Despite an increase of 4.9% in gross domestic product (GDP) in the third quarter, the negatives confronting the
U.S.
economy are many. First, the
United States
is facing a significant economic slowdown based on the continuing recession in the housing market, the tightening of credit and the negative wealth effects of declining home values. Combine those bitter ingredients with record high oil prices, a softening employment situation and the cheapest U.S. dollar ever, and there are real concerns that the U.S. consumer may cut spending, sending the U.S. economy into a period of protracted weakness.
On Halloween, the Federal Open Market Committee cut the Fed funds rate by 25-basis points to 4.5% and the discount window rate by the same amount to 5%, and said “The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth,” in their accompanying statement. In addition, the Fed revised downward its 2008 projections for real GDP growth to 1.8% from 2.5%, which was down from the June projection of 2.5% to 2.75%; a month later, the Bush administration cut its
expectation to 2.7% from 3.1%.
“The aggressive posture that the Fed started taking in August basically delayed what was going to be a recession in 2008, until 2009 or 2010,” says
Peter Kefalas
, head of research at Denali Asset Management. “We are on course for a serious slowdown, if not a recession, in the New Year,” he says, adding that the strategy has been to delay the recession until after the 2008 elections. He notes that the bond market has been anticipating an easier policy for a while and that the current interest rate on the 10-year Treasury note, which is less than 4%, is not realistic and that market rates should begin climbing to the 4.25% to 4.5% range.
“They just don’t believe that the Fed is serious about risks being balanced,” says James O’Sullivan,
U.S.
economist for UBS Investment Bank. “We will see if that persists, but the markets are fully pricing in a cut in December,” he says, adding that while the economic situation had not deteri
orated dramatically relative to
expectations in early December, corporate earnings are down and the financial sector is amongst the worst hit. “Spreads are out; you look at LIBOR and CP [commercial paper] spreads over the funds rate, they are up pretty sharply since the October meeting,” he says, discounting the probability that the Fed would add any restrictiveness to the financial system, which would likely cause growth to slow. At this point, O’Sullivan says that Treasuries and Fed funds futures contracts are looking for
another 100-basis points