Only a month ago, the market was fully pricing in at least one rate hike from the Fed by the end of this year (with a significant 77 percent chance of a quarter-point tightening by August 5th). Things have certainly changed since then. According to Fed Fund futures, trader are now pricing in a 50 percent probability of only a 25 bp hike by year’s end with a 92.8 percent chance that the policy group will stay pat through August. Such a dramatic turn in speculation has accompanied the evolution of what may be the next leg of the US-borne financial crisis. Falling victim to last summer’s subprime meltdown, Freddie Mac and Fannie Mae are on the verge of collapse; and all suggested forms of rescue are saddled with adverse side effects.
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CREDIT MARKET: HOW IS IT DOING?
A DEEPER LOOK INTO THE CHANGES THIS WEEK:
Credit markets have taken a turn for the worst this past week as confidence in corporate and government solvency is worn down. On the risky side of the market, credit default swaps have actually fell back somewhat; but with major lenders and banks scheduled to report earnings over the coming days, the risk has certainly increased. Far more overwhelming for credit conditions however is the ongoing problems with Freddie and Fannie. Suggestions that the government may take on their debt has led Treasury credit default protection to record highs.
Not only has the rise in uncertainty surrounding earnings and the government’s plans to bail out the nation’s largest mortgage insurers led to a shift in demand for credit worthiness, but it has also skewed rates across the yield curve. With write downs a virtual guarantee from banks over the next few weeks and legislation likely to be decided on stabilizing Fannie and Freddie rather sooner, investors have been seeking the safety of short-term paper. As a result, the rate on the three-month T-Bill plunged 28 percent to 1.3327 just this past week!
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FINANCIAL MARKETS: HOW ARE THEY DOING? [/B]
Risk in the capital markets couldn’t be much worse. With the benchmark equities indexes already heading into a deep slump, the Freddie Mac and Fannie Mae meltdown has officially depressed stocks into a ‘bear market.’ Just this past week, the S&P 500 closed more than 20 percent off its record highs set back in October of last year. Now at more than two-and-a-half year lows, the outlook for equity markets only worsens for the coming weeks. Not only does the health of the two government lenders threaten a credit crunch, but it could also shake international confidence in the US financial structure. What’s more, even if the resolution is relatively painless, the earnings releases over the next two weeks certainly will not be. Finally, beyond these short-term considerations, there is still the ailing health of the US economy through the second quarter to consider. No doubt, the market turmoil will further the economy’s slide into recession.
[B]A DEEPER LOOK INTO THE CHANGES THIS WEEK:[/B]
Equity markets were accelerating their declines last week. The benchmark Dow dropped another 3.7 percent; but this loss pales in comparison to the performance in some of the market’s key sectors. Facing the fall out from the government lenders crisis and potential write downs, the Financial Index plunged 14.9 percent and Real Estate Index dropped 9.5 percent from the same time last week. Consumer-related shares were equally hard hit. The retail group fell 9.5 percent.
It is no surprising given the multi-year lows in equity benchmarks and promise of an unflattering second quarter earnings season that market condition indicators have continued to deteriorate. The market’s primary fear gauge, the VIX, surged another 5.4 percent to 28.5 percent this past (market commentators suggest the indicator typically peaks in the mid-30’s before a bottom is in place). What’s more, the put/call ratio has marked a dramatic reversal as managers buy up portfolio protection.
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U.S. CONSUMER: HOW ARE THEY DOING?[/B]
In an ironic contradiction to the recent health of the financial markets, the leading U. of M. consumer confidence report actually improved for its June reading. However, the report’s details revealed the outlook for the economy was its most pessimistic since 1980. This is perhaps a more accurate gauge of what is to be expected from consumers’ contributions to economic expansion through the rest of the year. Despite the dismal state of sentiment in the consumer and business sector, though the Fed retains its optimism that conditions will improve. In his Testimony before Congress, Fed Chairman Ben Bernanke noted downside risks to growth have “diminished somewhat,” with the board’s projections for 2008 expansion being raised to 1.0-1.6 percent from 0.3-1.2 percent. However, such a buoyant outlook will likely depend on the US consumer; and with joblessness expected to rise, doubt is certainly high.
[B]A DEEPER LOOK INTO THE CHANGES THIS WEEK:[/B]
Conditions have grown so negative for the economy and financial markets that modest improvements seem to be signs that the worst may finally be behind us. This is the flawed logic perhaps seen in leading indicators. The ABC consumer confidence report held at -41 (well off its lows), but the economic conditions component notably sank. With employment trends unraveling, the surprise 58,000-file drop in jobless claims may have seemed a promising sign; but this was merely due to a calculation adjustment. Instead, continuing claims reflected the true nature of the job market by hitting its highest level since December of 2003.
Long-term economic indicators paint a picture of a struggling economy. A side effect of consumer confidence dragging near-three decade lows, spending has experienced a sharp drop off. While ICSC Chain Store Sales and BLS Retail Sales reports each showed an increase in spending through June, details from both reports show Americans are merely spending more at gas stations, grocery markets and discount stores. At the same time, discretionary consumption has actually plummeted. In fact, the BLS report’s 0.1 percent pick up actually turns into a 0.5 percent drop (the first in four months) when gas receipts are deducted.
Written by: John Kicklighter, Currency Analyst for DailyFX.com
Questions or comments on this or other articles John has authored? You can email him at <[email protected]>.