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The Week Ahead: Fed Stirs Debate

Sunday, 19 Aug 2007 | 5:36 PM ET

Investors hoping for the quiet dog days of August may find a reprieve from the market's summer storm next week, but they more likely will find themselves in markets tossed by a debate on the Fed's next move and the health of the economy.

The Fed relieved some anxiety with a half-point discount rate cut Friday and assurances that it would continue supplying liquidity to the banking system. The discount rate is the rate the Fed charges for short-term lending to financial institutions, and it currently stands at 5.75%.

The Fed also changed its view about the economy, noting that "downside risks to growth have increased appreciably."

Some on Wall Street are betting big that the Fed will cut its target for the more important Fed funds rate, starting at its next meeting Sept. 18. That rate is currently 5.25%.

The Dow gained 233 points or 1.8%, after the Fed's move Friday, ending a six day losing streak. At one point during the day the Dow soared 321 points.

In what was a volatile week for stocks, the Dow ended up losing 160 points, or 1.2% to finish at 13,079. The Dow is up 4.9% year-to-date. Nasdaq fell 39, or 1.6% for the week, and the S&P 500 was down 7 or 0.5%. The Nasdaq is up 3.7% year-to-date, and the S&P 500 is up 1.9% this year.

In a wild ride of its own, the yen moved to a 14-month high against the dollar. The yen stood at 114.21, gaining 3.6% against the dollar in just a week. The move up is a side effect of the unwinding of the carry trade. Traders used the popular 'carry trade' to borrow in cheap yen and invest in higher yielding currencies.

The bench mark 10-year Treasury gained 26/32 points for the week, lowering its yield to 4.673%.

Inside the Fed's Head

"I think the next week is going to be about market participants trying to get into the head of the Fed, trying to make a case of why an easing is going to happen," said Edward Marrinan, chief credit strategist for J.P. Morgan.

"The whole behavior and kind of positioning of the markets today (Friday) in the wake of the Fed's decision to cut the discount rate set the stage and raises the stakes around September 18. Everybody and his dog is waiting for interest rates to be cut. What happens if on September 18, the Fed says, 'No we're not cutting'?" he said.

"Our house view is that the Fed is going to cut, but we'd be remiss if we didn't consider the possibility that they don't," Marrinan said. "All the happy thoughts and positive momentum that could be generated by today's move could be lost and more."

In response to a question about troubled lender Countrywide Financial, Marrinan said the Fed move would help, but it was not intended to bail out the mortgage market. "This is not a panacea for all that's wrong in our mortgage markets," he said.

"We have a residential mortgage market that's not moving smoothly or properly," he said, adding the Fed was acting in its own interest to restore liquidity, not as a bail out to banks that gave easy credit to hedge funds or made bad mortgage loans.

Merrill Lynch's David Rosenberg, in a report titled 'Bernanke's Baby Steps,' said they've never seen the Fed cut the discount rate so much without a change in the funds rate, "so clearly it is trying to send a message to the markets without having to imply that it is panicking."

Rosenberg also called the cut "symbolic" and said the real message was in the Fed's statement. "Not a word about inflation this time - the Fed said that it is 'monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in the financial markets.'"

Citi's market strategist Tobias Levkovich, in a note Friday afternoon, said a cut in the fed funds rate seems more likely and that the Fed action seemed needed because of signs the economy is slowing from auto and housing worries, as well as credit market conditions.

Econorama

CNBC senior economic correspondent Steve Liesman says the real economic news this week will come from watching the Fed's actions in the markets. He also says watch the high quality credit markets. If the Fed continues to see too much constriction in the markets, it could make more moves to add liquidity including, perhaps, further tweaking that discount rate.

"It's worth it for investors to lengthen their time horizon on a fix. It's soccer, not football," he said.

"The big event of the week is going to be (Richmond Fed president Jeffrey) Lacker on Tuesday," said Liesman. Lacker will be speaking in Charlotte, N.C. on the economy. Liesman will be there to report on the speech and subsequent Q&A session.

