The Federal Reserve Open Market Committee has cut the fed funds rate by 100 basis points since September 2007 amid growing concerns about the health of the U.S. economy. Yet, despite the recent easing of financial conditions, traders remain pessimistic about the extent of the US subprime loan meltdown. Expectations for the outcome of the January 31 FOMC meeting changed dramatically on Tuesday after a key report on retail sales for December came in much weaker than expected. According to futures trading on the Fed Funds rate, traders are fully pricing a 50 bps rate cut and as much as 46 percent probability of a 75 bps rate cut to 3.75 percent.

Credit markets remain extremely tight as the spread between junk-rated corporate bonds and U.S. Treasuries surged more 11 bps to trade close to 608 bps.

Although we have seen some signs of improvement on the U.S. lending market, short term interbank lending rates remain well above government bond yields of similar maturity.

The equity market sell off continues for yet another week. Wednesday’s open for the Dow Jones Industrial Average officially ushered the benchmark index below 12,500 and boosted its year-to-date percentage loss beyond 6 percent. The beginning of the earnings season was partially responsible for the extended loss. Aside from an early profit announcement from IBM, most of the large firms that have released earnings have disappointed Wall Street’s already low expectations (this is especially true of the financial sector). Another player in stocks’ steady fall from investment grace was the economic calendar. The trade deficit ballooned to a 14-month high, retailers reported their worst holiday season since 2003 and inflation held near highs.

Fears of a possible US borne recession are growing quickly. A few weeks ago, the popular consensus for fourth quarter growth sought a 1.0 percent pace of annualized growth. However, this projection, and the outlook for 2008, has deteriorated substantially as the consumer sector seems to be loosing its footing. Adding to clear signs that employment trends were waning and consumer sentiment was falling fast, a 0.4 percent drop in retail sales over the crucial holiday shopping month of December confirmed that domestic consumption was offering little help to the US economy.

The financial sector continues to suffer the worst of the equity market’s losses. Citigroup, the world’s largest bank, crowded out the financial headlines after reporting a $9.8 billion loss – the biggest in its 196-year history – and an $18 billion write down due to mortgage-related losses. JP Morgan’s report was less severe, yet by no means a positive for the banking sector with a reported 34 percent drop in fourth quarter profit on a $1.3 billion write down. With many firms still uncovering losses in complex derivatives and new CEOs looking to trim fat, investors’ forecasts may not improve any time soon.

Disappointing December Advance Retail Sales figures has clearly dented outlook on domestic consumption levels—especially as the US saw its worst year-end holiday spending period since 2003. The threat of further falls in critical consumer spending has subsequently fueled speculation that the Federal Reserve will continue to cut rates aggressively in order to stave off a broader economic recession, and prospects remain relatively dim for the domestic consumer. Given an ongoing housing recession and worsening job prospects, the Fed seemingly has little choice but to continue cutting rates through 2008.

Extreme volatility in Mortgage Applications likely reflects the underlying difficulty in obtaining mortgage credit. This has coincided with further routs in all relevant housing sales indicators, and the confluence of falling credit demand on home sales underlines the difficulty in the domestic real estate sector. Such dismal housing data has unsurprisingly coincided with weak end-of-year Retail Sales figures, and it seems only a matter of time before the ongoing housing recession places a clear dent on overall household consumption.

 
Continued stock market routs have unsurprisingly left housing-linked stocks at further lows, but a recent bid for troubled mortgage lender Countrywide Financial has given the stock some much needed support in days past. Indeed, the stock price nearly doubled within a single trading day, and any further buyouts of distressed financial firms could potentially bolster outlook for the broader sector. It seems relatively clear that all mortgage and housing-linked firms may see further difficulty through the medium term, but there remains a glimmer of hope that such corporations may survive on significant capital infusions.