Desperately Seeking Optimism

GOOD MORNING. Stock in Asia closed higher today; U.S. futures are pointing to a higher open.

Will the Fed go from cautious to upbeat? That’s the big question today as traders await the Federal Reserve’s policy statement and decision on interest rates this afternoon. Most economists expect the Fed to leave rates unchanged, while adjusting its statement on the economy to reflect improving business conditions. Question is, how will the markets react if the Fed changes its tone, hinting at rate hikes to come?

The economy does seem to be improving these days, according to a variety of recent indicators. U.S. auto sales improved for many manufacturers in October, with GM recording its first year-over-year gain since January 2008. Pending home sales and construction spending have also been trending higher. And the ISM manufacturing index registered a big jump in October, beating consensus estimate handily. The index rose to 55.7 (53 was anticipated), up from 52.6 in September—the best results since April 2006. Both the production and employment components of the index surged in the month. Traders will get a better sense of employment strength when ADP releases figures on non-farm payrolls today.

Of course, economists also see some clouds in these figures. Home sales got a big surge from tax credits for first-time homebuyers, points out economist David Rosenberg of Gluskin Sheff. And if those tax credits are allowed to expire then home sales could dry up. The government’s fiscal stimulus programs and low interest rates have had the effect of making credit much cheaper too, but much of that easy money has been offset by a collapse in bank lending, which Rosenberg figures is the equivalent of a 300 basis point rate hike. “It remains to be seen which effect outlasts the other,” he notes.

The markets have grown more volatile too, often rising early on positive economic news only to give up much of the gains in the afternoon or next day. Some strategists say the markets are likely to remain range-bound for some time. Stocks are “undergoing a digestion” since their 40% surge from the bear-market bottom in March, according to Sam Stovall, Standard & Poor’s chief investment strategist. Stovall expects a pullback in prices over the near term and thinks the S&P will close the year around 1055, only slightly higher than its closing level yesterday, though he has a 12-month target of 1150.

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