special reports

The US economy and its volatile currency have come to the end of 2008 at a major crossroads. At its last policy meeting, the Federal Open Market Committee lowered the benchmark lending rate for the last time to target a range between zero and 0.25 percent range. And, while this technically leaves the policy group the option to officially drop the rate to zero; this is not likely a move they will make as they look to avoid the stigma attached to a zero interest rate policy (ZIRP). However, an ongoing credit crisis and ballooning recession nonetheless demands action from policy makers. Looking ahead, the Fed will probably increase its joint activities with the US Treasury in trying to boost liquidity for short-term loans, guaranteeing new debt and taking so-called toxic debt off banks’ balance sheets. Considering considerable efforts have been made to do all of these things in past months, the market will remain understandable pessimistic. Ultimately, only a rebound in lender and investor confidence can set things right.

Market conditions seem to have improved considerably over the past few months. However, this may me more a reflection of year-end position squaring and liquidation than a genuine improvement in sentiment. Indeed, low liquidity has clearly snuffed out high volatility across the spectrum of asset classes, which has further supported congestion in the hard-hit credit and equity markets. When investors and policy makers return for the new year, they will find financial conditions are actually in a worst state than they were through the final quarter of 2008. With banks hording cash, capital shrinking and consumer wealth plunging, there are far greater difficulties ahead.

The US and global recessions are deepening going into the new year. The initial credit shock of 2008 has had its impact on banking, financial institutions and housing, However, the damage won’t end there. The next, major collapse in this unfolding crisis will be consumer spending.  Accounting for some 70 percent of overall growth in the US, the future of domestic consumption will determine whether the world’s largest economy is looking at a mild slump in GDP or full-blown depression. And, looking at recent data, the outlook is bleak. Unemployment is soaring and consumer confidence is at record lows. Certainly, the bottom is not yet in sight.

Activity in the capital markets over the past few weeks should be evaluated from a bigger picture perspective. While equities have gained ground, LIBOR rates have contracted and credit has improved, it is largely due to the unusual levels of liquidity and position squaring for accounting purposes. Where the market’s go in the first quarter of 2009 will be a question of fundamentals and the overall health of investor sentiment. Neither looks promising. The world’s capital base will continue to shrink as the global recession unfolds; and the lack of available funds will further discourage from banks and traders from taking risks. Another ongoing issue will be the health of the world’s major corporations. No longer is the financial crisis isolated to the financial sector. Recently, the ripples have hit the US auto manufacturers. At this pace, it will only be a matter of time before other consumer-related industries buckle.

Stocks have been more-or-less range bound for the past month – helping to establish a potential launching point for a possible trend reversal. However, a recovery from the equities market would have to find a rebound in optimism to truly develop. While there is the possibility that risk-takers may deem P/E ratios and other gauges of relative value as enticing, risk appetite is not very deep and fundamentals will certainly not support a true turn in the market. A lack of money circulating through the economy will pinch earnings and curb production activity. Commodity prices will better reflect economic activity.

Like underlying market activity, general risk trends have reverted back towards historical means thanks largely to the downtime the market has been given through the holiday / year-end period. However, this break may play an integral step in permanently stabilizing sentiment – a necessary first step before the eventual recovery stage. With panic largely exercised from the October wave of deleveraging, traders are now taking a critical look at the cumulative effort that has been made to thaw lending and spending. If the drop in credit default risk, market-based LIBOR rates and volatility indicators holds, it could mark the first step.