Market hinges on Fed committee meeting; Moody's reviews CBS.

U.S. interest rate policy takes center stage today as a much-awaited meeting of the nation's monetary policymakers gets underway.

Federal Reserve Board officials have their work cut out for them this week as they meet amid bond market concerns that inflation is on the rise and the U.S. dollar continues to weaken.

At issue is whether another increase in short-term rates is in order. Bond market analysts interviewed Friday generally believe the U.S. central bank will leave interest rate policy unchanged. They argue that recent economic news has failed to present the Fed with a clear picture of the overall economic fundamentals.

Treasury Market Yields Prev. Prev. Friday Week Month3-Month Bill 4.28 4.25 4.216-Month Bill 4.81 4.75 4.701-Year Bill 5.48 5.36 5.222-Year Note 6.15 6.06 5.843-Year Note 6.46 6.36 6.195-Year Note 6.93 6.83 6.607-Year Note 6.97 6.86 6.6310-Year Note 7.31 7.20 6.9830-Year Bond 7.60 7.51 7.26

Another incentive for the Fed to do nothing is uncertainty about how the global financial markets would react to a tightening move. Some feel the fixed-income markets would react negatively because such a move might act to validate investors' fear of inflation and signal that the Fed will continue to ratchet up rates.

"The Fed will hold steady and issue a directive which is biased toward tightening sometime in the near future," said Paul Kasriel, monetary economist at Northern Trust Securities.

Adding to the list of reasons for steady policy, Kasriel said it would be out of character for the central bank to tighten credit a few days before the release of the June employment figures. The Fed, he said, would rather have those numbers in hand before making any decisions.

A number of Wall Street observers subscribe to a scenario where the Fed would coordinate a tightening of credit with rate cuts by both the Bank of Japan and the Bundesbank. They believe that raising U.S. interest rates at the same time two other Group of Seven members nations ease policy would avoid a potential meltdown in the global marketplace.

"Tightening could be destructive to the financial markets in the U.S. and abroad," said Raymond Stone, a managing director at Stone & McCarthy Research Associates. "But moving at the same time as the [Bank of Japan] and the Bundesbank could help avoid that."

Such discussions could take place at this weekend's economic summit meeting in Naples, Italy, when the largest industrialized nations meet to discuss the global economy. Bond market players agree that interest rate policy and the weak dollar will be major points of focus.

The fragile dollar continued to hurt the Treasury market last week as investors speculated about the likely effect of its recent declines on Federal Reserve policy.

Government bond prices fell as market players remain fearful that the sliding dollar will force the central bank to raise interest rates sooner than expected.

Compounding the fears was the failure by central banks, through more than a dozen rounds of concerted intervention last week, to shore up the flagging dollar. With intervention looking less and less like a viable method of supporting the dollar, bond market observers are now more inclined to believe that rates are headed up soon.

Against that backdrop, market observers remain mixed on whether the central bank would boost credit in coming weeks to bolster the sagging dollar. Much of the debate centers on whether the Fed would be willing to support the dollar at the expense of maintaining economic expansion.

The consensus among Wall Street experts is that the Fed would not tighten credit solely because of weakness in the U.S. unit. At best, most say that the dollar would be a contributing factor to a decision by the FMOC to tighten credit.

Dollar weakness is a negative for fixed-income investors because of the inflationary implications inherent in a declining currency's value. Lower currency rates are inflationary because they generally make imports more expensive, provide an umbrella for domestic retailers and producers to raise prices, and shift demand toward U.S.-made products while factories are running near full capacity.

The problem for the bond market in such a rising-inflation scenario is the lack of demand for U.S. government and corporate securities, especially among foreign investors. Without the help of funds flowing out of other markets into U.S. investments, fixed-income observers continue to argue that the bond market will have a difficult time recovering recent losses.

Complicating the picture even further for inflation-weary bond investors were some mixed signals on price pressures in the national economy last week. On the bright side for the fixed-income markets, statistics released yesterday on import prices for May by the Labor Department revealed little evidence of import inflation. Though import prices rose 1.1% last month, on a year-over-year basis, import prices were up just 0.3% last month.

"The numbers are not horrible and suggest import price pressures haven't picked up all that much," said Michael Moran, chief economist at Daiwa Securities America Inc. He noted that excluding petroleum, import prices edged up 0.2% last month, following a 0.3% increase in April.

But bond investors are not getting ahead of themselves. They realize that one possible explanation for why the dollar's declines have not yet translated into higher import prices is that there is typically a long lag between exchange rates and any impact on final prices. In all likelihood, Moran said, it will take at least three months for the drop in the dollar to translate into higher import prices.

On the other side, a report from the National Association of Purchasing Managers shows that as activity in the manufacturing sector rolls ahead, price pressures are continuing to mount.

The NAPM index for overall business conditions slipped in June to 57.5 from 57.7 in May. A reading over 50 reflects an expanding economy.

The report also offered some signs of rising price pressures. The NAPM prices paid index rose to 73.5 in June, the highest level since August 1988 and up from 71.5 last month. The report says that price increases continued to spread and that more purchasing executives experienced instances of price pressures.

In the May and June NAPM reports, only 4% of the purchasing managers in the poll reported paying lower prices, down from 17% last July. Another 48% reported that they were paying higher prices in June. Back in March, only 28% said they were paying higher prices.

Stone of Stone & McCarthy said that if the manufacturing sector of the economy continues to expand at its current rate, it's only a matter of time before price increases are passed onto the cost of finished goods.

In futures on Friday, the September bond contract ended up 4/32 at 101.11.

In the cash markets, the 6% two-year note was quoted late Friday up 1/32 at 99.22-99.23 to yield 6.15%. The 6 3/4% five-year note ended up 1/32 at 99.05-99.07 to yield 6.93%. The 7 1/4% 10-year note was unchanged at 99.13-99.17 to yield 7.31%, and the 6 1/4% 30-year bond was up 2/32 at 85.04-84.07 to yield 7.60%.

The three-month Treasury bill was up six basis points at 4.28%. The six-month bill was up one basis point at 4.81%, and the year bill was up one basis point at 5.48%.

Moody's Investors Service said it placed CBS Inc.'s A3 senior unsecured debt ratings under review for a possible downgrade.

Corporate Securities

The review reflects Moody's concern that the significant cash outflow, estimated at about $2.9 billion, to current CBS shareholders as part of the company's merger plans with QVC Inc. will require significant external financing and that a sizable portion would be funded with debt.

Because CBS has a substantial cash position, Moody's said it anticipates approximately $1.7 billion will be debt-financed. In addition, a new class of convertible preferred shares will probably be issued. These additional fixed-income securities may significantly reduce the merged entity's financial flexibility and the cash flow coverage of fixed charges.

The review will first focus on the final terms of the proposed merger and their potential impact on cash flow coverage of fixed charges, the anticipated levels of cash flow, which will be earmarked for future capital deployments, and other financial measures. Also, Moody's will assess future operating strategies, possible synergies between CBS and QVC, and plans for the merged entity under new leadership to expand further.

Ratings affected are the senior unsecured notes and debentures rated A3, and senior unsecured shelf registration rated A3, Moody's said.

In Friday's secondary market for corporate securities, spreads of investment-grade issues narrowed by 1/8 to 1/4 of a point, while high-yield issues generally ended unchanged.

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