global central bank comments

The Federal Reserve Open Market Committee (FOMC) is scheduled to announce its final monetary policy decision for the year and almost certainly this cycle next Tuesday. According to the markets, the future is clear. Fed Funds futures are pricing in a 94 percent probability that Chairman Ben Bernanke and his fellow rate setters will cut the benchmark lending rate another 75 basis points to a mere 0.25 percent. This would be the lowest level for the overnight lending rate in more than 35 years and would force the policy authority to find an alternative means to encourage lending and revive economic growth. And, an alternative they will certainly have to find. With the central bank guaranteeing loans and providing near unlimited liquidity to the market, financial institutions are hesitant to take counterparty risk and lend to each other. What’s more, the worst of the global recession is still ahead; and frozen credit will not offset job losses and income deflation for consumers.

Trading conditions have improved; but investor sentiment is still severely depressed. Market rates (LIBOR) are still set at a massive premium over the risk-free Treasury rates. It seems that not even negative interest rates in short-term government paper is incentive enough for investors to diversify out of the safety of the US government’s guarantee and back into a market that refuses to take outsized risks. With the national and global recessions ballooning, caution will flourish – especially with expected returns on traditional assets at recent record lows. Add to that fears that entire sectors could fail (and further seize credit) and another panic is a real threat.

While third quarter growth numbers were dour, the US recession was just beginning with this contraction. Data that has come out over the past few weeks suggests the final GDP reading for 2008 could usher the economy to its worst recession since the early 1980s. Critical to the ultimate outcome of the failing economy is the health of the consumer. Last Friday, the Bureau of Labor Statistics reported an incredible 533,000 jobs were cut through November – the biggest net decline since 1974. Add to that the fading wealth through housing and a severe lack of available credit, and the consumer may lead the US into a depression.

Capital markets have seen modest improvements over the past week; but price action for the past few months reveals the true health of trader and investor confidence. Congestion has held equities, commodities, commercial bonds and other risk-related assets since the panic selling through October was finally curbed by the cumulative efforts of the central bank and Congress. However, with the Fed soon to hit the bottom of the barrel on monetary policy and lawmakers running out of money for all the industries that are asking for alms, it seems further pain is inevitable. Like authorities were forced to do with Leman Brothers in the financial sector, they will eventually have to let major firms in other industries go bankrupt or run the risk of capsizing the entire economy. Investors know that the recession is global and cannot be fixed on a national level; so seeking return when risk is so abundant is out of the question.

Over the past week, the next major threat to the normal functioning of the credit markets and to the dominant bear trend was brought into focus. The United States’ three major auto manufacturers are on the verge of collapse and have submitted their pleas for a bailout. However, the Fed has already nixed the possibility for loans from the central bank (over collateral concerns); and Congress has suggested they would only extend the industry $15 billion – not enough to meet liquidity needs through the first quarter. As the global recession tightens its grip, the list of struggling industries and firms will multiply.

While equities and bond yields may be on the rebound, risk aversion is still overwhelming the markets. Frozen credit markets and an unfolding economic crunch are duel concerns; and each could depress sentiment on its own. The recession seems to be the momentum behind the market slump however. Under normal economic conditions, the level of liquidity the Fed has facilitated in the market would inspire confidence and lending. However, with potential returns near recent record lows and forecasted to only get worse, there is no balance between risk and reward. In turn, the junk-bond spread, credit swaps and VIX all press higher.