Trouble ahead for the Fed

NEW YORK (CNNMoney.com) -- Since the Federal Reserve cut two key interest rates by a half of a percentage point two weeks ago, the Dow Jones Industrial Average has gained 5 percent. The Dow hit a new all-time high Monday as fears of a credit crunch-induced recession appear to be waning.

The Fed got what it wanted. Or did it? The markets' reaction may actually complicate matters for Fed Chairman Ben Bernanke and his fellow policy makers at their next scheduled meeting on Oct. 30-31, and create a new conundrum - to use a word made popular by Bernanke's predecessor, Alan Greenspan - for the Fed.

Stocks have rallied since the Fed cut interest rates on Sept. 18 on hopes that more cuts are coming.

...but bond yields have risen as well, a possible sign that fixed-income investors don't think more rate cuts are likely.

On the one hand, it may be easy for the Fed to declare that its big rate cuts helped restore confidence in the financial markets and decide to keep the federal funds rate steady at 4.75 percent and the discount rate at 5.25 percent.

The federal funds rate, an overnight lending rate that banks charge each other, affects the rates on various types of consumer loans, while the discount rate is what it costs banks to borrow directly from the Federal Reserve.

The Fed also cut the discount rate by a half of a percentage point in a surprise move on Aug. 17. And since that date, the Dow is up 10 percent.

Clearly, the Fed's actions sent a message that it is ready, willing and able to respond in times of crisis to prevent further weakening of the markets and the economy.

"What the Fed did had more to do with psychology than fundamentals. It showed the markets it would provide liquidity and not cause the housing markets to cause more havoc," said Jeff Cummer, president and chief portfolio manager, with SMH Capital Advisors, a Fort Worth, Texas-based money management firm.

But by moving so quickly to soothe the worries of investors, the Fed may also have raised the expectation that it will keep cutting rates. And it may be this expectation of further rate cuts, and not the actual rate cuts themselves, that are fueling the market's recent rally.

According to federal funds futures listed on the Chicago Board of Trade, investors are pricing in a strong likelihood of a quarter-point rate cut at the Fed's next meeting.

Investors are pricing in a 100 percent probability that the central bank will cut rates at least once by the end of the year and that by next spring, rates could be as low as 4.25 percent. So to use another of Greenspan's famous expressions, investors may be once again suffering from "irrational exuberance."

"Investors have built in expectations for another rate cut in October and future moves beyond that. But that's totally inconsistent with the substantial improvements in the market. Much of the basis for the Fed's move was to restore some of the order within the markets," said Keith Hembre, chief economist with First American Funds in Minneapolis.

With all this in mind, what's the Fed going to do on Halloween? Will it give investors a trick or a treat?

Hembre thinks investors will be disappointed. He said he believes the Fed will keep rates unchanged at its next meeting unless there is more data that points to a "material swoon" in the economy.

The record low pending home sales figure reported Tuesday could qualify as more evidence that the housing market woes have the potential to spill over into the broader economy.

But Hembre said the Fed could also point to "skyrocketing" oil, gold and other commodity prices as evidence that inflation is not yet dead and use that as justification for keeping rates steady.

Ted Parrish, co-manager of the Henssler Equity fund, agreed that the Fed might be able to sit tight later this month.

"It's not a shoo-in that the Fed is going to cut again. With the market firming up, I can see the Fed backing way from a rate cut. With Citigroup (Charts, Fortune 500) and UBS (Charts) taking big write-offs, everyone is giddy, thinking that the worst is over," Parrish said, referring to the fact that both bank stocks rose Monday following news of third-quarter charges due to exposure to bad subprime mortgage loans.

To cut rates again, Parrish said, the Fed will probably need to see another disappointing jobs report. That could come Friday, when the government releases the latest employment figures.

A rise in unemployment to 4.7 percent in September from 4.6 percent in August - an increase that's expected - could lead the Fed to lower rates in October.

"The unemployment report this Friday will play a big role in what the Fed does. It alone won't dictate if the fed cuts rates but if there are fewer jobs created that will ease labor costs and make inflation less of a problem," Parrish said.

But SMH Capital's Cummer thinks the Fed should be more concerned with the lagging U.S. dollar, which could lead to longer-term pricing pressures.

"On a global basis, the pressure is for higher interest rates," he said. "The more the dollar continues to decline, the higher inflation you have. By lowering interest rates, the Fed has actually created an inflation problem for themselves and will eventually have to raise rates again."

Cummer added that even though fed funds futures are pointing to another rate cut, and investors in stocks are clearly banking on more cuts, he thinks the bond market doesn't share that opinion.

To that end, the yield on the benchmark 10-year U.S. Treasury has actually increased slightly since the Fed lowered rates on Sept. 18.

"The bond market isn't sold on the idea of more rate cuts," he said. "People in the fixed-income market realize there is little room for the Fed to cut interest rates since the dollar is so pathetic."