Fed Minutes Suggest An End To Rate Cuts, Yet Markets Still Unsure

Conditions in the credit markets continue to improve; and the renewed sense of stability for the financial markets is certainly lending itself to speculation that the Fed is nearing the end of its dovish rate regime. This past week, there were few reports of major right downs or news that suggests major financial institutions are finding it more difficult to access liquidity. In fact, a report from the Federal Reserve reveals that direct loans to banks are the highest on record - supporting Governor Ben Bernanke’s reassurances that the central bank is ready and willing to increase its auctions should it be needed. What’s more, the lending freeze may be further thawed by the Fed’s forecasts by a rebound in growth through the second half noted in the recently released minutes. This supports comments made by Paulson that markets may be at the point where economics are more important than credit.

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CREDIT MARKET: HOW IS IT DOING?

         Conditions in the credit markets continue to improve; and the renewed sense of stability for the financial markets is certainly lending itself to speculation that the Fed is nearing the end of its dovish rate regime. This past week, there were few reports of major right downs or news that suggests major financial institutions are finding it more difficult to access liquidity. In fact, a report from the Federal Reserve reveals that direct loans to banks are the highest on record - supporting Governor Ben Bernanke’s reassurances that the central bank is ready and willing to increase its auctions should it be needed. What’s more, the lending freeze may be further thawed by the Fed’s forecasts by a rebound in growth through the second half noted in the recently released minutes. This supports comments made by Paulson that markets may be at the point where economics are more important than credit.


A DEEPER LOOK INTO THE CHANGES THIS WEEK:

         With the Fed having essentially stamped its guarantee on available liquidity, the market has found a happy equilibrium for risk premium in the debt market. While the default swap rates are still elevated compared to levels a year ago, they have retraced more than 60 percent of the run up during the height of the financial turmoil. At the same time, the calming of fears hasn’t necessarily translated into a rebound in risk appetite. While default premiums have plunged, the junk bond spread is still near its recent record high with investors in Treasuries.  
                                   
         
         
         While there has been a clear rebound in yield appetite in other asset classes; traders are still heavily invested in the relative safety of short-term paper and Treasuries. With the SEC setting out guidelines for businesses to start disclosing liquidity and capitalization and a recent regulatory filing suggesting banks have not accounted for an additional $35 billion worth of write downs, this caution is warranted. At the same time, with the Fed’s most recent auction seeing its lowest stop-out rate in since the special facility began, it seems the tides are turning. 

FINANCIAL MARKETS: HOW ARE THEY DOING?

         The appetite for risk is still elevated across the capital markets; yet the advance seems to be meeting greater resistance week after week. For equities (the proxy for risk in the financial markets), bulls seem to have hit a temporary ceiling with macro fundamentals taking an undesirable turn. On the one hand, capital expenditure trends – and overall growth potential – have taken a hit from a renewed surge in the prices for vital crude. Just today, the price of oil surpassed $130/barrel with market commentators projecting a relatively unfettered advance to $150 over the coming weeks. Just as threatening to investment trends were the comments in the Fed’s minutes. The policy group specifically noted that the concerns surrounding growth and inflation were “more closely balanced” and that the April rate cut was a “close call” - comments suggesting the Fed will not help the market out with further rate cuts.
                                   
         
         
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A DEEPER LOOK INTO THE CHANGES THIS WEEK:

         While the longer-term trend still sees bullish potential for the stock market, the upside has certainly been tempered by price action this week with a key trendline falling. Until today, the major benchmarks were relatively unchanged from last week’s levels, but the FOMC minutes’ hawkish turn clearly took the wind out of traders’ sails. In fact, without cheap money available for investment and forecasts for a “significant” increase in unemployment, the expected recovery from the past three quarters’ write downs looks bleak. 
                                   
         
         Direction in the capital markets has certainly turned, but market activity indicators are still holding onto their bullish convictions. Volatility fell to a new 10-month low before rebounding with yesterday’s and today’s drop in the underlying indexes. At the same time, the put-call ratio has dipped to a new six-month low of its own, with traders not yet seeing a need to purchase protective puts. On the other hand, market breadth has certainly flipped with the number of decliners increasing as the downturn spreads throughout the various sectors. 

U.S. CONSUMER: HOW ARE THEY DOING?

While the Federal Reserve deems the economic outlook strong enough that it no longer needs to be as accommodative with monetary policy, their outlook for growth hasn’t improved much. On the one hand, the minutes suggested growth would rebound in the second half of the year. However, the statement also noted more than a few policy members feel the economy has actually contracted through the second quarter. What’s more, the forecast for growth through 2008 was revised lower from 1.3 – 2.0 percent to 0.3 – 1.2 percent. Adding to the malaise, recent data suggests that the Fed’s outlook may be too optimistic. The University of Michigan’s consumer confidence survey plunged to a fresh 28-year low in May while inflation forecasts for the coming year were pushed to a 17-year high 5.2 percent. Even the Leading Indicators’ modest uptick was suspect with improvements in some of the worst performing components.

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         [B]A DEEPER LOOK INTO THE CHANGES THIS WEEK:[/B]
                                                     
         
         For the timeliest read on consumer and growth trends, there is rarely as leading an indicator as the Fed’s own forecasts. The outlook for growth was somewhat mixed thanks to the expected activity in the second half; yet warnings that joblessness could ‘increase significantly’ suggest the spending habits of the largest economic sector is in jeopardy. What’s more, gauges of confidence and housing activity have similarly faltered. The most recent sentiment figures are at near three-decade lows; and with gas nearing $4 a gallon and lenders refusing to pass on the Fed’s easing to consumers, confidence will likely worsen.
                                   
         
         
         The health of the US economy is perhaps one of the biggest variables in the outlook for interest rates and the future of the US dollar. The Fed’s projections are mixed at best – even if they do lead the policy authority to put the stopper in further rate cuts. For a market that is hanging on fragile confidence, it is warnings of downside risks that could revive the possibility of a recession through tempered consumer spending and business investment trends. With this in mind, the mention that a number of policy makers saw growth already contracting through the second quarter will make it that much more difficult to sustain expansion.

[I]Written By: John Kicklighter, Currency Analyst for DailyFX.com

Questions? Comments? Email John at <[email protected]> to discuss this or other articles he has authored.[/I]