped to 3.73% from 3.82% as bond bulls regained confidence after the dollar dropped in response to market confusion about what the Fed's next move might be, Action Economics said. The 30-year note gained 1-13/32 to 98-16/32 for a yield of 4.46%.

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