Merrill watching stocks for Fed hints

By Ros Krasny

NEW YORK (Reuters) - The Federal Reserve's unending string of interest rate hikes has surprised some investors this year and there is no guarantee the central bank is done, a top Merrill Lynch strategist said on Monday.

Richard Bernstein, Merrill Lynch's chief investment strategist, said the equities sector that shows leadership over the coming weeks could be a signal of whether or not the Fed could pause soon.

"If the leadership in the equities market returns to commodities and energy, if gold goes back to $700 per ounce on a hint that the Fed is done, then the Fed is not going to be done," Bernstein said at the Reuters Investment Outlook Summit in New York.

Conversely, if there is a swing to more defensive stocks it could support ideas that a likely Fed hike to 5.25 percent in June -- a 17th consecutive move in the string that started in June 2004 -- will be the last move for now, he said.

Financial markets show upward of an 80 percent chance that the Federal Open Market Committee will raise rates by one-quarter percentage point after its June 28-29 meeting, but a limited chance -- about 33 percent -- for an additional rate increase in 2006.

"What amazes me is people's confidence in the Fed that they will get it right. ... The Fed has never gotten a tightening cycle just right," Bernstein said.

Uncertainty about the rate outlook, in part, encouraged Merrill Lynch to alter its portfolio balance in May, raising the cash component to 20 percent versus a 10 percent benchmark.

At this point "the markets are trading more on Fedspeak than on economics," Bernstein said.

"Investors had been treated to an immense amount of clairvoyance about what the Fed was going to do, and now they have no idea. The Fed's counterstatements have led to this great level of uncertainty," Bernstein said.

Over the past week Fed officials have struck a more unified note with a series of comments that have emphasized the risks of inflation. That has removed most doubts about the chance for an 17th consecutive rate increase in June.

Bernstein did not tie market volatility about the Fed's likely policy course to the arrival of Ben Bernanke as chairman in February after 18 years of Fed leadership by Alan Greenspan.

"I think in general that the comments coming from the Fed were trying to emphasize an immense amount of transparency at a turning point," he said.

Bernstein said the U.S. Treasury yield curve, which last week returned to a small inversion, was a key indicator to watch.

The U.S. 10-year Treasury yield <US10YT=RR> is currently trading just below the 5 percent fed funds rate for the first time since early 2001.

Historically, an inverted yield curve has been a leading indicator of recession in the United States economy, although lag times have varied timely, from two to as many as eight quarters.  Continued...