Fed rate cut may haunt Wall Street

By Ellis Mnyandu -Analysis

NEW YORK (Reuters) - Stock market players are clamoring for the Fed to cut interest rates, hoping that such a move by the U.S. central bank will rescue listing credit markets and restore investors' shaken confidence.

They should be careful what they ask for. If history's any guide, a rate cut by the Fed could sound the death knell for the bull market's run from late 2002.

At best, the cut in the Fed's benchmark rate would be seen as underscoring the U.S. central bank's intent to do everything it can to ease anxiety in the financial markets.

But to other investors, it may signal growing unease about slowing economic growth inside the Fed, whose policy-setters had until recently made fighting inflation the core of their policy thrust.

A cut would also show that losses stemming from the U.S. subprime sector have seeped deeper into the broader economy, causing the Fed to want to forestall the prospect for an even sharper slowdown, analysts said.

But as the turmoil from the subprime sector grows, what's deemed good for credit markets may not be so good for stocks.

"People are taking it for granted that the rate cut will help the stock market," said Rajeev Dhawan, director of the Economic Forecasting Center at the J. Mack Robinson College of Business in Atlanta, Georgia.

"If the Fed cut," he said, "that would mean it's really admitting that the economy is weak ... so why should stocks" head higher?

The Fed's policy-setting committee is scheduled to meet and pronounce its decision on interest rates on Sept 18. The Fed has left its benchmark fed funds rate target unchanged at 5.25 percent since late June 2006.

Even before that September meeting, some investors are growing optimistic about a likely cut in the Fed's benchmark rate. But not everyone sees such a move as a panacea as the housing market stalls further.

ROOM FOR SURPRISES

A cut in the Fed's discount rate at which it lends to banks and its statement that "tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward" nonetheless showed on Friday that the latest upheaval in the credit markets has given authorities room to surprise or to swiftly change course when needed.

As such, the biggest test for stock investors in the coming days, analysts say, would be interpreting each action that the Fed takes as authorities keep their policy toolbox close at hand.

"I think a cut in interest rates is inevitable and the right thing to do. I think most people in this business will probably tell you that," said Warren Simpson, managing director at Stephens Capital Management, in Little Rock, Arkansas.

But would a fed funds rate cut make the stock market go higher?

"There's no guarantee that it would," said Liz Ann Sonders, chief investment strategist at Charles Schwab & Co., based in San Francisco, California.

"The most recent experience (a series of cuts that started in January 2001) was quite disastrous," she said. "Ultimately, it depends on the health of the overall economy."

Market data shows that the Fed's rate cuts in the wake of the 2001 recession coincided with or spawned underperformance of stocks as economic malaise persisted.

As soon as the Fed moved to raise rates, starting in June 2004, U.S. stocks charged ahead, adding fuel to a bull rally that as recently as last month propelled the S&P 500 .SPX and the Dow Jones industrial average .DJI to records.

Research from Birinyi Associates Inc, based in Connecticut, shows that on average, the stock market had already begun to rebound in the month before a cut by the Federal Reserve.

Average performance of the S&P 500 shows a gain of 2.46 percent, a month before a surprise Fed cut, and a 2.76 percent jump for the Dow Jones industrial average in that period.

On the day of the change, the Dow showed an average gain of 1.9 percent and the S&P 500 an increase of 2.52 percent.

So if and when the Fed rate cut comes, the stock market could already have priced in the worst-case scenario for the economy, making it likely that it could try to defy recent history and actually head higher despite the cut.

"You have mixed messages. Everybody wants to have a rate cut, but at the same time, if you do have one it's symbolic of deeper problems," said Cleveland Rueckert, market analyst at Birinyi Associates. "It's hard to tell whether people underestimated the fallout from the subprime mortgage sector or they are overreacting to the attention that it's gotten."

(Additional reporting by Cal Mankowski and Kristina Cooke)