As expected last week, the Federal Reserve cut the US benchmark lending rate 50bps to 1.00 percent. Now with the Fed Funds rate matching its lowest level since the Bretton Woods pact collapsed, we can see speculation beginning to take a hawkish turn through further months.

The Economy And The Credit Market

As expected last week, the Federal Reserve cut the US benchmark lending rate 50bps to 1.00 percent. Now with the Fed Funds rate matching its lowest level since the Bretton Woods pact collapsed, we can see speculation beginning to take a hawkish turn through further months. With little room to further loosen monetary policy, market participants are forecasting one more aggressive cut in December and then a slow rebound through the opening months of 2009. We can see in Fed Fund futures that market participants are pricing in a 98 percent probability that that the central bank will cut rates another 50 bps at the December 16th meeting. However, beyond this year-end meeting the curve begins to take a positive slant. For example, there is an 84 percent probability that the benchmark will be at 0.75 percent. With the fundamental traders trying to decipher which economy will emerge from recession first and with the best positioned rates, this may be a sign of lasting strength for the US dollar.

A Closer Look At Financial And Consumer Conditions

The health of the financial and credit markets has certainly improved over the past few weeks; but the fundamental issues underlying the recent crisis have not been answered since the panic unwinding of risk through the first half of October. The bailout, rate cuts and constant injections of liquidity by the Fed and other major central banks has helped curb fear of bankruptcies brought on by a lack of funds and massive withdrawals; yet there is far too much credit built up in the markets. This leverage must be worked off and all officials can do is to make it as gentle a landing as possible.

While the outlook for interest rates has improved over the past few weeks, expectations surrounding economic activity have continued to deteriorate. The Commerce Department’s first reading on third quarter GDP was better than economists had forecasted; but it still marked the sharpest contraction since 2001. This is only the first step into recession; and considering more timely data, the second step will be far worse. The biggest factor to a long-lasting and deep recession is the consumer spending. Confidence is at a three decade low and NFPs are expected to drop a 10th month with Friday’s reading.

The Financial And Capital Markets

Though the fundamental outlook for the economy and lending has improved little, the capital markets have risen over the past week. This is likely a relief rally as the dramatic decline in asset prices and unwinding of risky positions through the past three months as investors realize the market slump was too aggressive for such a short time; and capital needs to be invested to make at least a decent level of return when inflation is still extraordinarily high. However, capitulation moves do not last for long. A look at the credit markets shows that despite all the short-term funds that have been injected into the market by the Fed, banks are still hesitant to lend as they try to bolster their own reserves. What’s more, with ongoing writedowns and deleveraging still on the docket, investment trends will be depressed for some time. Even if these issues were answered, the market will still have to deal with a global recession – the natural driver of a bear market.

A Closer Look At Market Conditions

With the rebound in risk appetite from depressed levels, it isn’t a surprise to see a significant rebound from the most popular, speculative assets. The equities market has seen a substantial reversal with the Dow 30 up over 5 percent on the week and the battered financial sector gauge up more than 12 percent. Effectively, stocks could extend their rebound for some time; yet the overall market would still be in a dominant bear trend. Commodities have fared worse with the rebound, as the oncoming recession overwhelms speculative considerations.

Risk appetite has improved over the week, but caution is still in the air. Immediate indicators of risk and volatility (that are often mean reverting) have improved – like the 20 percentage point drop in VIX. On the other hand, the overall level of fear in the market – though off records – is still at historically high levels. The best gauge for risk aversion in the market is the extent investors are willing to put their money into the market. With risk premium on credit default swaps and the junk bond spread still pushing record highs, a bear market seems firmly set.

John Kicklighter a Currency Strategist at FXCM.