watch what the fed watches

The tables have turned for risk concerns in the credit market. Fears that a major bank or corporation may fall into default surged over the past week after a number of respectable analysts and policy officials suggested the credit crunch was far from over. Aside from RBS’s forecast for a credit and financial market collapse within three months, Goldman Sachs downgraded the entire financial sector and said another $65 billion in capital will be needed to offset ongoing write downs. Elsewhere, former Fed Chairman Alan Greenspan forecasted the market ‘crisis’ may hold through 2009.

With the central bank’s rate decision just around the corner and economic data steadily degrading, the capital markets have seen a surge in selling activity. Aside from the positive turn for the US dollar, equities seem to be exhibiting the highest correlation to volatile interest rate expectations. The benchmark Dow plunged nearly three percent through Tuesday’s close as investors looked to unwind their long positions ahead of what may be confirmation of an unfavorable turn in the interest rate cycle. This would be a particularly taxing turn of events for US businesses considering the current state of – and outlook for –economic growth. Over the past week, data has shown that consumers’ willingness to spend has plunged to the lowest level in at least four decades and manufacturing activity has fallen across the US. Should higher rates curb investment and spending even further, the impact on revenues could be even more severe and raise the probability of a recession in the second half of this year.

The consistency with which selling pressure has permeated all corners of the US stock market this past week may be a sign that investors are on the cusp of a significant bear run. None of the major sectors were spared from the declines as consumer spending-related groups were depressed by fading employment trends and deteriorating spending forecasts. The financial sector dropped 3.3 percent on its own as investors feared the impact of higher rates on a struggling credit market.

Market condition indicators have broken down right along with the downturn in stock prices, furthering speculation that a significant market turn may be at hand. Over the past week, the proportion of declining shares rose to 65 percent as selling overwhelmed the benchmark indexes. In fact, demand for protective puts (read in the put-call ratio) rose to the highest level in nearly two months. At the same time, the Volatility Index (a gauge of fear in the market) jumped 1.34 percent to rise back above 22 percent.

Though the dollar has clearly benefited from intensified speculation of an impending turn in the Fed’s policy stance, there seems to be far less concern about the health of the world’s largest economy going into the second half of the year. Data this past week has clearly increased the probability that growth figures would produce negative readings as soon as the second quarter GDP numbers crossed the wires. Reminding economists and market participants that a sizable anchor is still slowing the economy, housing data from the S&P CS Index dropped to its lowest level on record as stringent lending rates, increased foreclosures and fading consumer optimism have depressed prices to levels not seen in a generation. A far greater concern exists in consumer spending going forward. American’s are now the most pessimistic in their outlook for the economy since records began more than 40 years ago.

 A DEEPER LOOK INTO THE CHANGES THIS WEEK:

While most of the closely followed government and proprietary indicators have deteriorated over the past few months, the more timely reports have actually shown modest improvements over the past week. The ABC consumer confidence gauge for the week through June 15th stepped higher – though the indicator is still very near its recent record low. At the same time, employment trends perked up with initial jobless claims contracting by 5,000 filings to 381,000 while the unemployment rate for those eligible for benefits ticked lower to 2.3 percent. On the other hand, neither of these figures is encouraging enough to curb forecasts of steadily a ongoing drop in payrolls.