The biggest data point of the week comes Friday when durable goods for July and new home sales are reported. Leading economic indicators are released Monday. Weekly jobless claims come out Thursday.

New Market Psychology

CNBC's Jim Cramer has been one of the most outspoken advocates for a Fed rate cut, and he was also early to warn investors to take profits just before the market turmoil began.

"This changes the whole psychology from one of depression to one of elation," said Cramer of the Fed's move.

"We're out of the woods," Cramer said, reaffirming his view that the Dow will end the year at 14,500. "Everybody who's been on the sidelines waiting can now act."

"A lot of people who have cash didn't want to put it to work because they didn't know if the center would hold, but now they do," he said. Cramer added that he would put money back to work even in groups that he was avoiding, like financials. "Everything you hated, you have to like, except for the home builders," he said.

Surveying the Experts

CNBC conducted a snap survey of market experts to gauge their view of the Fed news. Of the 50 economists, strategists and money managers responding, 46% said they believe the Fed will cut its target interest rate at or before its September meeting. The respondents on the whole also had a greater expectation that the Fed would cut rates.

More than half, 55%, said they believe we have seen the bottom of the stock market's correction.

Rick Santelli, CNBC's eyes and ears in the Chicago futures pits, disagrees with the idea of a September rate cut and thinks there may be more downward pressure on stocks.

"Do I think the low is in for equities? No. Do I think the equities are where the pressure is? No, I believe they are being held hostage," Santelli said.

"I think everything so far fits," Santelli said of the Fed. "But I still think for an actual, targeted rate cut, a lot of things have to occur between now and September 18 to make that a reality, and I don't think we're anywhere near that. To me, they are doing everything they can do to help, but they don't want to lob their biggest grenade."

Hurricane Watch

As hurricane Dean heads into the Gulf, the oil industry is watching closely to see if the storm will affect oil production facilities.

Oil rose 1.4% Friday, giving it a 0.7% gain for the week to $71.98 per barrel. Gasoline rose 3.1% Friday on a fire in Chevron's Pascagoula facility, and was up 4.3% for the week to $2.0388 per gallon.

"Everybody positioned themselves as much as they could here, knowing as precious little as we do. Our meteorology tells us (the storm's) size could be so big that it will be able to go in any direction," said John Kilduff, senior vice president with MF Global. "The most vulnerable part of the gulf looks to be southern Texas -- the Brownsville, Houston region, which is where the bulk of the oil and natural gas producing facilities lie. On top of that, depending on how it moves on shore, we'd be worried about the key refining facilities in Houston and the greater Houston area."

"Right now its looking like (it hits) Tuesday into Wednesday, but given how fast it's starting to move, we could advance that timetable," said Kilduff, a CNBC contributor. "There's other possibilities -- that it could stall, churn in the Gulf -- but that would also wreak havoc on the oil facilities and the ocean bed piping system."

What Would You Call It?

CNBC's Erin Burnett and her producer Ellen Egeth were searching for a name to describe the credit contagion, mortgage meltdown, global markets train wreck so they asked CNBC viewers what they thought.

Here's some suggestions: subprime slime; subprime shakedown; subprime sh*tstorm; subprimal fear; mortgage meltdown; mortgage shortage; mortgage massacre; Bernanke-panky; Fed fiasco; Bernanke bust; hedge trimmer; hedgie wedgie; hedge hog crisis; lend-ron; banking spanking; cranky Bernanke; debt wreck; liquidundrum; housing dousing; credit wreckoning; ill-liquidity and from cp to tp.

Personally, my favorites are subprime slime; subprimal fear and subprime tsunami. The last one has the real feel of the U.S. debt problem washing up on foreign shores and swamping them.

"I believe in quality over cleverness, so I would vote for 'mortgage meltdown,'" says CNBC Managing Editor Tyler Mathisen. "I also like 'credit wreckoning.' That was my own. Hence, I like it."