Speculation Of A Fed Hike Creeps Back As Financial Fears Subside

Investors were remarkably bearish on the US economy and all its assets last week as fears surrounding second quarter earnings and a potential Freddie Mac/Fannie Mae collapse peaked. However, this worst case scenario would ultimately prove overly pessimistic as the bearish momentum behind the GSEs faltered and banks' accounting figures ended up on the positive side of depressed forecasts. Subsequently, as the outlook for the markets brightened, so did forecasts for the eventual turn to rate hikes from the Fed.

CREDIT MARKET: HOW IS IT DOING?

Investors were remarkably bearish on the US economy and all its assets last week as fears surrounding second quarter earnings and a potential Freddie Mac/Fannie Mae collapse peaked. However, this worst case scenario would ultimately prove overly pessimistic as the bearish momentum behind the GSEs faltered and banks' accounting figures ended up on the positive side of depressed forecasts. Subsequently, as the outlook for the markets brightened, so did forecasts for the eventual turn to rate hikes from the Fed. Interest rate futures are still reflecting a 93 percent probability that the policy group will hold rates on August 5th; but the chances for at least a 25bp hike by the end of the year (December 16th) has actually jumped from 50 percent last week to 81 percent today. If write-downs continue to come in under the high water mark, the probabilities will continue to improve for rate hawks.

A DEEPER LOOK INTO THE CHANGES THIS WEEK:

Despite the substantial losses and write-downs from major banks and uncertainty still underlying America's largest lenders, credit conditions have actually improved over the past week. The better than expected balance sheets from the financial sector led to a 6.4 percent drop in credit default premiums. In turn, traders started to transfer capital into more risky assets as seen in the 1 percent drop in the junk bond spread. However, conditions are still fragile on multi-billion dollar write-offs and so rates remain near multi-month highs.

Skepticism in the health of the US and global credit market is still in full force; and for good reason. The Treasury is looking for permission to sop up debt from Freddie and Fannie - a move that some speculate will tarnish the appeal of US treasuries all the up to more risky assets. Elsewhere, financial firms are still marking up large losses as the subprime crunch continues to make waves. And, adding another factor to caution, Assured Guaranty (one of only two bond insurers with an Aaa debt rating) is in danger of a downgrade from Moody's

FINANCIAL MARKETS: HOW ARE THEY DOING?

The capital markets have enjoyed a sharp reversal in favor of long-term bulls. Since hitting a two-year low just a week ago, the benchmark Dow Jones Industrial Average has rallied over 7 percent on a combination of better-than-expected earnings figures, optimism from policy makers and a massive pull back in raw material prices. In the same period, crude prices have collapsed over 14 percent to close below $130 per barrel. Far more important though was Fed Chairman Ben Bernanke's outlook for growth in 2008, which was lifted from 0.3-1.2 percent estimated back in April to 1.0-1.6 percent in the Fed's most recent forecast. Further helping in a big way was the outperforming second quarter accounting figures in some of the equity market's most volatile market sectors. While it is far too early - and likely incorrect - to assume stocks have found their bottom, this strength certainly curbs potential panic selling.

A DEEPER LOOK INTO THE CHANGES THIS WEEK

Benchmark stock indexes have experienced significant reversals, but these turns are nothing compared to the strength noted in some of the most active sectors. With the financial group hosting the most bearish sentiment up until last week, it was no surprise to see it mark the biggest jump. The banking sector experienced a massive 19 percent advance from last week thanks to better-than-expected-earnings from Citi, JP Morgan and Bank of American among others.

Not only are share prices improving with this most recent risk rebound, but market condition indicators have also recovered this past week. The VIX dropped some 7 percentage points from a four-month high thanks to eased concerns over an impending collapse of the United States' largest lenders and the potential for catastrophic earnings figures. However, this modest improvement hasn't completely shaken the bears as volatility is still relatively high and protective put interest is rising with the low premiums

U.S. CONSUMER: HOW ARE THEY DOING?

While the Fed Chairman may see a more optimistic future for the world's largest economy, American consumers are having a hard time seeing the silver lining. Better-than-expected earnings and a couple of GSEs avoiding bankruptcy are not events that would immediately improve the optimism of a group that is suffering from rising unemployment, stalling wage growth and stubbornly high costs for food, energy and credit. Data released this past week does little to confirm Bernanke's optimism. The housing recession continues to search for a deeper bottom, the cost of living has risen to new heights, employment trends slipped another notch and other officials are still fearful. In fact a number of Fed board members continually warn that inflation must be subdued if the economy is to be stabilized. What's more, another report from the bank suggests an ongoing housing decent will eventually change Americans to net savers

A DEEPER LOOK INTO CHANGES THIS WEEK

Short-term economic condition indicators have improved; but these rebounds from significant lows must be taken with a grain of salt. For the evolving downturn in employment trends, initial claims for unemployment benefits rose to 366,000 - while continuing claims ticked down from a four-and-a-half year high. The residential recession is generating timid levels of optimism. The lowest average 30-year FRM in six weeks led to a 1.7 percent pick up in mortgage applications - the first incidence of three consecutive weekly improvements since January. Finally, consumer sentiment is slowly climbing off its multi-year low. The ABC confidence gauge unexpectedly held steady, though at -41, the indicator is still deep in pessimistic territory

Government and long-term indicators aren't even showing the restrained optimism that the short-term numbers have hinted at this past week. The headline figure for the economic docket (and consumer) over the period was the June CPI reading. Consumer inflation hit an alarming 17-year high 5.0 percent last month as energy costs jumped 6.6 percent. Wrapping this figure into the popular misery gauge (combining inflation and joblessness) brings the indicator up to its worst levels since January of 1993. Elsewhere, the Leading Indicators composite stood as a notable contradictor to Bernanke's favorable view for growth. Projecting growth in the coming three to six months, the report slipped another 0.1 percent - the 9th month in 12 the figure has fallen.

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