As expected, the Federal Open Market Committee cut the benchmark Fed Funds rate by 25bp to 2.00 percent – the lowest level since November of 2004. Given current conditions, the easing would be expected to further ease the burden on the credit markets and revive risk appetite. However, considering the tepid, initial reaction from the money market and risk premiums, it seems this move was already priced in by both traders and banks. There was clearly a shift in both risk-free and high-yielding paper heading into the rate decision, suggesting the market had heavily favored the modest easing. But, where do the markets go from here? With yields for short-term paper (both risk-free and speculative) rising, default premiums plunging and longer-maturity rates rebounding, the market may be signaling the worst is past.

Risk appetite is still a big question mark for the credit markets. While fears of ongoing debt default have plunged over the past two months, this shift is no doubt specifically influenced by the better-than-expected earnings over the past few weeks. On the other hand, the risk aversion reflected in the junk bond spread’s stubborn hold near recent record highs may be somewhat misleading as demand for both Treasury and corporate paper recover from the credit crunch in tandem. However, until corporate yields outpace risk-free, banks will remain cautious.

Signs that the credit crunch is beginning to thaw are most visible in the money market. Both Treasuries and Libor rates have experienced a tentative rebound since the closing days of March – representing a waning demand for paper with low risk and high liquidity. Looking more broadly, the rising taste for risk is tangible. Just last week, mortgage securities were outperforming Treasuries for the first time this year. What’s more, demand for the most recent 5-year T-note auction hit a 2003 low, while corporations issued a record $43.3 billion.

With a general rebound in risk appetite spreading more freely through global financial markets, equities have enjoyed a return to their bullish roots. Through the past week, the benchmark Dow composite rose nearly 1.6 percent all while fear and volatility gauges have fallen. However, the tentative recovery in stock markets has been certainly far slower going than the six-month panic-fueled sell off that preceded it. Considering Wednesday’s two major economic releases, the market’s hesitancy comes as little surprise. First, the Fed’s 25bp cut reveals the policy group has reduced its aggressive pace of easing; while their statement hints at a neutral policy stance for the immediate future. The first quarter GDP numbers are similarly concerning. While the world’s largest economy was able to avoid the beginnings of a recession through the first quarter, consumer spending cooled sharply. With sentiment recently hitting a 26-year low, the Q2 outlook is rather bleak.

The past week’s equity market advance was somewhat uneven across the major economic groups. Consumer-related firms reported a modest advance on par with the performance of the broad Dow index as data has confirmed Americans’ confidence levels have pushed new lows despite the economy’s resilient hold to positive growth. More prominent however has been the performance of the financial sector. A more than 5 percent jump in the index reflects banks’ sensitivity to the rebound in liquidity amid the hard-hit credit market.

Gauges of fear and volatility extended their pull back over the past week. Guided by the slow rebound in risk appetite and the modest, rising trend in equity markets, the S&P Volatility Index dropped below 20 percent last week - its lowest level since December of last year. At the same time expected volatility has cooled, fear of a new downleg in equities has similarly dropped with the put-call ratio slipping to a trend low. However, if both of these indicators are to sustain their declines, the Dow and S&P 500 will likely need to overtake 13,000 and 1,400 respectively.

While investor sentiment is improving and recent economic indicators have come across the wires better than expected, data surrounding the American consumer continues to crumble. This past Friday, the University of Michigan revised its April sentiment survey to a new 26-year low. What’s more, the Conference Board has further confirmed the steady rise in pessimism as its own confidence gauge fell to a five-year low. An ongoing erosion in sentiment seems to be the likely course for American’s considering food and gas prices have surged to new highs, lending restrictions and stubbornly high mortgage rates are thwarting a housing recovery and unemployment is on the rise. Such timely indicators clearly take precedence over the lagging GDP report. And, even the Fed cut offers little relief as banks have yet to fully pass on the lower rates to borrowers.

A DEEPER LOOK INTO THE CHANGES THIS WEEK:

The most recent consumer-health indicators maintain the dour outlook for employment, housing and overall spending. Both of the recent sentiment gauges have noted deep declines in forecast and projected spending components. Likely depressing consumption even further going further, the housing market is plunging new lows with mortgage applications falling to their lowest levels for 2008 and first quarter foreclosures doubling from the previous year. Employment conditions are little better. Though jobless claims eased from highs last week, the official NFP consensus was still looking for a fourth-consecutive drop.

The health of the US economy was better than expected, but still concerning. A 0.6 percent annualized pace of first quarter growth not only beat economists’ forecasts, but it more importantly eased fears that the world’s largest economy would fall into a recession. However, steady growth through the opening months of the year doesn’t preclude a recession latter on. In fact, components of the growth report may already point to momentum towards a contraction. Consumer spending slipped for a second consecutive quarter and business investment fell for only the second time in four years.