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Week Ahead: Banking Reform Will Overshadow Even the Fed

Banking reform will likely overshadow the Fed in the coming week, as Congress edges closer to a new financial regulatory reform bill whose effect on the financial sector is still murky.

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Investors will also trawl through housing and other data for signs the economic recovery is on course, after a recent batch of disappointing indicators rekindled fears of a double dip recession.

The Fed's two-day rate meeting should end Wednesday with no policy changes, but the Fed may give a nod to the risks the ripples from the European debt crisis pose for the economy. U.S. economic data, particularly Thursday's weekly jobless claims, could be a problem for markets if it continues to show up weaker than expected.

"The most important things, broadly speaking, that are going to drive the markets over the next couple of months are going to be [financial regulation] and the employment picture," said Jason Trennert, chief investment strategist with Strategas Research.

Concerns about Europe's sovereign debt mess were temporarily pushed aside, and the euro turned in a 2.3 percent weekly gain against the dollar, to $1.2374. The currency got a boost as European leaders agreed to release results of stress tests of major banks. A successful Spanish bond auction also helped the euro and calmed fears that that country would soon seek a bailout of its own.

The Dow rose 238 points or 2.4 percent in the past week, and the S&P 500 also rose 2.4 percent to 1117. The S&P had its best two week performance since November, 2009 and its highest close since May 18. Gold settled at a new high Friday of $1,258.30.

Gold
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Gold

Investors will also continue to watch BP's mile-deep oil gusher in the Gulf of Mexico, as it increasingly becomes an economic concern and a negative for markets. The energy sector did recover 2.7 percent in the past week.

"It's hard to watch the circus that was before Congress yesterday (Thursday) and feel bullish about buying stocks regardless of your feelings about BP's culpability...So much of this comes down to policy, and there's a relatively small amount of officials and policy makers in Washington, Brussels and Beijing that are casting a very wide shadow over the financial markets," said Trennert.

Citigroup chief U.S. equities strategist Tobias Levkovich said the crisis in the Gulf is negatively impacting companies and stocks, and creating long-term uncertainty about the future shape of the oil industry, and its regulation. But he said the decline in energy stocks has also created a buying opportunity in the sector, which has also been hurt by a stronger dollar.

Financial Reform

The shape of financial regulatory reform is still unclear, as conferees meet on major aspects of the legislation next week. The committee is aiming to reach a compromise that would combine the House and Senate legislation by Thursday, with floor votes the following week.

"Obviously, the desire is to get it done before July Fourth because they all go on vacation. I don't know if you hear a lot more than you've heard this week but you'll probably get a sense of what the bill will look like," Trennert said. The most important issue to resolve is what happens to the swaps businesses of banks, which the Senate bill required be separated from the rest of the business. Under a compromise version, those assets could be retained by parent companies but isolated.

"That's the most important part of it in terms of its immediate potential impact on the financial markets. They're going to obviously be forced to have enough capital so they're going to have to recapitalize that part of the bank. It is also going to be a fairly meaningful earnings hit. It's the devil in the details," he said. "If it's going to raise capital requirements for financial institutions that are already worried about having adequate reserves, it may eventually be good policy, but I'm not sure it's the best policy right now."

On Tuesday, the conferees will take on consumer financial protection and whether to limit fees on debit card transactions.

"If you look at the stocks that haven't made it back above the 200-day moving average, financials are one of them and that's due to [financial regulation]," said Art Hogan, managing director at Jefferies. The S&P financial sector was up 2.3 percent in the past week, but it's down more than 8 percent in the past two months and has been one of the worst performers since April.

Levkovich said he likes regional banks but is staying away from the diversified financials that would be impacted by the bill. "Regional banks...don't have to worry about derivatives, swaps, too big to fail or prop trading for the most part," he said.

Progress on financial reform legislation would also give President Obama a blueprint to share with other world leaders when he reaches the G-20 meeting in Canada next weekend. Obama meet with G-8 leaders in Huntsville, Ontario at the end of the week, ahead of the G-20 meeting in Toronto. G-20 finance ministers have been working toward a more unified approach to regulating the global banking system though an agreement is not expected until the end of the year.

