Fed cuts rates aggressively as “financial markets remain distressed”

Seeking to thwart an incipient recession the US Federal Reserve slashed interest rates by 125 bps over the last fortnight through two successive cuts within a span of 9 days. On the heels of a global stock sell off on January 22nd, which was triggered by the Fitch downgrade of No.2 bond insurer Ambac Financial Group and further aggravated by the French bank Société Générale’s liquidation of equity positions taken by its rogue trader, the Fed made a surprise intermeeting cut of 75 bps in the federal funds target rate. However, heightened concerns regarding the onset of a potential US recession, thanks to the “stress in financial markets” and “weakening of the economic outlook”, forced the Fed’s hand for the second time, as it slashed the Fed rate and discount rate by another 50 bps to 3% and 3.5% at the January 30th FOMC meeting. Jittery
credit market conditions further reinforced the Fed’s decision as mounting losses on securities guaranteed by major bond insurer’s added onto the market’s concerns of further write downs by major financial institutions. In an effort to complement the Fed’s monetary policy endeavor, the White House and the Congressional leaders quickly hammered out a fiscal stimulus plan with nearly USD 150 bn of tax relief aimed to bolster the ailing U.S. economy. Tax credits amounting to USD 100 bn form the key part of the proposal. We believe that the bill, which now awaits the senate’s nod, is unlikely to do away with the need for further easing by the Fed since it should be effective only by mid 2008 even in the most optimistic scenario.

Economic data released over the last fortnight was skewed on the downside despite a few bright spots. Recessionary fears gripped the US economy as the pace of economic growth faltered in the 4th quarter of 2007 with the US GDP edging up 0.6% QoQ annualized, much below consensus estimates of +1.2%, compared to a solid 4.9% growth posted in the third quarter of 2007. The beleaguered US housing market is showing no signs of bottoming as new home sales in December 2007 plummeted 40.7% YoY to 604k, its lowest level since 559k in February 1995. The labor market, deemed to be the last leg of the crippling US economy, shed 17K jobs in January belying consensus estimates (+65k) that were upbeat after the robust January ADP employment data release. This is its first decline since August 2003 (-42K) when the labor
market hadn’t fully recovered from the 2001 recession. The surge in durable goods orders and the rebound in ISM were the two bright spots amidst the gloomy scenario. December durable goods orders surged 5.2% MoM (0.5% previously) while ISM rebounded above the pivotal 50 level to 50.7 in January (48.4 previously) thereby hinting that business investments are still holding up despite the ongoing troubles in the US economy.

On the brighter side, money market conditions continued to improve over the fortnight, on the back of constant liquidity injection by the Federal Reserve and Sovereign Wealth Funds. The results of the January 14th and 28th TAF auctions confirmed that the Fed has done considerably well in managing market liquidity since the earlier auctions as fewer banks turned to the Fed to shore up their liquidity position. Despite a comfortable liquidity scenario, financial markets remain fragile with S&P threatening to downgrade more than 8000 mortgage investments, the largest during the past few months. With the Fed having left the door open
for further cuts in future, the fed rate is likely to be slashed further to 2.5% by the end of Q1-08. Not to mention that the risks remain skewed to the downside...