Despite the pressure still evident in both the financial markets and economic data, market participants are still very confident that the Fed will take a wait-and-see approach to rates come June 25th. In fact, Fed Fund futures show there is a 94 percent probability the FOMC will hold the benchmark at 2.00 percent next month. However, this outlook is heavily dependent on the basis that the worst of the credit crunch is over. With that caveat in mind, it stands to reason that the government’s growth numbers (which are lagging) may have not reflected the worst of the credit crunch. If this turns out to be the case, negative growth could further exacerbate strained confidence among lenders and spark another round of market turmoil. On the other hand, both the Fed and major banks are taking steps to stamp out the crisis over the long-term.  

 The market’s appetite for risk faltered somewhat last week as major financial institutions continued to report significant losses and write downs. However, policy authorities seem to be introducing policy that would bring an end to the credit crisis just as fast as the poor earnings reports hit the wires. Fed Chairman Bernanke recently suggested the Fed was prepared to increase the bank’s liquidity injections at any sign of trouble. Less straightforward in its impact, the SEC said banks would have to start reporting liquidity and capital levels later this year.

While sentiment has improved across the more risky asset classes, the demand for short-term paper has been slow to ease. Nonetheless, the Fed’s regular TAF auctions have certainly shown some progress with the three-month T-bill rates rising to their highest levels since the end of February as capital is allocated away from the risk-free asset. In fact, the Fed’s most recent $75 billion injection into the market saw a bid-to-cover ratio of 1.29 – suggesting demand may be reaching a point of satiation.

With most of the major first quarter earnings releases having come and gone, market participants are better able to assess the damage from the rapid cooling in growth and the influences of the ongoing credit crunch. While the write downs from bad debt riddled the balance sheets of banks, insurance companies and lenders, the consensus is that the damage hasn’t been as severe as the market was prepared for. Looking at activity in equities and other risk-related assets, the market seems to be unwinding the dour predictions that were priced in through the sharp declines witnessed through the latter part of 2007 and early 2008. However, to sustain a bullish market so near record highs, economic activity will no doubt have to step in to fill the fundamental gap. In that vein, the growth outlook is already improving. Recent data revealed the trade balance improved and consumers are still making discretionary purchases.

 The benchmark equities indexes have extended their steady yet tame advances for another week. The Dow rose 1.1 percent since last Wednesday while the S&P 500 advanced 1.6 percent. Looking at the individual sectors’ performance, both those groups that have a high correlation to consumer spending and interest rates saw significantly greater gains. This may suggest the financial sector is holding the broader market back after another round of high profile write downs and particularly Citi’s plans to sell nearly $500 billion in assets.

In addition to the steady gains in capital markets, investors have enjoyed a significant improvement in general activity. The S&P 500 Volatility Index dropped to its lowest level since October, portending steady markets into the foreseeable future. What’s more, the outlook for a sustained bullish run is reflected in options, which saw the put-call ratio report the weakest net demand for puts this year. However, just as quickly as sentiment can change in these still cautious markets, volatility could just as easily rebound as traders rush for the exits.

If the US economy is to avert a period of negative growth – or even a recession – the greatest hope lies with the American consumer. Over the past week, a number of indicators offered a mixed outlook for the health of the vital sector. Taking a direct read on consumption habits, the April retail sales reading reported an in-line 0.2 percent drop in purchases. However, when the sharp drop in autos purchases were excluded, spending actually rose 0.5 percent with notable increases in building material and furniture. Taking some of the edge off promising data though was a near tripling of consumer credit through March to $15.0 billion - indicating American’s have to rely on loans to sustain their spending habits. Inflation trends may offer some relief. The average price for goods in the consumer basket rose only 0.2 percent - the smallest increase since August - though food prices are pushing 18-year highs.

The more timely readings on consumer health have been just as mixed as the more encompassing and lagging government reports. For consumer sentiment, the weekly ABC confidence gauge maintained its sharp descent with another drop through May 11th to its most pessimistic level since November of 1992. No doubt, rising prices and the outlook for employment are contributing to the gloom. While initial jobless claims have risen two weeks in a row, the average of 3 million Americans collecting benefits over the past four weeks marks the worst conditions since May of 2004.

Investors and policy makers are intently analyzing any data that may divine the future for the world’s largest economy. The greatest potential contribution to an optimistic outlook could be found in the recent consumer spending data. The retail sales report for April showed that, though spending on autos took a significant hit, Americans were still making discretionary purchases. What’s more encouraging, spending on housing related goods improved while gasoline receipts were virtually unchanged. If this marks a genuine trend, the economic stimulus checks from the government could act as an accelerant.