U.S. Stocks To Extend Fed Honeymoon Next Week

NEW YORK (MarketWatch) -- Stocks are expected to continue rising next week, lifted by sustained optimism over the hefty cut in interest rates delivered by the Federal Reserve this past week, analysts said.

But the market's advance might still be dented, or even derailed, by a slew of economic data, along with the dollar hitting record lows, crude oil at record highs, possible profit warnings and potentially more victims of this summer's credit crisis.

"The Fed is blanketing the economy with lower rates, which is a positive scenario for the market," according to Paul Mendelsohn, chief investment strategist at Windham Financial Services.

"Though we're not out of the woods yet, we might be OK going forward unless we have something major that takes us back to where we where a couple of weeks ago, with banks and funds falling apart," he said.

Over the past week, the market was jolted out of its credit-market anxieties after the Fed cut rates by 50 basis points, twice the size expected by Wall Street. The move, and comments by Fed officials, signaled that the central bank thought there were serious risks of a credit seizure impacting the broader economy.

On Tuesday, the Dow Jones Industrial Average jumped 336 points, or 2.5%, as Wall Street cheered the move.

Wall Street cheered the move given that stocks historically tend to perform better when interest rates are falling, said Owen Fitzpatrick, head of the U.S. equity group at Deutsche Bank.

"We'll still remain choppy in the near term, but we're setting ourselves up for long-term benefits from rate cuts," he added.

For the week, both the blue-chip average and the S&P 500 Index advanced 2.8%, their best weekly performance since March. The Nasdaq Composite Index gained 2.7% on the week.

Also helping to lift the market this week, the Wall Street middlemen at the center of the credit crisis -- Goldman Sachs Group , Morgan Stanley , Lehman Brothers Holdings , and Bear Stearns Cos. -- all posted quarterly profits. Their executives also sought to assure investors that the worst of the credit crisis is past.

Consumer, economic worries

But not all earnings were rosy over the past week. FedEx Corp. , which often serves as an economic barometer, warned Thursday that soaring fuel prices and turmoil in housing and financial markets are hurting earnings.

Also on Thursday, Circuit City Stores Inc.'s quarterly loss was wider than expected and sent retail stocks sharply lower.

"There is general concern about earnings growth now that the economy is slowing," commented Deutsche Bank's Fitzpatrick.

Next week, investors will turn to earnings from retailer Bed, Bath & Beyond Inc. on Wednesday and Rite Aid Corp. on Thursday for more clues on consumer spending.

Home builder Lennar Corp. will also report earnings Wednesday, while KB Home reports Thursday.

But the third-quarter earnings season will really kick in later in October, leaving investors uncertain. "Earnings continue to paint a mixed picture, but Wall Street is looking toward October and figuring that the weak expectations have been built in," wrote Marc Pado, market strategist at Cantor Fitzgerald, in a note. "We've got weeks to wait for that data."

A heavy week for economic data will culminate Friday with key August reports on personal income and consumer spending, along with the core personal-expenditure index, the Fed's favorite measure of inflation.

Ahead of this, the Conference Board will report on Tuesday its September index on consumer confidence. Also Tuesday will be existing home sales, to be followed by August durable-goods orders on Wednesday and new home sales Thursday.

Friday also will see the Chicago purchasing-managers index and construction-spending reports.

Not everyone cheers Fed's move

While stocks rallied last week, the rate cut led the dollar to slide tall-time lows against the euro, which helped send crude oil and gold to record highs, rekindling inflation fears and lifting long-term bond yields.

Lower rates make the dollar less attractive against other currencies. The U.S. dollar sank to parity against the Canadian dollar, while the euro rose above $1.40 for the first time.

Meanwhile, most commodities, including oil and gold, are dollar-denominated. When the buck's value falls, it takes more dollars to buy the same amount of a commodity, therefore lifting its price.

With other imports also becoming more expensive, some fear that the Fed's move could fuel inflation down the line. Those concerns were reflected in long-term bonds, which fell after the Fed's rate cuts, lifting their yields.

Bond yields move inversely to price. Bonds provide fixed income, and long-term bonds especially lose value as inflation rises over time.

The benchmark 10-year bond fell in price this week, while its yield rose to 4.62%, compared with 4.46% last Friday.

Some market strategists believe the economy and the market can handle a little inflation to boost growth.

"We knew that this was coming," said Cantor Fitzgerald's Pado. "It is a good excuse for a short-term pullback, but we would be willing to accept higher inflation if it means better economic growth. This will take months to pan out."

Reverse conundrum

With 10-year yields, used to benchmark most mortgage rates, now rising, some analysts fear that the Fed's rate cut (or cuts) won't have the desired effects on the economy, especially on housing.

When former Fed Chairman Alan Greenspan raised short-term interest rates between 2004 and 2006, long-term bond rates failed to rise in unison, as normally happens. Greenspan called the phenomenon "a conundrum," which he attributed to Asian central banks and others buying long-term bonds, which kept their yields low.

"It's now getting to work in reverse," said Windham Financial's Mendelsohn. "Asians are staying away from Treasurys with the dollar falling and commodity prices rising, [and] 10-year yields are going to rise. It's going to make the housing market worse."

By Nick Godt