Last week the U.S. Federal Reserve Open Market Committee decided to lower its target for the Federal Funds rate by 50 basis points to 3 percent. The Fed Board of Governors justified its decision by saying that downside risks to growth remain while inflation is expected to moderate in coming quarters. The Fed also expressed its concern that “financial markets remain under considerable stress, and credit has tightened further for some businesses and households”.  Yet, the decision to cut rates was not unanimously. Voting against it was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting. Looking ahead, the next Fed meeting is on March 18 and according to futures trading on the Fed Funds rate, traders are fully pricing a 25 bps rate cut and as much as 72 percent probability of a 50 bps rate cut to 2.5 percent.

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 603 bps.

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

The recent stock market recovery quickly ended to start the week’s trade, as dismal economic data and generally poor market sentiment forced sizeable Dow and S&P losses. The Financial sector felt the brunt of the market sell-off, and indeed analyst downgrades of key banking stocks only worsened outlook for the downtrodden sector. It is difficult to imagine that fallen market titans such as Citigroup and Bank of America could fall significantly lower from current price levels, but recent price action certainly reminds us that further losses could be in store for the key corporate shares. Other sectors were less affected by the broader sell-off, and the Dow Jones Retail Index has held up surprisingly well despite fears of a US recession. All in all, economic sentiment seems to support further stock market losses. But it remains to be seen whether aggressive Federal Reserve Rate cuts will be enough to lift downtrodden US shares.

The Dow and its major sub-indices resumed their medium-term downtrend, falling significantly to start the current week of trading. Yet it is interesting to note that the Retail Index has outperformed the broader market, as fears of a recession should intuitively force sizeable losses in consumer-linked industries. The slight divergence suggests that markets feel that this is a Financials-led recession, and subsequent implications for Federal Reserve Monetary Policy are less clear. Much like the Fed, we will be in a “wait and see” mode in terms of economic data and potential effects on interest rate outlook.

 
Analyst downgrades of key banking stocks forced further losses in Citigroup, BofA, and JP Morgan shares. Markets seemed marginally willing to re-enter the downtrodden banking stocks, but it remains to be seen whether or not we can expect noteworthy recoveries through the months ahead. Despite the fact that these shares remain attractive by traditional valuation models, investors are yet unwilling to risk capital in fear of further sizeable losses due to subprime exposure.

The outlook for the domestic consumer continues to deteriorate, as dismal Non Farm Payrolls data and fast-rising unemployment insurance claims clearly worsen outlook for domestic labor trends. The Federal Reserve has surely taken note, with aggressive rate cuts and a proposed fiscal stimulus aimed at boosting consumption throughout the broader economy. Whether or not this will be enough to stave off a recession is yet to be seen, but few are optimistic for consumption prospects through 2008.  

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 downturn has clearly forced losses among key consumer-linked shares, but it serves to note that discount retailer Walmart nonetheless trades near 52-week highs through recent trade. Investors seemingly feel confident that the conglomerate will post respectable sales even in a US economic downturn, as consumers buy lower-priced Walmart goods on declines in disposable income. Based on such reasoning, Walmart may continue to outperform the broader market in the case of a significant US economic slowdown.