Hope grows for a half-point cut

NEW YORK (CNNMoney.com) -- A quarter of a point cut or a half of a point cut? That is the big question for investors to grapple with ahead of next week's Federal Reserve meeting.

Wall Street has heard signals loud and clear that a cut is coming. Fed Vice Chairman Donald Kohn said last Wednesday that the central bank needed to be "nimble." The next day, Fed chair Ben Bernanke indicated in a speech that the Fed will stay "alert" and "flexible."

"Bernanke gave the markets an early Christmas gift. If there were any doubts about a rate cut, they are now gone. He wrapped it up, stamped it and sent it in the mail," said John Norris, managing director of Oakworth Capital, a private bank based in Birmingham, Ala.

According to futures listed on the Chicago Board of Trade, investors are placing a 100 percent bet that the Fed will lower the key federal funds rate by at least a quarter of a percentage point to 4.25 percent on Dec. 11. What's more, traders are factoring in a 34 percent probability of a half-point cut to 4 percent.

The central bank reduced the fed funds rate, an overnight bank lending rate that affects how much interest consumers and businesses pay on a wide variety of loans, by a half of a point on Sept. 18 and by another quarter of a point on Oct. 31.

The rate cuts have come in response to the turmoil created in the financial services sector as a result of the subprime mortgage meltdown.

Problems in the housing market have caused gut-wrenching volatility in the stock and bond markets since August. Investors are worried about the future of many large financial institutions.

Big diversified banks Citigroup (Charts, Fortune 500) and Wachovia (Charts, Fortune 500), mortgage lenders Washington Mutual (Charts, Fortune 500) and Countrywide (Charts, Fortune 500), investment bank Merrill Lynch (Charts, Fortune 500) and government sponsored enterprises Fannie Mae (Charts) and Freddie Mac (Charts, Fortune 500) have reported write-downs associated with the credit crunch and bad investments in mortgages.

The Fed has already indicated in its most recent economic outlook that it expects the economy to slow somewhat in 2008, partly because of the mortgage woes.

Stocks have rallied in the past week - a move Norris said has been sparked by renewed optimism that the Fed will act aggressively in order to stave off a recession.

"All signs are pointing to weaker growth next year, so the Fed might be thinking that it should not wait around. They may want to just get a half-point cut on the table sooner rather than later since the markets expect rates to go to 4 percent at some point next year."

In fact, according to the fed funds futures, investors are pricing in a nearly 100 percent chance that the federal funds rate will be 3.5 percent by July.

Michael Strauss, chief economist with Commonfund, a money management firm based in Wilton, Conn., said the Fed's willingness to cut rates now might be an acknowledgment that it was too slow to lower interest rates earlier this year. He thinks the Fed was focusing too much on inflation concerns and not enough on the possibility of economic weakness.

"Kohn and Bernanke have recognized that the Fed's gotten this wrong," Strauss said. "They should have been more forward-looking in March when you first began to have the subprime problems surface and saw that the housing market was in for a big correction."

Strauss added that it is a good sign that the Fed seems to realize that it now might need to be more proactive in order to ensure that the housing problems don't worsen.

"There is the potential, if we continue to see weak data, for a 50-point cut," Strauss said. "If things don't get better, the Fed will be more aggressive."

But John Kosar, director of research with Asbury Research, an institutional research firm in Chicago, said he thinks that the Fed's two rate cuts are already serving to restore some order to the financial markets and that the Fed might be wise to keep rates unchanged on Dec. 11.

The market chose to focus on Kohn's description of the Fed's policymaking stance as "nimble," but Kosar pointed out that he thinks investors may be ignoring other comments from the Fed that hint at a more balanced approach.

To that end, Kosar noted other language in Kohn's "nimble" address. Kohn said: "In general, nonfinancial businesses have been in very good financial condition; outside of variable-rate mortgages, households are meeting their obligations with, to date, only a little increase in delinquency rates, which generally remain at low levels."

Of course, Fed comments are like Rorschach tests for economists.

"People read into the Fed's comments what they want to. People picked out one word from Kohn," Kosar said. "To me, maybe the market is a little too overeager and aggressive with its rate cut expectations. The Fed has gone out of its way in speeches and minutes to suggest that what's going on with subprime and housing is contained and not spreading."

Kosar is clearly in the minority view, however. The Fed may be trying to talk up the economy to prove that it still has inflation fighting credibility. But based on recent performance in the bond market this is clearly not the message investors want to hear.

As such, the yield on the benchmark 10-year U.S. Treasury has dipped below 4 percent. The bond rally (prices and yields move in opposite directions) is a sign that fixed-income investors are more worried about an economic slump and not inflation.

"We think the rally in high-quality bonds will continue into the new year. One source for that rally is the investor perception, which we share, that the Federal Reserve is likely to continue along a market-friendly policy course for fear that market anxiety will spill over into the rest of the economy," wrote Joe Balestrino, fixed-income market strategist at Federated Investors, in a report last week.

The Fed may be worried that the end of the housing slump is still a ways off and that for this reason, the central bank needs to be vigilant, Balestrino added.

"The Fed's actions in recent months have apparently been driven by worry that the lending market, particularly that for very short-term debt, was freezing up. That concern is likely to persist for as long as the housing crisis lasts," Balestrino wrote. "And bottoming in that sector probably will play out not over months, but quarters. This leads us to expect more Fed rate cuts going forward."

And with oil prices now retreating below $90 a barrel after flirting with $100, the market - and Fed - probably has even less reason to worry about inflation.

"The Fed has indicated it is willing to cut the federal funds rate further if they have to. Tighter financial conditions increase the downside risk for the markets and economy," said Alan Levenson, chief economist with T. Rowe Price. "Given the level of concern about the economy in the short-term, the Fed should put inflation on the back burner."