"I'm not sure he'll have anything definitive although I think he can credibly go to G-20 and indicate the U.S. is well on its way to establishing a 21st century regulatory process and I think Europeans will come and say we're addressing our fiscal issues and we have provided reassurance to the markets about the status of the banking sector. I think everybody is addressing the issues that come up in their part of the world," said Robert Sinche, chief strategist at Lily Pond Capital.

"China has clearly focused on its issue and said leave us alone on the currency," he said. The U.S. had been pushing China to let its currency appreciate against the dollar.

Market Has 'Extreme Lack of Conviction'

Whither Stocks

The overall market is likely to churn this summer, Levkovich said. "There's an extreme lack of conviction, so if the market is trending up investors kind of go with it and if it's trending down, investors kind of go with it...It was three weeks ago when you had that 330-point drop in the Dow, partially because of the jobs number. That was enough to tear some people's hope out," said Levkovich.

"So they're looking for something, and the fact the market has been able to bounce back from its low and cross the 1100 level on the S&P gives the them a feeling it's not just falling apart on them. Our view is that we go through the summer, we're going to go up and we're going to go down but there's not going to be a lot of things that will tell you what to believe or not to believe," he said. Levkovich said he still expects the S&P to end the year at 1175, and that it may make a move higher towards the end of the year.

Trennert sees equities as the best value from an asset allocation point of view, but stocks may not perform until some of the uncertainties, like regulatory reform, are resolved. "I think all of these uncertainties are the main reason why investors are willing to leave money in money market funds, or put money to work in bonds and are unwilling to pay 12 times earnings for Microsoft," said Trennert. "The range of outcomes from either the economy or policy are so wide that nobody wants to take risks."

If the harshest elements are removed from the financial reform bill, he said stocks could rally.

Levkovich said U.S. investors focus so much on Europe because they worry the U.S. could face the same fiscal issues and that is a head wind for the market. But the anticipated report form the bipartisan commission on the deficit and efforts by politicians to show fiscal restraint around the mid term election in November may help the market.

Investors are also concerned about higher taxes in 2011, as the Bush tax cuts expire at year end. He also said the fact that individuals will have to pay higher taxes may not be all negative. "That's another sense of more fiscal responsibility if you're going to have to pay," he said.

The upcoming earnings season may bring a few bumps of its own. "Earnings estimates are going to be trimmed down, and people are putting in the foreign exchange affects from Europe," he said. "You've got worries about the slowdown in Europe, worries about the economic indicators potentially having slowed their momentum domestically, and we've got a couple of numbers, whether its retail sales or the Empire State index, which just aren't fantastic. We have this perverse expectation things have to get better and better and that's not how economic trends occur. You put that all together, and the news flow won't be that fantastic but it won't be all that bad either."

In the next week, earnings from Walgreen are released Tuesday. Bed Bath & Beyond and Nike report Wednesday, while Discover Financial , Oracle and Researchin Motion report Thursday.

Econorama

The Fed's two-day meeting could result in a slight tweak to the Fed's statement but it is not likely to say much more than that it is concerned about Europe, analysts and economists say.

Trennert said besides the Fed, he thinks jobless claims could be a big item to watch and they could be a market mover. "This (past) week claims were disappointing. The longer we go without employment picking up, the greater the concerns about a double dip. I still think that's remote, but it's important. I think the problems in Europe are of such a magnitude that the Fed is going to continue to keep liquidity ample," he said. "I would say there's very little chance of getting a surprise from the Fed until well into 2011."

Housing data tops the list of economic data in the coming week. Existing home sales and FHFA home price data are reported Tuesday, and new home sales are Wednesday. Durable goods are reported Thursday, as is weekly jobless claims data. On Friday, consumer sentiment and the final look at first quarter GDP are released.

The Treasury in the coming week auctions $40 billion in 2-year notes Tuesday; $38 billion 5-year notes Wednesday, and $30 billion in 7-year notes Thursday.

Questions? Comments? Email us at marketinsider@cnbc.com

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.