The Fed Hits the Emergency Button

Bernanke and Co.'s surprise 75 basis-point easing in response to economic weakness seemed to be working as financials regained some strength

The market's "January from Hell" seemed ready to get a whole lot worse on Tuesday, as global markets tumbled and U.S. index futures pointed to super-sized losses at the Wall Street open.

Then the Fed stepped in.

The Federal Reserve announced an emergency rate cut of 75 basis points Tuesday morning at around 8:20 am ET, taking the Fed funds target rate down to 3.5%. The central bank cited "a weakening of the economic outlook and increasing downside risks to growth." The Fed also approved a 75-basis-point decrease in the discount rate to 4%.

As expected, major U.S. stock indexes plummeted after the opening bell, with the Dow Jones industrial average falling 446 points, the Nasdaq dropping 118 points and the S&P 500 index shedding 46 points, all within the first four minutes of trading. But a bounce in financial and retail sectors helped the markets rebound off their lows, nearly reversing them completely by 11:15 a.m.

On Tuesday, the Dow Jones industrial average was trading 61.78 points, or 0.51%, lower at 12,037.52. The broader S&P 500 index was down 6.51 points, or 0.49%, at 1,318.68. The tech-heavy Nasdaq composite index got the smallest bounce and was down 35.35 points, or 1.51%, to trade at 2,304.67.

In cutting rates, Fed policymakers also noted that while "strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households." Moreover, said the Fed, "incoming information indicates a deepening of the housing contraction as well as some softening in labor markets".

The Fed's move came amid a deepening global rout in equities markets, particularly in Asia, which was spawned by panicky "bear market" recession fears, though even deeper losses were mitigated somewhat by hopeful rumors of a coordinated interest rate cut among global central banks, reports Action Economics.

Japan's Nikkei-225 index closed 5.65% lower (having lost 10% over the past two sessions), while Hong Kong's Hang Seng index sank 8.7%. Ahead of the dramatic Fed announcement, European bourses traded down 1.8%-3% lower, but recovered as U.S. equities bounced off their lows. In London, the FTSE 100 Index was up 2.01% at 5,690.10. In Paris, the CAC 40 Index rose 2.08% to 4,843.33, and in Germany, the DAX Index edged up 0.16% to 6,801.09.

"Clearly, [the rate cut] was meant to surprise the market with an in-between FOMC meetings and with a 75 instead of 50" basis point easing, said Kurt Karl, chief U.S. economist at Swiss Re in New York. "That's normally how you get a positive reaction from the markets, by being more aggressive than expected."

That strategy appeared to be working as equity indexes trimmed their losses by two-thirds, led by the financials and certain retail names as Sears Holdings (SHLD), Home Depot (HD) and Target (TGT).

Markets have been worried about a possible global recession starting in the U.S., as well as widening bank loan problems. Rumors were rampant in the market that the Fed might act Monday, according to S&P MarketScope.

Financial shares have been battered following large earnings misses by Bank of America (BAC) and Wachovia (WB), with BofA reporting a 95% net income plunge and $5.2 billion write-down, while Wachovia's net income sank 98% with a $1.5 billion charge.

Bond insurer Ambac Financial (ABK) confirmed a $3.2 billion net loss following $5.2 billion in mark-to-market credit derivative losses. But Ambac, after falling more than 70% last week as credit downgrade fears were confirmed, was trading more than 30% higher on Tuesday.

Karl said he expected the rebound in financial stocks to be more meaningful and sustainable than fleeting, given how beaten down they have been.

"Rate cuts are most helpful to the financial sector because they’re able to borrow at lower rates and lend at higher rates," Karl said.

The fact that the yields on the 10-year U.S. Treasury note had dipped by only 10 points compared with the 75-point drop in the borrowing rate bodes well for the banks, he said.

In a research note, John Ryding, Bear Stearns' chief U.S. economist, traced the rationale for the emergency rate cut back to a speech by Federal Reserve Governor Frederic Mishkin a week and a half ago, in which he argued that at times of severe financial turmoil, policy had to be “timely,” “decisive,” and “flexible.”

The Fed's statement Tuesday "carries a clear weakness bias and downplays any inflation risks, which leaves the door open to further rate reduction" and "leaves us thinking that the Fed will cut rates again at next week’s meeting by either 25 or 50 basis points," Ryding's note said.

But Ryding said he disagreed with the Fed over the longer-term outlook for the inflation risk, saying that "events have a strong stagflationary feel about them," referring to the recession-cum-high-inflation that plagued the U.S. economy 30 years ago.

Indeed, economists are worried that the weaker U.S. dollar as a result of the lower interest rates will spark an explosion in inflation that would be hard to rein in. Many analysts are calling for more coordinated action among central banks around the world to prevent the economic slowdown in the U.S. from spreading globally.

The Bank of Canada responded by cutting rates by a quarter percentage point on Tuesday, matching expectations by lowering the target for the overnight rate to 4.00% and keeping the door open to further easing, Action Economics said. Now the markets are waiting for encouraging signs from the European Central Bank and the Bank of Japan, whose currencies have been very strong against the dollar over the past six months.

"The falling dollar makes it problematic for growth in Europe and Japan and if they're not cutting [rates] with coordinated action, then we have greater global risks," Karl said.

Oil futures sank to $86.11 per barrel in electronic trading overnight in reaction to sharp drops in global equities, particularly in Asia. The February contract on NYMEX, which expires at the end of the trading day Tuesday, was trading $1.32 lower at $89.25 per barrel as traders focused on prospects for a slowing economy and shrinking demand for energy. But the market was also encouraged by the significant bounce off the overnight low, CNBC Business News said.

Among other stocks in the news Tuesday, UnitedHealth Group (UNH) shares fell 4.5% as the company reported fourth-quarter earnings per share of 92 cents, vs. 84 cents one year earlier, on a 3.2% revenue rise. The company sees first quarter earnings of 82 cents to 84 cents per share, and continues to project 2008 EPS of $3.95-$4.00.

Northstar Neuroscience (NSTR) shares plunged 83.6% after it announced that its Everest pivotal trial evaluating cortical stimulation to improve hand and arm function in stroke survivors did not meet its primary efficacy endpoint. Jefferies reportedly downgraded the stock to underperform.

Waters Corp. (WAT) shares fell TK% after the manufacturer of analystic instruments for the pharmaceutical and life sciemnce industries posted lower-than-expected fouryth-quarter GAAP earnings of 96 cents vs. 78 cents per share a year ago on a 13% revenue rise.

Ventana Medical Systems (VMSI) agreed to be acquired by Roche (RHHBY) in a $3.4 billion deal after the Swiss giant raised its bid for Ventana to $89.50 cash per VMSI share.

Target (TGT) shares climbed 4.1% after it reportedly said January sales are coming in at the low-end of its previously stated range of -1% to +1%.
Treasury Market

Long yields have surged after the emergency Fed cut, reports Action Economics. The short-end of the yield curve, however, has been capped by ongoing expectations of another follow-up move at next week's meeting as the Fed attempts to head off a more virulent spread of the housing downturn into the broader economy.

The 2-year yield bounced to 2.18%, compared with overnight lows under 2.0% as the 2-year bond rose 10/32 to 102-00/32. The 10-year yield surged toward 3.60% from the 3.55% area, well up from overnight lows near 3.45%, as the bond climbed 11/32 to 105-14/32. The 30-year bond fell 13/32 to 111-16/32 on a yield of 4.30%. The yield spread between the 2-year and 10-year issues remains steep at +140 basis points on the combination of easier policy and stagflation fears.