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Volatility in the credit markets has jumped considerably over the past few weeks. For default swaps rates, this volatility comes with an 8.6 percent jump in premiums as investors brace for the next round of write downs. Further contributing to the jump in risk was a warning from Moody’s that defaults over the coming year could jump five fold. Equally concerning was a report from Wachovia that said CDO defaults since October have totaled 200. Nominally, that equates to an estimated $220 billion, which is 36 percent of CDOs with US ABS exposure.

 

 The rebound in short-term money market rates was stalled for another week. For risk-free Treasury paper, the mood of improving credit conditions and liquidity was quashed by the Fed’s most recent TAF injection. Confirming the FOMC’s concerns that financial markets are still “under stress,” the $75 billion auction was met with 77 bids totaling $90.9 billion. Things were little better for more risky Libor instruments as the overnight dollar Libor rates surged 111 bps at the quarter’s end as firms looked to bolster their ailing balance sheets.

Though the central bank’s commentary did little to boost expectations for an eventual rate hike for currency traders, the mixed concerns generated significant fear for investors in the capital markets. A return to rate hikes this year is fully priced in; yet by the Fed’s own admission, the outlook for economic activity is bleak. This is the worst set of conditions for equity investors as a considerable probability of negative growth (or even a recession through the second half) is made all the worse by the potential for higher lending rates to further curb consumer spending and business investment. Setting the tone for the second half of the year, the benchmark Dow closed its worst June performance since 1930. What’s more, the joint drop in Treasuries and equities (only the sixth instance since the Savings and Loans Crises of the 1990s) was the worst combined performance from the markets in nearly 14 years.

Equity markets have clearly faltered over the past week. The Dow Jones Industrial Average dropped below 11,500 to push lows that have not been since August of 2006. Leading this decline were the struggling financial and auto sectors, which have been downgraded by analysts and are on the verge of receiving similar sentiments from credit agencies. The banking group fell more than 6.9 percent on the week, while many of the consumer-related sectors tallied losses nearer to 3 percent.

Confirming that the bearish turn in equity markets is finding genuine selling pressure - and not merely experiencing dips for bargain buying - the S&P Volatility Index rose another 1.2 percentage points. At 22.4 percent, the fear gauge is at its highest level since April. Also, as would be expected, market breadth is showing that declining shares are far outstripping those on an uptick. What’s more, with major support giving way, investors exercised a slew of puts to cap losses on the quarter.

Fed warnings and temporary improvements in economic data have done little to improve the outlook for the US consumer and the broader economy. In the policy board’s statement, officials noted that employment was weakening, credit conditions were still tight and the housing recession was in full swing. These individual concerns notably offset the general statement that “downside risks to growth” appeared to have “diminished somewhat.” What’s more, the reference to firming consumer spending conflicted with forecasts that are shaped by the worst levels of pessimism in over two decades and fears that inflation and a pull back in wage growth would lead investors to be more frugal through the second half of the year. If the American consumer eases off credit and instead reins in spending, the world’s largest economy will be brought one step closer to a recession.

A DEEPER LOOK INTO THE CHANGES THIS WEEK:

While the most recent round of government indicators have crossed the wires with unexpectedly strong results, the more timely, leading gauges are still reflecting a struggling economy. Ahead of the early released payrolls report, continuing jobless claims rose to their highest levels since February of 2004, suggesting managers aren’t simply throttling back on their hiring practices, but they were also making cuts. For the housing market, mortgage applications dropped another 9.3 percent, bringing demand to six year lows. With rates near their highest levels in a year, and sentiment at quarter century lows, major purchases are likely to be put on hold.

Recently released economic data crossed the wires unexpectedly strong. However, like the Fed’s commentary, these numbers came with hitches. The biggest jump in personal income through May in two-and-half years was largely the result of the temporary tax rebates; and this strong jump wouldn’t even translate into an equivalent rise in spending. Elsewhere, existing home sales improved 2 percent through the same period, but new home sales fell back to its near 17-year low. The first expansion in the manufacturing sector, boosted spirits until market participants noticed that the prices gauge was at a 29-year high and employment and orders numbers were still down.