Fed cuts to mark pre-Xmas trading

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By Jeremy Gaunt, European Investment Correspondent

LONDON (Reuters) - Investors head into what for many will be the last full trading week of the year expecting more stimulative U.S. interest rate cuts but rattled by emerging dissent over how governments should boost ailing economies.

They will also get another check on the post-credit crunch health of the financial sector with fourth-quarter earnings results from banking giants Goldman Sachs and Morgan Stanley .

The price of oil, meanwhile, is likely to be in particular focus with oil-producing nations meeting to discuss supply cuts at a time when lower prices are one of the few areas of easing pressure on monetary authorities.

Investors needed no new stress after a year which has seen the global banking model break down, the value of stocks halve, lending freeze up and volatility soar, but the new wrinkle is squabbling among authorities about how to proceed.

"The problem is that when you have politics involved ... you get a lot of back and forth. It's not like when you watch economic data," said Michala Marcussen, strategy director at Societe Generale Asset Management.

Failure by U.S. lawmakers last week to agree a bail out for America's top automakers was a shock to the system for investors who have become used to governments and central banks pledging to do what it takes to build confidence and flood the global economy with money.

There was a similar U.S. Congress impasse over a financial bailout package earlier in the year, which ended in a compromise. But the latest fight means there will be no automaker bailout passed this year.

To that can be added a growing row in Europe over how far governments should go to pump up deteriorating economies. In unusually undiplomatic terms, German officials have been slating others, primarily Britain, for going into debt with rescue plans.

For investors -- who hate uncertainty -- it all suggests more volatility ahead just as some confidence was coming back to markets. State Street's latest investment flow data, for example, showed a tentative growth in risk appetite.

RUNNING OUT OF ROOM?

One area from where help is almost certain to come, however, is the Federal Reserve, which meets on Tuesday. The U.S. central bank is widely expected to slash interest rates by as much as 75 basis points to just 0.25 percent.

Since the financial crisis escalated in September 2007, the Fed has cut rates from 5.25 percent to the current 1.0 percent in order to pump money into both the U.S. banking system and the now recessionary economy.

There is a debate among investors, however, about whether it is working, given the continued deterioration of the economy and the volatility of financial markets.

Former Fed Governor Frederic Mishkin said last week that such talk was wrong and asked just how bad things would have been if the Fed had not acted as aggressively as it has.

But the issue is also arising -- and not just in the United States -- of what happens when rates are so low that they cannot be cut anymore.

Quantitative easing, which essentially entails pumping money into the system by boosting money supply, is likely.

One impact of this for investors could be on government bonds, which central banks might buy to keep yields low.

But whatever the impact, investors are ending the year in a new environment.

"The unprecedented nature of the crisis has caught out forecasters and policymakers alike," ING said in a note. "Led by the U.S., past monetary and fiscal norms are being abandoned in desperate attempts to curtail recession and deflation."

OIL AND BANKS AGAIN

Investor attention this week will also be on foreign exchange and energy markets.

In the case of the former, volatility jumped at the end of last week after the U.S. automaker bailout failed, with the dollar weakening sharply after five weeks of gains against major currencies <.DXY>.

Focus will be on whether the latest weakness is a short-lived reaction or whether the currency's recent burst of strength is now over. The soaring yen may also begin to concern Japanese authorities.

The price of oil, too, will be in focus with the Organization of Petroleum Exporting Countries (OPEC) meeting on Wednesday in Oran, Algeria.

Crude has fallen close to 70 percent since peaking in mid-July as a weaker global economy has smothered demand. This has removed inflation as a worry for general investors and allowed central banks to cut rates.

But OPEC is expected to agree a large cut in supply at the Oran meeting. The cartel's president has called for a more "severe" reduction than the 2 million barrels a day already agreed.

And then there are the banks. Goldman reports on Tuesday and Morgan Stanley on Wednesday. Both are expected to announce quarterly losses, but the reports will be studied for signs of further credit-related woes or signs of improvement.

Goldman has announced at least 4,800 jobs cuts globally as it weathers the financial storm, while Morgan Stanley has announced at least 6,800.

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