A second aggressive rate cut in just over a week on Wednesday from the Federal Reserve failed to help Wall Street stocks, while the dollar came under pressure and gold set a record high.
The Fed cut both the Fed funds and discount rates by 50 basis points, to 3 per cent and 3.5 per cent respectively. That came after last week's inter-meeting 75bp reduction in the funds rate.
In its accompanying statement, the US central bank said that financial markets remained under considerable stress and that recent information indicated a deepening of the housing contraction as well as some softening in labour markets.
"The Fed's number one current priority is to soften this economic downturn, and appears ready to do what it takes," said Max Bublitz, chief strategist at SCM Advisors.
Wall Street initially rallied, but returned to negative territory in the last hour of trade amid renewed jitters over the financial strength of bond insurers Ambac and MBIA. The S&P 500 rose as much as 1.7 per cent after the Fed acted, only to close down 0.5 per cent at 1,355.81.
In the US Treasury market, the two-year yield reversed an early rise and was down 5bp at 2.22 per cent. Interest rate futures rallied and priced in at least a 2.5 per cent funds rate by the end of April. "In light of what this cut means for future strategy, we look for the Fed to cut another 50 basis points in March followed by 25 basis point cuts at both the April and June meetings," said Drew Matus, economist at Lehman Brothers. "This leaves us with a terminal Fed funds rate of 2 per cent."
Longer-dated Treasury yields rose further after the rate cut as traders priced in a stronger chance that the economy will rebound and inflation rises. The yield on the 10-year bond was up 4bp at 3.70 per cent, sparking a steeper yield curve. Treasury inflation breakeven rates were wider indicating a higher expectation of inflation.
"The risks to acting so decisively can be seen in the yield curve, as 2s/10s have steepened out to nearly 150 bps on inflationary concerns and aided by the cut," said David Ader, bond strategist at RBS Greenwich Capital. "While surely not a near-term concern for the Fed, the lingering inflation concerns will undoubtedly come back into play as 2008 progresses."
John Miller, chief investment officer at Nuveen Investments said: "Inflation has not gone down and the Fed is postponing its focus of preventing inflation."
Measures of credit risk initially eased after the Fed's move. The Markit CDX index of credit default swaps that reference US investment grade rate corporations narrowed to 99.5bp from 103bp. Renewed concern about bond insurers helped push the CDX back to 106.5bp in late trade. The index is down from a recent peak around 125bp, but is up from 78bp at the start of the year.
One bright note after the latest rate cut is that further relief for holders of floating rate mortgages beckons.
"The direct effect of a rate cut is primarily going to be on adjustable rate loan resets," said Don Brownstein, chief investment officer of Structured Portfolio Management, a hedge fund manager focused on the mortgage and structured credit markets. "Particularly if Libor rates continue their return to a more normal relationship with Treasury rates, adjustable rate loans won't reset as high as they would have without the cut."
The dollar weakened almost across the board, and it closed at its weakest level against the euro. The dollar index closed just above its record low set in November and has fallen more than 2 per cent since the Fed cut rates last week.
The move by the Fed yesterday followed a mixed bag of US economic releases earlier in the day.
A survey from ADP Employer Services showed that 130,000 private sector jobs were created in January, about three times the expected increase, heightening expectations that tomorrow's crucial non-farm payrolls report could turn out to be stronger than expected.
"ADP has proved itself horribly misleading several times over the past year but the fact remains that it is the best - or least bad, anyway - single advance indicator of payrolls," said Ian Shepherdson, chief US economist at High Frequency Economics.
While there may be a bounce in the January payrolls, economists caution the trend has been weakening in recent months.
"The longer-term trends in the labour market demonstrate clear softening with the six-month moving average slowing from a gain of 180,000 at the beginning of 2007 to less than 90,000 jobs at the end of the year," said Thomas Higgins, chief economist at Payden & Rygel. "This Friday's payroll number may be a last hurrah for those who are bullish on the US economy before the economic data take a turn for the worse as we head into February and March."
Meanwhile, US fourth-quarter gross domestic product growth came in much weaker than expected. The economy expanded at an annualised rate of 0.6 per cent in the fourth quarter of last year - the slowest pace for five years and down sharply from 4.9 per cent in the third quarter.
"The pace of economic activity basically stalled out in the fourth quarter," said David Rosenberg, chief economist at Merrill Lynch. "Of course, there are going to be two more revisions to the figure before we get a final result, but this was a big haircut from the 4.9 per cent pace posted in the third quarter and 3.8 per cent in the second."
Tony Crescenzi, chief bond strategist at Miller Tabak, took a more optimistic view, saying the GDP report showed that business inventories had been "extraordinarily well managed" during the economic slowdown, boding well for the future.
Equity markets in Europe and Asia saw relatively quiet trading as investors the US rate news.
In Asia, an early attempt to build on Tuesday's gains came to nought as uncertainty about the Fed set in. In Tokyo, the Nikkei 225 Average ended 1 per cent lower, while Hong Kong shed 2.6 per cent and Seoul fell 3 per cent to a nine-month low.
European stocks adopted a similarly cautious tone, with fresh writedowns at Swiss bank UBS further damping the mood. The FTSE Eurofirst 300 index fell 0.7 per cent.
European government bonds edged back in quiet trading ahead of the Fed's decision. with the 10-year Bund yield up 3bp at 4.01 per cent. The 10-year Japanese government bond yield fell 4 bp to 1.43 per cent following the slide in Japanese equities.
In commodities, oil prices edged higher after a choppy session as investors reacted to news of a bigger-than- forecast increase in US crude inventories last week.
March West Texas Intermediate rose 69 cents to $92.33 a barrel.
The price of spot gold in New York was $8.45 higher at $932.15 after reaching a record $936.95.
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