The Federal Open Market Committee’s policy stance is clearly in a state of change. Credit conditions have improved, growth has maintained its positive tack and inflation has stepped back into the forefront; and yet, the market’s benchmark for interest rate speculation (Fed Funds futures) has actually reduced its hawkish reading over the past week. This sense of caution is warranted considering demand for and risk in lending is still near recent historical highs. What’s more, the latest comments from Fed Chairman Ben Bernanke, while highlighting the balance of inflation and growth risks, came with a warning for weak second quarter growth. If the world’s largest economy sinks into the beginning stages of a recession, the eventual recovery in the credit market will no doubt be deferred as banks further limit lending on the prospect of greater defaults.

The fear premium in debt instruments continued to rise this past week. Credit default swap rates rose 3.4 percent to once again overtake the 100 basis point mark as rising interest rates are boosting the default risk for loans at the consumer level all the way up to major financial institutions. In the past few days, new homeowners were confronted with the highest average rate for a 30-year FRM in 11-weeks. Elsewhere, Standard & Poor’s issued a report revealing firms were holding the least cash to cover their debt obligations on record.

The promising rebound in yields for short-term paper was curbed this past week. Liquidity concerns were back on the table after the recent $75 billion Fed TAF auction was met with the second largest bid since auctions began last December. There was further an international aspect to the return to highly liquid money market paper. A report from Europe showed sales of asset backed debt dropped to the lowest levels in a decade. Also, in the UK, troubles from major lender Bradford & Bingley sparked comparisons to the ill-fated Northern Rock fiasco.

The strong rebound in capital markets has clearly lost its footing over the past few weeks. The benchmark US equity indices extended loses from their respective mid-May peaks with help from both sentimental and fundamental elements. For equity traders, the recent comments from Fed Chairman Bernanke were taken as confirmation that the central bank would no longer assist firms with interest rate cuts. What’s more, recent headlines have seen a number of financial institutions ousting CEOs, turning to foreign capital to boost reserves and receiving debt downgrades as the market prepares for further writedowns. However, this bearish sentiment wouldn’t be isolated to stocks alone. Corporate debt has waned as default concerns have returned and commodities’ record breaking run hit a wall with regulatory bodies looking into irregular trading. A symbolic reversal comes on crudes’ recent three-week low. 

So far, the week-over-week change from the equities market has been relatively mild. However, the significant selling pressure can’t be covered by such broad readings. Both the retail and real estate indices are barely holding to positive territory as the good will from the positive revision to first quarter growth wears thin. The financial sector, on the other hand, was coming under much greater weight. With the Fed foreshadowing a neutral turn in monetary policy, banks and lenders may be left to their write downs and credit troubles.

Suggesting the past few weeks of selling pressure is legitimate, the market-wide downturn in asset prices has come hand-in-hand with a jump in hedging and rebound in volatility. The put-call ratio jumped from a five month low after Bernanke’s comments led investors to buy protection for a potential, long-term bear market. At the same time, volatility noted a recovery that pushed the S&P Volatility Index back above 20 percent for the first time in a month. A genuine pick up in volatility would no doubt lead to another round of liquidating risky equities.

While speculation surrounding the health of US growth had improved through the month of May, it may have been merely a response to the belief that it could not get any worse. Recent data suggests this may not be the case. Despite the positive revision to the first quarter growth reading, the potential for a recession in the world’s largest economy is still very real. In fact, the Fed Chairman’s forecast for a ‘relatively weak’ second quarter merely bring the economy one step closer to the dreaded ‘R’ word. With recent data revealing the manufacturing sector is cooling and the housing market is falling deeper into its own recession, the future of growth is almost certainly balanced on the shoulders of the American consumer – the largest component of GDP. This is a precarious position to be in considering employment and wage growth have just recently turned are still very close to recent record highs.

 A DEEPER LOOK INTO THE CHANGES THIS WEEK:

 The more timely economic indicators crossing the wires over the past week have put economists and traders back on the defensive. Setting the tone for the upcoming non-farm payrolls report, continuing claims pushed to a fresh four-year high while the Challenger job cuts figure for May surged 46 percent – the sharpest increase in two years. Following this data, The ABC consumer sentiment survey saw a modest rebound but was still very close to its record lows. Finally, mortgage applications snuffed any hope of a housing rebound. Applications sank 15.3 percent to its lowest overall level in six years. 

While the leading economic indicators have retained a bleak outlook, the more closely followed lagging figures are still padding hope for a recovery in growth trends through the year’s end. This past week, the ISM’s manufacturing and service sector surveys offered a mixed view on the health of the economy. Factory activity was culled by record input costs and floundering demand, which in turn led activity to contract for a fourth consecutive month. In direct contrast, however, the much larger service sector actually expanded on orders and activity; yet a drop in employment certainly raises concern.