Why The Fed May Only Cut By 25bp

Conditions continue to sour for the fragile credit sector; but in the absence of another crisis, the risk priced into the market seems to be reaching a temporary level of stability. Over the past week, junk spreads, default swaps and money market rates have all come in somewhat. However, despite the modest improvements, the next credit seizure waits just around the corner with a number of headlines that threaten to revive concern in the fear-driven market. Over the past week, news has done little to improve confidence in liquidity. Moody’s announced it had cut major bond insurer FGIC’s credit rating to a level just above junk. Rumors circulated that Fed strategists where looking into viability of nationalizing banks. And, outside the US, UK’s largest mortgage lender announced it would turn away business by raising its rates.

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CREDIT MARKET: HOW IS IT DOING?
Conditions continue to sour for the fragile credit sector; but in the absence of another crisis, the risk priced into the market seems to be reaching a temporary level of stability. Over the past week, junk spreads, default swaps and money market rates have all come in somewhat. However, despite the modest improvements, the next credit seizure waits just around the corner with a number of headlines that threaten to revive concern in the fear-driven market. Over the past week, news has done little to improve confidence in liquidity. Moody’s announced it had cut major bond insurer FGIC’s credit rating to a level just above junk. Rumors circulated that Fed strategists where looking into viability of nationalizing banks. And, outside the US, UK’s largest mortgage lender announced it would turn away business by raising its rates.


A DEEPER LOOK INTO THE CHANGES THIS WEEK:


Risk premium underlying corporate debt was still deflated from the Fed’s large liquidity injection and their acceptance of otherwise toxic debt as collateral last week. However, confidence in the corporate world’s ability to repay their loans still relies on the health of economy and financial firms’ ability to price their assets. With analysts and the Fed seeing a contraction in growth through the first half and banks still marking major write downs, the bottom still eludes the market. Rates on short-term paper marked a reserved rebound over the past week thanks to a strong performance from the other markets. However, demand for liquidity has been settled little over the same period. While speculative markets have reported a tentative rebound, lending is still sticky with investors waiting for confirmation that the solvency of major financial institutions is not in jeopardy from ongoing write downs and bloated backlogs of difficult to price assets.

STOCK MARKET: HOW IS IT DOING?
Equities spent most of the past week in the red; but a momentous rally on Tuesday would ultimately leave the benchmark Dow higher than where we had left it last week. In fact, the stock index rallied 3.2 percent, setting the record for the eighth largest advance in history. This sudden reversal in the market was ultimately founded on otherwise tepid news. In fact, on the day that equities marked their impressive rally, a couple major banks announced major write downs on debt-related losses. However, this was seemingly eclipsed by news that Lehman Brothers was able to raise $4 billion in capital in a market that was supposedly tapped for liquidity and optimism. However, a true turn to optimism is still in doubt. In testimony Wednesday, Fed Chairman Bernanke predicted a contraction in GDP through the first half of 2008, while another policy maker remarked the current situation resembles the leading edge of the last US recession - a very bearish outlook for investors.

A DEEPER LOOK INTO THE CHANGES THIS WEEK:


The advance in the stock market showed remarkable consistency across the major sectors, suggesting the fundamentally-light rally was rooted more in a response to oversold sentiment in the market rather than a more encouraging outlook for growth and revenues. Predictably, the financial and real estate groups marked the biggest reversal from lows this past week owing to the thawing in the credit market. However with manufacturing still contracting and NFPs due soon, the larger groups may soon take a turn for the worst. Tuesday’s event risk had the greatest influence over those companies in the financial sector – though the news lent itself more to volatility than direction. News that major investment banks UBS and Deutsche Bank wrote off $19 billion and $3.9 billion respectively clearly showed the investment community that the credit crisis has not ended. On the other hand, Lehman’s ability to raise capital suggests the market is still willing to invest. What’s more, with few profit warnings crossing the wires, analysts are growing more confident in 1Q earnings.

U.S. CONSUMER: HOW ARE THEY DOING?
There were few major, scheduled economic releases to cross the wires recently; but those indicators that were issued reported a struggling American consumer. The measure of personal income through February unexpectedly rose, but faltering confidence certainly kept that wealth from passing back into the economy. Spending through the same period cooled to a 0.1 percent pickup, the weakest rise in 17 months. And, considering expectations for employment data and stubbornly high living costs, the consumer sector’s contribution to growth doesn’t seem promising. The less volatile reading for initial jobless claims rose to its highest level since October of 2005 and NFPs are expected to print the third consecutive contraction in employment. As for living costs, gasoline prices have held near record highs and lending rates have yet to ease

A DEEPER LOOK INTO THE CHANGES THIS WEEK:



Confirmation of a bottom for the housing recession continues to escape us. Last Wednesday, new home sales dropped to a new 13 year low as falling prices and tighter lending restrictions have kept potential buyers on the sideline. What’s more, the lack of confidence for a turn in the housing cycle was reflected in mortgage applications, which dropped the most since October 1998. On the other hand, the incredible volatility in mortgage filings may be a clue that prices and conditions are encouraging Americans to return to the market. Prices have fallen, construction cooled; now what is needed is a rebound in sales.
Consumer-related stocks continue to take the brunt of the market’s bearish outlook for growth. Data has already revealed a cooling in manufacturing and service sectors. However, the consumer – the engine of growth – has only begun to close the purse strings. Lending firms have been weighed down by the ongoing contraction in the housing market and the lack of pass through of Fed’s aggressive rate cuts to the consumer level. Rising unemployment and consumer confidence at 16-year lows has further cooled discretionary spending, but continue to push Americans to discount retail chains.
Written by: John Kicklighter, Currency Analyst for DailyFX.com