watch what the fed watches

Just a week after the Federal Reserve took part in a coordinated rate cut by lowering its benchmark lending rate 50 basis points to 1.50 percent, the markets are still forecasting another aggressive cut for the policy board’s next meeting on October 29th. A similar shift in rate expectations has been seen across the globe as investors and policy officials hold their breath to see whether or not the cumulative effects of monetary easing, vows to recapitalize banks and guarantees on bank lending will be enough to snuff out the worst financial crisis in at least 70 years. Even if fears that the credit market may seize at any time pass, the US (and indeed global) economy is still expected to fall into recession through the second half of this year – a natural damper on rates. This discouraging outlook has led traders in Fed Fund futures to fully price in a 25bp rate cut and a rising 36 percent probability of another 50bp reduction.

Though the markets have found relief in US and European bailouts – it seems that the break is from sheer panic and not from an overall bearish bias on investment trends. There is still a clear demand for low risk returns as is evidenced by the consistent drop in three-month T-bill yields. At the same time, Libor rates with the same maturity however have steadily risen nearly two percent over the past few weeks. This divergence reflects an improvement in lending conditions (with government guarantees) but with expectations for investment to be stunted by new regulations, lingering caution and expected recession.

As we have been saying for a while, the strong 2Q GDP reading was offering a false sense of security in the health of the US. In the fall out of the financial crisis, there are few doubts that the world’s largest economy is heading for a crippling recession. Data has already set the stage for negative growth through the third quarter, and the outlook has certainly dimmed from there. Consumers will be the pivotal player for whether the oncoming downturn will be mild or severe. With unemployment at a five-year high and retail sales hitting a three-year low,  the outlook certainly doesn’t look promising.

The past week’s worth of price action has been dramatic. By last Friday’s close, the capital, commodities and money markets broke bearish records as fear was pushing traders to irrational exuberance. Sensing the urgency of the situation, and the lack of options at their disposal, global policy makers made the decision to step into the free markets to encourage stability in sentiment and price action. Plans to guarantee new senior debt from financial institutions, take stakes in banks and move toxic debt off balance sheets certainly goes a long way to dampening fears of windfall bankruptcies and defaults. However, with the haze of panic lifted, traders are now left with the realization that returns will be hampered by the governmental intervention. What’s more, even with the crisis passed, there are still forecasts of a global recession to deal with. In the end, this period may have merely been an accelerant in a bear market.

The shifts in capital markets have been incredible over the past week. Through Friday, the US equities market closed its worst weekly performance since the Great Depression. However, massive direction moves usually lead to equally incredible retracements and that is what we saw Monday. A record breaking 11.1 percent rally for the Dow 30 balanced the over-extended market; but we have seen a notable lack of follow through. The pas two weeks aside, commodities and stocks have been falling for months – a sign of a broader bear market.

While many market participants and commentators safely assume that confidence in investing and lending has improved, signs from the markets themselves suggests we have merely broken from panic rather than seen a turn in conditions. Lenders are still skeptical about their counterparts as can be seen in overnight lending rate and default swaps. For traders, the overall level of equity benchmarks and volatility are the best gauges. While the Dow has bounced from lows and VIX has pulled back, the former is still below 9,000 and latter near 60 percent!