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The Federal Reserve has been trying to put out fires all over the financial markets; but the damage may be to wide spread to return the markets back to normal anytime soon. With rumors of additional bank failures and a fast approaching recession growing, traders have quickly turned on their forecasts for interest rates. In just a week’s time, the market has come from almost absolute certainty that the Fed would hold the benchmark lending rate this year (before entertaining hikes in the second half of 2009) to fully expecting at least one rate cut by the years end. In fact, Fed Fund futures are pricing in a 92 percent probability that the central bank will cut by a quarter percent to 1.75 by year at the October 29th meeting (with an 8 percent chance for a 50 basis point cut). Looking to the December meeting, a 25bp cut fully expected and there is a 27.5 percent chance that we will be at 1.50 percent. The further out we look, the steeper the curve becomes.

The Financial Crisis that has fully developed over the past week has focused everyone’s attention on the health of the credit and financial markets; but the long-term impact will be on the economy. With lending and business investment set to curb growth for an economy already suffering from a housing depression and tangible consumer sector contraction, a recession through the second half of the year seems virtually guarantee. This puts the US dollar on the chopping block, but the currency’s performance will still (as it always has) depend on whether the US recession is worse than the other major economies’ woes and whether the US can pull up first.

With the collapse of Lehman Brothers and the government takeover of insurance giant AIG, the credit markets have fallen into a panic state. Money market rates saw the biggest jump in overnight rates since records began and the three-month lending among banks (LIBOR) jumped the most since 1999. Few if any banks are willing to take additional risk in these markets, and lending is the primary victim. This leaves us in dire conditions as the lack of liquidity merely adds to the financial strain and further directs the economy into deeper waters.

While the Treasury and Fed have moved in to prevent the potentially devastating collapse of AIG, the sentiment among traders and investors suggests we are still deeply embroiled in a financial crisis that could lead the markets to a collapse not seen since 1987 or even the Great Depression. The general malaise is centered on the activity in the credit markets. However, the fundamental concern that has driven the lending prices to such incredible levels is the fear that many banks, lenders, insurers – and even those less financially dependent sectors further down the line – may be facing abrupt failures much like Lehman Brothers. Even if the companies are able to avert bankruptcy, there is still the issue of huge inventories of unmovable assets. As companies have to adjust their books for losses, there will be little room to take on additional fixed investment – especially as consumer demand shrinks with the contraction in growth that is borne from this crisis.

Even the casual observer of interest rates could tell there is something wrong in the credit markets by looking at a chart of any money-market, Treasury or consumer debt product. Reflecting the fear in the health of the financial system, rates on credit default swaps have rallied to levels not seen in decades and demand for risk-free and liquid, short-term money market products. The three-month T-Bill rate plunged to 0.233 percent today – the lowest it’s been since 1954. At the same time, money market rates are pushing recent record highs.  

For the market’s more traditional and accessible risk vehicle, equities have been incredibly volatile yet have not found a true confirmation of long-term bear trends. However, short-term losses show that the unusual circumstances is producing an overwhelming bearish sentiment; but investors are somewhat dazed by the unusual circumstances and are unsure of what the viable alternatives are as every asset class suffers. Looking at condition indicators, demand for puts has soared and the VIX volatility has soared to its highest level since Bear Stearns folded.