Confidence in the beleaguered credit markets seems to be slowly improving. With the Fed adding to its cumulative 325bps of easing last week and expanding its ad hoc efforts to revive liquidity, lenders are less fearful of a default and banks aren’t as apprehensive with taking on so-called risky assets that may be difficult to price and/or sell should there be another turn for the worse. Just this past week, the monetary policy authority has taken significant steps to squash the credit crisis once and for all. Adding to the already significant improvements to its lending facilities, the Fed announced it would increase its bi-weekly TAF auctions from $50 to $75 billion and further that it would now accept AAA-rated ABS as collateral. A potential long-term fix, Bernanke asked congress this morning to provide interest on commercial reserves.    

There have been a number of disconcerting reports this past week that have worked against the Fed’s ongoing efforts to thaw the credit market. After posting significant first quarter losses, both Citigroup and government-backed mortgage lender Fannie Mae have announced they will raise capital. Both will be good gauges for risk appetite. Elsewhere, a Fed report stated 70% of banks have increased their loan rates. This has helped to keep investors in risk-free Treasuries and in turn lifted junk bond rates to their highest level since 2003.

Though there has been a notable rebound in the appetite for yield across the capital markets and the risk of default has retraced nearly two thirds of its premium, yet market participants have been hesitant in moving out of short-term paper. On the other hand, there are notable signs of improvement. The Fed’s TAF auction received $96.6 billion for $75 billion offered, a significant reduction in the bid-to-cover ratio from a few weeks ago. This is further supported by the rebound in T-Bill rates as investors sell their protection.

The broad capital markets are still on their bullish trajectory, but the advance has been slow going. In fact, through the end of Wednesday’s trading session, the benchmark Dow index has ended the week nearly unchanged from where it began. Looking at the news and data that crossed the wires over the past few weeks, it isn’t difficult to understand investors’ skepticism in jumping back into stocks and other risk-friendly assets. Profit for most firms is still under significant pressure as crude and other raw material prices have reached record highs. At the same time, the outlook for consumer demand has been jeopardized by data showing that the economy has lost jobs for four consecutive months and Americans’ are the most pessimistic in 26 years. More worrisome, the consumer sector’s steady deterioration could finally push the US economy into a dreaded recession that would no doubt hit investment return.

Though the benchmark equity indexes held relatively unchanged over the past week, there was nonetheless considerable volatility among the major component groups. The most active group happened to be the financial index which saw a significant advance after the Fed announced its quarter point rate cut and raised speculation that the easing cycle was over. However, this positive news was marred by reports that Fannie Mae and Citigroup would have to raise capital in the market to compensate for sizable first-quarter losses.

Though the general rise in stocks and other financial markets has been timid, the reduction in risk measures has not. Through the past week, gauges of volatility and interest behind hedging losses through options have eased significantly. The S&P 500 volatility index slipped to its lowest level since October of last year when it dropped below 19 percent. Reduced levels of expected market activity typically accompany a bullish move in the underlying. However, the put-call ratio was more reserved in its support as the indicator has yet to break a very prominent rising trend.

While the data that has crossed the wires over the past week has been relatively promising for investors, it has not bolstered the outlook for consumers. Friday’s non-farm payroll report was a perfect example of the differing reactions between traders and American citizens. While the market was happy to see a smaller than expected drop in net layoffs, the fourth-consecutive drop in NFPs (the worst trend since the second half of 2003) confirms that conditions are still worsening. More recent data hasn’t even had a silver lining between the two groups. An independent report revealed business and individual bankruptcies in the US rose 31 percent in the year through April. Elsewhere, the government’s consumer credit indicator reported a jump from $5.2 to $15 billion as rising prices for necessary goods like gasoline and food are eating into disposable income and forcing consumers to rely on credit.

The more timely readings for consumer-related activity have offered mixed results for the health of the economy’s largest sector. The most prominent gauge for Americans’ confidence and spending habits was the NFP which printed a 20,000-person contraction through April. Previous recessions have seen consistent contractions of 10 or more months, suggesting much worse may be ahead. Suggesting this data has already weighed on sentiment, the weekly ABC confidence gauge slipped to its lowest level since 1993 in the period through May 3rd.

Though calls for a US-borne recession have cooled since the government reported annualized growth held at 0.6 percent through the first quarter, it seems as if the economy will still see a contraction (and perhaps a recession) later this year. The most concerning component to a faltering economy is the steady decline in employment and its heavy impact on confidence and spending habits. Elsewhere, recent data has shown the manufacturing sector contracted for a third month through April, despite the cheap dollar. Hope still lingers however with the unexpected rebound in the service sector – the largest employer.