Fed Eyes Another Easing

Against the backdrop of U.S. Treasury Secretary Henry Paulson's mortgage fix, the only mystery surrounding the Federal Reserve's meeting Tuesday is how much the central bank will cut rates.

The administration finally revealed its outline to avoid further home-price declines last week, but persistent seizures in the credit markets showed that banks are still facing a liquidity crunch. In light of the housing market's need for surgery, along with recent turmoil in the financial system, the central bank may follow the government's lead and err on the side of extra stimulus next week.

That means a 50-basis-point rate cut is a possibility, say some economists. The fed funds futures market is pricing in 100% odds of a 25-basis-point cut next week and 28% odds of a 50-basis point cut, which would bring the fed funds rate to 4%. The Fed has cut rates by 0.75% over the past two meetings of the Federal Open Market Committee. The futures market is also pricing in two more 25-basis-point cuts at the Fed's January and March 2008 meetings.

The markets seem to believe that a global, concerted effort to improve liquidity in credit markets is taking shape, says Joseph Balestrino, fixed-income strategist at Federated Investors, which has $23 billion in fixed-income assets under management.

He notes that the central banks of England and Canada cut their benchmark overnight borrowing rates last week, while Treasury Secretary Hank Paulson outlined a plan to help some subprime borrowers modify their mortgages.

The promise of rescue could make the bond market rethink its gloomy outlook. The effort to stem further losses and economic weakness led bond market investors to sell out of the safe-haven securities, which sent the yield in the 10-year benchmark Treasury bond back up above 4% this week after it spent much of the past 10 days yielding around 3.9%.

History, says Balestrino, shows that this means "the bond market is anticipating the Fed will do enough and do it fast enough to avoid recession." Balestrino noted that this market is trading "like yields have bottomed out."

Traders should watch the markets' reaction to higher bond yields. Low interest rates, after all, are what helped spark a surge in mortgage refinancing, with fixed mortgage rates around 6%, the lowest they've been in about two years.

Bond traders' recession fears also may be assuaged by recent economic data, which have been better than most analysts expected. The data reveal a sluggish economy that is on a downward trend, but perhaps not recession-bound. Friday's nonfarm payrolls report showed the economy added 94,000 new jobs, higher than the 70,000 analysts had expected. Likewise, the Institute for Supply Management's reports on manufacturing and service segments of the economy revealed weakness, but not contraction.

Next week's key economic data point for traders will be November's retail sales. Thus far, reads on the Thanksgiving shopping weekend's success have been somewhat mixed. In November, retailers posted a 4% jump in same-store sales from the same period a year ago. The increase was better than analysts' expectations for a 3.3% increase. But of the 43 chain stores that reported, just 44% beat estimates and 51% fell short, according to Thomson Financial.

"The evolution of the macroeconomic data takes 50 basis points off of the table, however the action at the Fed at this juncture is targeted to the financial sector and maintaining efficient functioning," says Joe Brusuelas, chief economist at IDEAglobal.

Credit markets remain strained, as Libor rates -- or the London interbank offered rates that banks use to lend to each other -- have been elevated in response to institutions' year-end capital requirements. Also, rates on short-term asset-backed commercial paper are higher than levels reached at the nadir of August's credit crunch.

"There is a lot of evidence that we are nowhere near a normal market," says Balestrino. "These stresses still have to be worked off."

And while the fed funds rate cut will undoubtedly cheer the markets, it's not clear that further rate cuts will help untie the credit markets' knots, says Balestrino. The 75 basis points of rate cuts have not thus far aided bank-to-bank lending or squelched liquidity concerns for companies like Citigroup(C Quote), Merrill Lynch (MER Quote), Washington Mutual (WM Quote), Wells Fargo (WFC Quote) and Countrywide Financial (CFC Quote).

Perhaps another cut to the fed funds discount window could succeed. The discount rate is currently 5%.

1 What would best describe your stance heading into the coming week of trading? Bullish Bearish Neutral 2 Which of these sectors do you think is set to move up in the coming week? --Choose One--Aerospace and DefenseAirlinesAutomobilesBeverages and Food ProductsBiotechnologyCommercial BanksComputers and PeripheralsConsumer NondurablesEnergy Equipment & ServicesHMOs and HospitalsHomebuildingInsuranceIntegrated OilInternet, Software ServicesInvestment Bankers and BrokersMediaMultiline RetailPharmaceuticalsPrecious MetalsSemis, Semi EquipmentTelecom EquipmentTobacco and AlcoholWireless CommunicationsUtilities 3 Which of these sectors do you think is set to move down in the coming week? --Choose One--Aerospace and DefenseAirlinesAutomobilesBeverages and Food ProductsBiotechnologyCommercial BanksComputers and PeripheralsConsumer NondurablesEnergy Equipment & ServicesHMOs and HospitalsHomebuildingInsuranceIntegrated OilInternet, Software ServicesInvestment Bankers and BrokersMediaMultiline RetailPharmaceuticalsPrecious MetalsSemis, Semi EquipmentTelecom EquipmentTobacco and AlcoholWireless CommunicationsUtilities View the results without voting