watch what the fed watches

Confidence was on the rise last week as market participants were placing their hope in the stimulus plan that the US Senate was set to vote on after the weekend. However, the vote has since been passed and the altered,$789 billion bill will be sent to the president for confirmation; yet sentiment has actually soured since then. What’s more, this rise in pessimism further contradicts Treasury Secretary Timothy Geithner’s debut announcement in which he announced plans to develop a joint public / private investment fund to absorb toxic debt (in the stead of the proposed, all-public ‘bad bank’ model) and a $1 trillion program aimed at restoring credit to consumers and small businesses. Why do such massive amounts fail to inspire confidence? For one thing, these policy steps were already expected; but more importantly, this is a domestic solution for a global problem.  

General investor and lender sentiment faded this past week despite the US government’s progress on passing a massive economic stimulus package and the expansion of an already pervasive financial bailout plan. There is skepticism in both efforts as the market has activity priced in these steps some time ago and there is uncertainty as to when this money will actually enter the economy and what the final dollar amount will be on both fronts. In the meantime, US growth is degrading, Moody’s is set to review $303 billion in debt and global financial and economic problems are ballooning. Stability in the US doesn’t necessarily translate into stability for the global market.

While the markets hesitate on deciding between a rebound in confidence and a revived wave of deleveraging, the US and world economies continue to deteriorate. This past week, the US reported just short of 600,000 jobs were lost through January – marking the third consecutive month that payroll cuts topped half a million and bringing the total loss since the beginning of 2007 up to 3.57 million. This is irrefutable evidence of building momentum behind the US recession. With income trends fading, credit disappearing and wealth through housing contracting, the consumer may turn a significant recession into a severe one.

Financial and capital markets have been unable to find traction. The US government’s efforts to stimulate the economy and secure the credit markets are being constantly undermined by the accelerating plunge in economic activity. Domestically, the American economy reported a milder than expected economic contraction; but there is little doubt that this contraction will worsen through the first half of 2009 and drag expected returns with it. The US benchmark lending rate is already set just above zero (all rates of return on investments are built up from this rate) and its global counterparts are quickly driving towards a zero interest rate policy of their own. With the prominent risk of another financial or credit crunch lingering, these meager yields simply cannot compensate. However, at the same time, we have seen that markets have held back from a renewed plunge. Can this stability hold out long enough for confidence to return?

Market conditions have shown modest improvements over the past weeks; but bearish sentiment has not subsided. The promise of a massive financial stimulus plan to jump start growth and a public/private investment fund to absorb the toxic debt still clogging up the credit market represent promising milestones for this bear market. However, there is still no guarantee that these proposals will have the intended effect on the US economy. And all the while, we see the downward trajectory in growth leading the S&P 500 to forecast a 13.3 percent drop in dividends and the IEA estimate a the biggest drop in oil demand since 1982 this year.

We have seen a shift in the markets recently. Whereas underlying conditions were deteriorating and price action was stable just weeks ago, we now see junk bond spreads and default swaps tumbling while financial assets back towards their own multi-year lows. Where is this divergence coming from? This is largely a reflection of the government’s liquidity injections, guarantees and bailout contributions making headway in stabilizing the foundations of the credit and capital markets. However, while confidence in the sound functioning of the markets may improved, the outlook for returns has not - and will not until speculators can see a bottom in this recession.