special reports

Traders are fully pricing an additional 25 basis points cut in the Federal Funds interest rate and as much as 76 percent probability of a 50 bps rate cut when the Federal Open Market Committee announces its interest rate decision today at 2:15PM ET. Last week, the U.S. Federal Reserve decided to lower its target for the federal funds rate by 75 basis points to 3.5 percent. Nonetheless, even though the Federal Reserve has cut the fed funds rate by 175 basis points since September, the stock market will be very disappointed if the FOMC decides to lower the fed funds rate only by 25 bps. Looking ahead, the outlook for risky assets remains bearish and the current circumstances favor a further unwind of carry trades which could benefit lower yielding currencies like the Japanese yen and the Swiss franc.

Despite the recent easing on financial conditions boosted by repeated injections of liquidity by the world’s biggest central banks, credit markets remain extremely tight. For instance, the spread between junk-rated corporate bonds and U.S. Treasuries is trading close to 617 bps.

Short term money markets remain very tight as short term interbank lending rates remain well above government bond yields of similar maturity.

American equity markets have been slowly climbing back from last week’s lows. The sharp drop in the Dow last week pulled the benchmark Dow to its lowest level since October of 2006. However, this downdraft was clearly the product of panic selling and uncertainty in the market. The intensity in the sell off of global stocks through the US bank holiday on Monday, it was later learned, was triggered partly by a massive unwinding in positions from a build up of losing trades at Society General. Certainly, the FOMC’s surprise rate on Tuesday amplified volatility; but things settled down, the additional help from the Fed’s easing would eventually encourage a rebound from overextended lows. However, with the government reporting the slowest pace of US growth in five years, stock traders may demand a much more aggressive easing policy from the central bank to avert a recession and sustain their confidence.

In just the past week, the benchmark US stock indices (like those around the industrialized world) have rallied from their lows. From last week’s lows, the Dow has pushed nearly 10 percent higher. However, now it remains to be seen whether this move is merely a rebound in a larger down trend or the true change in trend. This pivotal decision on direction will likely hinge on both growth and Fed policy in the months and quarters ahead. With the fourth quarter growth reading threatening an impending US recession this morning, a benchmark lending rate of 3.00 percent may not be low enough to float consumer spending in 2008.

Though earnings season has passed for most of the major players in the banking sector, the sting of massive writedowns and disappointing fourth quarter earnings lingers. There is a divergence building within the group as a number of big bank stocks (like JP Morgan) have followed the broader market in a rebound from oversold levels. However, others (like Citigroup) have seen only modest improvement from their lows as the prospect of a US recession (and global cooling in growth to follow) will dampen investment and therefore cut into revenue. What’s more, lending is still stick and credit market spreads still wide, passing the burden for stability onto the Fed’s shoulders.

The outlook for the domestic consumer remains dim, but surprises in key labor numbers have improved market sentiment on consumption trends. A surge in ADP Employment numbers and steady drops in US Initial Jobless Claims have improved outlook for the domestic labor market. Yet markets will wait to see the upcoming Non Farm Payrolls data release to truly confirm that employment conditions have improved for the US consumer. A cursory look at retail stocks suggest that investors are paring bets that overall consumption will fall further through the year ahead, but we are clearly not out of the woods quite yet. Indeed, we may have to see a marked improvement in housing conditions before calling for a turn in consumer sentiment.

MBA Mortgage Applications continued to surge through the end of January, with the number of requests for mortgage credit reaching their highest since March, 2004. Such surges nonetheless coincide with further gloom in the broader housing market. We continue to argue that such strong rises in MBA Mortgage Applications are a function of tight credit markets—not of rebounding housing demand. As banks grow wary of extending credit, consumers are forced to re-apply for borrowing.

The recent stock market recovery has been kind to retail shares, as discount retailer Walmart has surged to its highest levels since mid-2007. Recent financial press writings suggest that value investors may be returning to the downtrodden retail sector, but such a bounce may represent the ‘calm before the storm’ if consumer spending continues to deteriorate. The Fed’s future interest rate decisions may have a trickle-down effect on share valuations, and markets clearly hope that the central bank will continue to cut interest rates aggressively through 2008.