Get into Our Head on the Fed 9/20/05

Good Morning.

Today we will discuss our views of what we believe the Federal Reserve will likely do. This has been the most uncertain Fed meeting that market participants have been involved with over the last couple of years. Allow us to outline the three most likely scenarios that we believe may occur.

First, the Fed has the option to continue on its path that it has been on for quite a while. This would entail raising rates by 0.25, detailing how the risks to growth and inflation are roughly balanced, long-term inflationary expectations are under control and that they intend on raising at a "measured pace".

Second, the Fed can pause and would likely alter the language to compensate by sounding very hawkish. Statements of how the pause is temporary and is related to uncertainties from Katrina will likely be found.

Third, the Fed can raise rates 0.25 yet dramatically change the language that we are accustomed to. They can sound dovish, delete the almighty "measured pace" phrase (which they would love to do), and express an inclination to WATCH the data as it flows over the next six weeks. They can positions themselves in a "watch" mode which would offer tremendous transparency into their next action.

Your friendly neighborhood Kcap Team believes that scenario number three is the most likely. Remember, the recent inflation data has been ominous. In fact, several sequential reports are indicating a disturbing inflationary trend. The Fed's primary reason for existence on the planet Earth is to preempt inflation. Given the difficult decision to fight inflation or protect growth, the Fed will err on the side of fighting inflation, each and every time.

The Fed is also well aware of the implications of retarding economic growth, much like they did when they maintained tightening for too long a period of time in 2000. They are aware of potentially catching the blame for throwing the economy into a recession. However, Alan Greenspan does not want to leave his post, scheduled for January 2006, as the Fed Chief that allowed inflation to reemerge as the ugly force that it once was. His low interest rate policy during his entire tenure has always been criticized as potentially causing a systemic inflation problem. No one is more aware of these risks than the man himself.

There are a lot of uncertainties in the U.S. Economy at this moment; however there are a lot of certainties as well. Why not attack the problems that are "certain" and watch and react to the "uncertain" problems as they develop? Inflation and the housing boom are "certain" problems today; therefore the Fed needs to behave accordingly by raising rates. Furthermore, inflation needs to be acted on preemptively, whereas fostering economic growth has a shorter reaction time to Fed stimulus. Remember, growth retardation from Katrina is still "uncertain".

We believe the stock market will react differently in all three scenarios.

• In scenario one, the stock market will likely sell off due to the dismantling of the "hope trade" for a Fed pause.
• Scenario two, will likely result in a stock market rally due to the continuation of the "hope trade" claiming the Fed is finally done (disregarding their language that this was likely a temporary pause).
• Scenario three will likely cause a knee-jerk sell off reaction that would be swiftly bought. Economists and analysts when analyzing the accompanying Fed statement would spin it positively in demonstrating the Feds new flexibility and transparency. Stock market participants would slowly rebuild the "hope trade" that the pause they were hoping for today will now only be six weeks away. Furthermore, they will likely know its coming as early as the Fed does through the flow of economic data.
  

In light of our view that scenario three is the most probable, we will ride through the Fed meeting approximately 60% invested and look to add a little more into a dip.

Enough said on the Fed.

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