watch what the fed watches

The Federal Reserve is running out of options to forcibly turn the fortunes of the US economy and global financial markets. Data over the past few weeks has confirmed that the global economy is indeed tumbling into recession, with the US leading the way. To counter the slide into the abyss, the market expects the FOMC members to continue their pace of deep cuts at the December 16th meeting – though there is little room left to move. Futures show traders are fully pricing in a 50bp rate cut and a significant 36 percent probability for a sharp 75bp reduction at the next meeting. Regardless, considering the benchmark now stands at only one percent, it is obvious that the additional stimulus would add little to present conditions. However, Bernanke and Paulson have realized this. A recent change in focus for the TARP and an additional $800 billion in liquidity from the Fed aimed at the consumer and housing represent steps in the right direction.

The health of the financial markets is still fragile despite a recovery in equities and other risk-related assets. A severe lack of investor confidence is keeping lending conditions from returning to normal. So, while temporary funds and overnight lending that is guaranteed by the US government seems plentiful, credit conditions still show a lack of liquidity in loans between banks and to consumers. However, for risk appetite to finally overcome the fear of default in the capital markets and for consumers to be confident enough to spend, counterparty risk must be reduced – a difficult proposition in a recession.

It is natural for rates of return to naturally contract during a recession. And, considering the steady deterioration of economic data from the US coffers over the past weeks and months, it seems that a particularly harsh slump will translate into an equally painful decline in interest (and therefore activity) through the remainder of this year and into the first half of 2009. Today, data reported the sharpest drop in personal consumption in seven years, the biggest slump in business investment since 2006 and new record lows for the housing recession. Next week’s NFPs will complete the painful outlook.

Heading into an extended holiday weekend, the US capital markets ended with an impressive rally. In fact, with Wednesday’s close, the benchmark S&P 500 marked its strongest four-day advance since 1933 while the VIX fear gauge dropped back below 55 percent. So, does this signal a major trend change for the markets? Unlikely. While the recovery over the past few days was impressive, few of the fundamental drivers to the nearly 35 percent year-to-date slump in equities have changed. The financial crisis is still as tangible as ever with Citi Group recently requiring a bailout while both auto manufacturers and home builders have queued up for government aid. More importantly, the global economy is just beginning to tumble into a painful recession. Not only will this lead to losses and withdrawn capital; but it will also depress rates of return – further delaying the true market recovery.

It was an impressive rebound for the equity markets this past week. After briefly plunging below 8,000 and testing a five-and-a-half year low, the Dow 30 set off on a 15 percent retracement that officially put the market on a strong footing before the Thanksgiving holiday. However, the future is not bright. Recent data showed capital investment is plunging and unemployment is on the rise. This, combined with the world-wide recession, suggests returns and revenue will be depressed at least through the first half of 2009.

Fortunately for investors, market conditions closed on a strong note for the regular trading hours of this week. Reflecting the bolstered sentiment behind the market’s rally, the benchmark volatility gauge for the stock market (the VIX has pulled back from a record high above 80 percent to just below 59 percent. However, this should not inspire confidence when the markets return to full capacity next week. The fear gauge is still nearly three times greater than normal. What’s more, fading confidence in lending conditions and growth represent an ongoing problem.