On The Street: Fed Chief Heeds Call For Cut

   By Dan Burrows and Rob Wherry
  Of SMARTMONEY.COM 

In his first big test since replacing Alan Greenspan at the helm of the Federal Reserve nearly 20 months ago, Ben Bernanke blinked. Taking a page out of his predecessor's memoir, the Fed chairman surprised the Street with an aggressive rate cut. Stocks soared as soon as the move was announced Tuesday afternoon.

After three months of dealing with the subprime mortgage mess, a subsequent credit crunch that required injections of billions of dollars into the economy and a jittery stock market that had fallen off as much as 9% from its all-time high earlier this year, investors of every stripe were calling (or, in the case of Jim Cramer, screaming) for Bernanke to lower rates. If he didn't, they warned, there would be dire consequences.

In the end, he didn't disappoint. After holding the target on the federal-funds rate steady at 5.25% for almost 15 months the Federal Open Market Committee, in a unanimous vote, trimmed it by a half percentage point to 4.75%, a level not seen since March 2006 and the first cut in four years. The central bank also lopped a half point off the discount rate that it charges banks for overnight loans. Equities reacted positively to the generous easing: The Dow Jones Industrial Average jumped 336 points to finish at 13,739.

"It's very encouraging that the Fed is doing what they need to do as opposed to doing what they think would look right, meaning that the Fed has to admit a little bit that they were wrong, that they should have cut a little while ago if they're being this aggressive now," says Art Hogan, chief market strategist at Jefferies & Co. "A lot of market participants have been saying that the Fed was behind the curve, but you can get caught up on monetary policy pretty quickly."

Now, investors are left to ponder what it all means. Who benefits from this cut -- and perhaps others that might come later this year? Is a recession on the horizon? In the end, though, we are betting Bernanke still has his work cut out for him. Energy prices remain high. The dollar continues to weaken against other currencies. And many investors think we still have even more bad news to digest from the housing market.

Bernanke "came out swinging," says Kurt Karl, chief market economist for Swiss Re. Karl says going forward he will be keeping a close eye on unemployment figures and signs of business confidence, like spending figures. He thinks the Fed will cut rates one more time by the end of the year. "I think this reduces the risk of a recession." Karl says. We may still have one, he hedges, but it will be "short and shallow."

That means all eyes are now focusing on 2008. "The cut will have no meaningful economic effect until next year," says Keith Hembre, chief economist at First American Funds. "You're looking at consumption growth that was 2% last quarter and will probably be 2% this quarter. I think it becomes weaker than that in the fourth quarter and into the first quarter of next year. Fed cuts can certainly help with that a little bit but I don't see a massive wave of borrowing."

True, Tuesday's cut could bode well for a few sectors like financial services and utilities, but they still carry significant risks, especially as the market's reaction was almost certainly disproportionate to the FOMC news. "Financials are all about to report earnings so that's a dangerous game to play," says Jefferies' Hogan. "They might not be the safest play this week. Historically interest rate cuts are good for financial and utilities, but I don't know that this is the environment to bet it."

No doubt, though, some financials-loving fund managers are happy with the rate moves. Bill Nygren, who manages Oakmark Select, was holding on to a large position in Washington Mutual (WM) that had caused the fund to trail its benchmark by 8.5% year to date. (WaMu closed up 5% Tuesday.) Bill Miller, who runs Legg Mason Value Trust, owns Citigroup (C), J.P. Morgan Chase (JPM), Capital One (COF) and Countrywide Financial (CFC). No doubt all these stocks will get a lift, too.

But alas, the euphoria of Tuesday's cut is likely to be short-lived. Indeed, Countrywide's troubles can't completely be fixed with a rate cut. The market may only be setting itself up for a fall as investors key in on earnings.

"Going forward I think this market will test the low end of the trading range simply because of the fact that we're going to be moving into earnings season," says Peter Cardillo, chief market economist at Avalon Partners. "There's the guessing game of how the subprime situation affected profits, and until we get a clearer picture of that the market probably will trend lower over the next few weeks."

And, of course, we'll all be back on Fed watch soon, fretting about a recession and tracking the news that's perceived as likely moving the Fed's needle: inflation, unemployment, consumer spending and earnings. "The data will be the driver of the market," Hogan says.

If that isn't spooky enough, the timing of the next FOMC meeting is rather inauspicious. It's slated for Halloween.

-For more information and analysis of companies and mutual funds, visit SmartMoney.com at http://www.smartmoney.com/

(END) Dow Jones Newswires

September 18, 2007 18:59 ET (22:59 GMT)