The Federal Reserve is scheduled to meet next Tuesday; but despite the dollar’s recent strength, the market is pricing in little chance of a quarter-point rate hike when everything is said and done. Currently, Fed Fund futures show a 6.3 percent probability of a hike to 2.25 percent – a significant drop from the nearly 25 percent odds measured only a month ago. Despite this expected passivity in the near-term however, traders still see a 71.5 percent chance that the central bank will tighten by the year’s end and shake the two-year easing/neutral cycle. All of this could change very quickly though as major event risk approaches. Both the 2Q GDP and July NFP numbers will offer a conclusive measure of strength for the world’s economy. And, considering the optimistic forecasts for growth and fragile state of financial markets, a disappointment here could have severe repercussions.

Credit conditions have stabilized recently, but caution is clearly still outweighing the market’s appetite for risk. This past week, risk trends and lending rates seemed to be relatively unfazed by a steady stream of discouraging reports. The week began the FDIC taking over two more regional banks and a warning from Fed President Stern that the credit crunch would only worsen. Doing little to ease fears that other major firms could go under in current market conditions, Merrill Lynch announced a write down and deep discount sale on $30.6 billion in bonds.

 

While demand for less risky Treasury and short-term paper has steadied over the past week, market participants are still clearly looking for security in a market racked by uncertainty. Rates on the three-month T-Bill slipped after news that the Fed’s July 28th $75 billion TAF auction was met with $90.56 billion in bids – marking another month that the market has indicated that liquidity is still scarce. The same concerns are registered out in the market place, with Merrill Lynch’s massive write downs and the high premiums on WaMu default protection.

Market activity is clearly bowing to the tide of approaching event risk. Benchmark equities have put distance between current prices and recent 18-month lows, commodity prices have pulled back from record highs and bond yields have been relegated to tight ranges. There is little doubt that the combination of a rate decision, second quarter growth report and employment number could dramatically change the outlook for the US economy through the second half; but market participants’ speculative spirit is still clearly bruised by the consequences of the credit meltdown last summer. What’s more, there are few signs in the market that expansion was as strong as economists’ forecasts suggest. While beating the worst of analysts’ depressed expectations, earnings were still deep in the red. What’s more, consumer spending, business investment and basic lending are clearly preventing a genuine economic rebound.

While stock benchmarks were relatively unchanged over the week, price action has been quite volatility. The Financial sector has seen the worst of its thanks to a series of earnings losses, massive write downs and liquidity concerns – not to mention the failure of two more banks. However, not to be outdone, consumer-related businesses are also feeling the sting of dramatic price action as low consumer confidence and high input prices force production managers to scale back.

Not only is dramatic price action reflecting concern, but market condition indicators are also painting a picture of growing caution. With GDP due this week and the Fed decision scheduled for Tuesday, implied volatility has pulled out of its dive to rise back above 22 percent. Further exposing the potential for a very disappointing outcome from all the data, the put-call ratio has climbed back above a ratio of 3 bearish puts for ever two bullish calls.

The official consensus for the second quarter growth report seems to suggest the American consumer may not pitch the world’s largest economy into a recession. Over the past week, two consumer confidence indicators crossed the wires with unexpected outcomes. The Conference Board’s sentiment report improved for the first time in seven months, while the University of Michigan’s gauge offered a surprise upside revision. However, the promise these indicators offer is certainly limited as these monthly bounces have merely lifted the readings from recent historical lows. What’s more, the fuel for optimism – steady wage growth and rising employment – has just begun to sputter. The government is expected to report the seventh consecutive contraction in net employment and a new two-year low in earnings growth.

A DEEPER LOOK INTO THE CHANGES THIS WEEK:

While monthly and quarterly indicators have offered an initial sense of optimism on the outlook for the US economy, more timely reports suggest something entirely different. Directly contrasting the upticks in the U of M and Conference Board sentiment reports, the ABC confidence indicator fell for the first time in two months this week thanks to a sharp drop in perceived personal finances, the buying climate and outlook for the economy. Further adding to the pressure on the American consumer’s shoulders, the average rate on a 30-year fixed rate mortgage jumped to its highest level in a year and initial jobless claims have jumped to a near for month high. 

Major economic indicators have been relatively promising – though only in comparison to readings from the past few months. The business proxy in durable goods orders rose 1.4 percent, both prominent consumer confidence readings improved and the government’s new home sales gauge showed the biggest drop in inventories in 40 years. However, the question the market will be asking is whether this enough to justify speculation for the US economy to avoid a recession in the second half. Conditions for the consumer are only expected to worsen, the housing market is still deep in recession and businesses continue to struggle with high material costs and waning demand.