Speculation surrounding the Fed’s monetary policy stance has intensified over the past week. In fact, following commentary by Chairman Ben Bernanke that suggested growth trends had improved over the past month and inflation was a greater priority going forward, the market stepped up the schedule for a FOMC rate hike. A week ago, futures were pricing in no change from the central bank in June and August, with a near 30 percent probability of a hike in September. Today, however, traders see a 15 percent chance of a quarter-point hike at the June 25th meeting and a 45 percent likelihood of one on August 5th. This hawkish turn matches a global trend which sees many central banks less concerned about growth and the financial market’s health as credit conditions improve and more anxious about the inflation that has resulted from the previous easing cycle.

Risk appetite read in investment grade debt yields has deteriorated modestly over the past week. Reminding investors of the very real default risk still lingering in the markets, Standard & Poor’s revealed a record 738 companies have suffered from a downgrade in their creditworthiness over the opening months of this year. Setting an equally ominous tone, a Moody’s report forecasted corporate debt would suffer another $1.6 trillion in downgrades and warnings over the second quarter.  

Though risk appetite may be wavering, there are still signs that investor confidence over the health of the financial markets and credit conditions is improving. Rates for three-month maturity Libor and Treasury paper both improved last week despite another overdrawing $96.6 billion TAF auction bid. Optimism was no doubt encouraged by the agreement between the NY Fed and 17 major banks to put all their CDS trades through a single clearing house and thereby drastically reduce default risk.

A bear market may be developing; but such a cycle would be the result of normal economic trends and deteriorating investor sentiment rather than the panic of collapsing financial structure like was seen last fall. This past week, a modest pullback in the benchmark equity indices evolved into an aggressive tumble. Heavy selling was triggered initially by a very disappointing round of employment data last Friday. A 400 point-plus drop in the Dow no doubt shook the conviction of many of the stalwart bulls still holding out for an aggressive rebound in broad risk appetite. Heading into this week, the dour outlook for returns was further battered by Fed Chairman Bernanke’s confirmation that the Board was shifting its focus to inflation and in so doing curbed hopes for further rate cuts. What’s more, ongoing supply concerns in the energy market have driven crude prices back towards record highs and rekindled the commodities’ inflation hedge as growth forecasts fade.

Equity markets have taken the brunt of the Fed’s hawkish turn and the volatile return in record crude prices. The benchmark Dow was nearly 3.75 percent off last week’s highs thanks to significant selling through today’s and last Friday’s sessions. Looking at the activity in the various index groups though, there was a clear divergence in the nature of the market’s selling. The financial group suffered the worst of the bearish pressure as the market battened down for ongoing write downs. For retail shares, it is the end to the Fed’s accommodative cuts.

Market conditions merely confirm the strength of the selling pressures in equities and other risk-related assets. The S&P VIX jumped sharply over the past few days to its high level in nearly two months – confirming fear that losses will accelerate. Maintaining the outlook for a bearish future for stocks, the put-call ratio has revealed a significant rise in the demand for protective puts.  As the benchmark Dow index works its way back towards major support seen around 11,750, fears of an intensified decline will no doubt drive volatility and demand for puts higher.

While the outlook for interest rates has perked up and the Fed has reflected on improving economic activity; the outlook for consumer spending continues to tumble. Data crossing the wires this past week was uniformly bad for the American consumer. Topping concerns was the sharp deterioration in employment trends – confirmed by the fifth consecutive contraction in unemployment and the highest jobless rate since October of 2004. Adding to the weakening labor conditions, reports showed that household wealth dropped by $1.7 trillion through the first quarter and home foreclosures through the same period hit a record. All of this was taken into account for the IBD/TIPP Economic Optimism report, which slipped to a new record low for the June reading.  Gauges for personal finances, the economic outlook and confidence in the Fed’s policy all marked new lows.

Most of the market’s timeliest economic indicators have seen a modest rebound since last week; yet most of the measures are not far from recent record lows. On the back of last Friday’s NFPs, first time filings for unemployment benefits dropped to their lowest level in six weeks through the open of June. At the same time, wealth concerns may ease somewhat as mortgage applications have jumped to a monthly high despite a rise in the most common 30-year fixed rate mortgage. Keeping caution in mind however, the weekly ABC consumer confidence reading held at -45 last week, just slightly above the record -51 low.

The outlook for economic activity is still hanging in the balance. Fed Chairman Bernanke remarked this past week that US growth had improved since last month and that there was less evidence that the economy was on the cusp of a significant downturn. On the other hand, the outlook for the consumer sector – the largest component of growth – has failed to gain traction while rising commodity price and inflation threaten to unravel any benefit expected through improvements in trade figures. Indeed, a closer looks at the Fed’s comments show more concern over inflation rather than optimism for growth.