The Outlook For Growth Sours As Speculation Of A Fed Hike Grows

[DailyFx]

With the Federal Open Market Committee scheduled to deliver their rate decision later today, the markets are left to weigh considerable speculation that the policy group will deliver a quarter point rate hike by September. There are a number of hitches to this hawkish plan: credit conditions are still unstable; capital markets have recently seen an unfavorable pickup in volatility and selling; and the worst of the economic slowdown has yet to impact the American economy.







CREDIT MARKET: HOW IS IT DOING?
With the Federal Open Market Committee scheduled to deliver their rate decision later today, the markets are left to weigh considerable speculation that the policy group will deliver a quarter point rate hike by September. There are a number of hitches to this hawkish plan: credit conditions are still unstable; capital markets have recently seen an unfavorable pickup in volatility and selling; and the worst of the economic slowdown has yet to impact the American economy. Nonetheless, traders, through Fed Fund futures, are betting there is a 10 percent chance of a 25bp hike today and nearly 90 percent probability that the benchmark rate will be at 2.25 percent by September 16th. Should Chairman Ben Bernanke keep rates steady and the Fed’s statement fail to prop up the intensified outlook for positive rates, market participants may be left to unwind the premium behind potentially overzealous forecasts.

A DEEPER LOOK INTO THE CHANGES THIS WEEK:

The tables have turned for risk concerns in the credit market. Fears that a major bank or corporation may fall into default surged over the past week after a number of respectable analysts and policy officials suggested the credit crunch was far from over. Aside from RBS’s forecast for a credit and financial market collapse within three months, Goldman Sachs downgraded the entire financial sector and said another $65 billion in capital will be needed to offset ongoing write downs. Elsewhere, former Fed Chairman Alan Greenspan forecasted the market ‘crisis’ may hold through 2009.

With the considerable jump in default swap premiums over the past week and the tangible fear surrounding the health of financial markets, investors have slowly curbed their demand for higher duration debt. Rates on short-term Libor paper were little moved last week, extending a trend of congestive price action to nearly four months. On the other hand, there has been a notable reversion to the relative safety of ‘risk-free’ Treasuries. After hitting a four-month high of its own, the rate on the three-month T-bill fell 7.8 percent to 1.823 percent



FINANCIAL MARKETS: HOW ARE THEY DOING?
With the central bank’s rate decision just around the corner and economic data steadily degrading, the capital markets have seen a surge in selling activity. Aside from the positive turn for the US dollar, equities seem to be exhibiting the highest correlation to volatile interest rate expectations. The benchmark Dow plunged nearly three percent through Tuesday’s close as investors looked to unwind their long positions ahead of what may be confirmation of an unfavorable turn in the interest rate cycle. This would be a particularly taxing turn of events for US businesses considering the current state of – and outlook for –economic growth. Over the past week, data has shown that consumers’ willingness to spend has plunged to the lowest level in at least four decades and manufacturing activity has fallen across the US. Should higher rates curb investment and spending even further, the impact on revenues could be even more severe and raise the probability of a recession in the second half of this year.





A DEEPER LOOK INTO THE CHANGES THIS WEEK:

The consistency with which selling pressure has permeated all corners of the US stock market this past week may be a sign that investors are on the cusp of a significant bear run. None of the major sectors were spared from the declines as consumer spending-related groups were depressed by fading employment trends and deteriorating spending forecasts. The financial sector dropped 3.3 percent on its own as investors feared the impact of higher rates on a struggling credit market.

Market condition indicators have broken down right along with the downturn in stock prices, furthering speculation that a significant market turn may be at hand. Over the past week, the proportion of declining shares rose to 65 percent as selling overwhelmed the benchmark indexes. In fact, demand for protective puts (read in the put-call ratio) rose to the highest level in nearly two months. At the same time, the Volatility Index (a gauge of fear in the market) jumped 1.34 percent to rise back above 22 percent.



U.S. CONSUMER: HOW ARE THEY DOING?

With the Fed apparently shifting focus from financial market stability and faltering growth to inflation trends, the outlook for the US economy has certainly dimmed. While much of the pressure in benchmark price gauges over the past six months have come from volatile goods like fuel and food, the central bank sees a clear threat to the health of long-term consumer spending and overall growth trends. This means the economy will be left to what many officials hope will be a soft-landing through the near-term (second half of 2008) as consumer spending is further depressed by higher lending rates and the additional pressure on the housing market and employment.