The Federal Open Market Committee holds its regularly scheduled meeting Tuesday and is not expected to announce any major policy initiatives, at the conclusion of the meeting. The decline in financial markets is viewed as too fresh for the Fed to react to in any major way, but it may comment about financial conditions and the economy.
"They've got a very cluttered balance sheet. The Fed doesn't have a lot of room, but I believe in this environment he (Fed chairman Ben Bernanke) has to say something. People don't feel inspired. There's a leadership vacuum," said Art Cashin, director of floor operations at UBS. "I think the problem is after what we saw last week (in Washington ) there's a growing fear here that if a great crisis erupted, geopolitical or otherwise, that these guys can't work together to get things done."
Whether global markets can stabilize Tuesday is the big question, as the selling cycle continued in early Asian trading and hotter than expected Chinese inflation data hurt sentiment. Traders described Monday's sharp 6 percent Wall Street decline as a high-volume downdraft, with no buyers in sight.
Confidence skidded along with stocks. Hedge funds and other major investors unloaded shares across the board, and the hardest hit were the financials, positioned at the very heart of the markets and the soft spot of the economy. The S&P financial sector declined nearly 10 percent. Worst hit was Bank of America, off 20 percent on fears it needs to raise capital.
The Dow plunged 634 points or 5.6 percent to 10,809, its worst day since the depths of the financial crisis in December, 2008. The S&P 500 lost 6.66 percent to 1119, a point below a key support level.
"That's the eerie part of it. You can't see any appreciable rallies. There's not a rush of bargain hunting. It's just eerie. It was unrelenting," said Cashin.
Treasurys Monday saw a flight to safety as investors fled risk markets. Oil, for instance, lost 6.4 percent to $81.31 and was falling into the upper $70s in late trading. Meanwhile, investors snapped up gold, driving the metal $61 higher to $1,710.20 per ounce.
Besides the Fed meeting Tuesday, there is productivity and costs data at 8:30 a.m. The NFIB small business survey is released at 7:30 a.m.
A test for the markets will be three Treasury auctions this week. Tuesday's 1 p.m. auction is for $32 billion 3-year notes.
Standard and Poor's downgrade of the U.S. credit rating was a catalyst behind Monday's selling. Another factor is skepticism about Europe's ability to halt the spread of contagion to its banking system. However, the European Central Bank was able to add some stability to debt markets by buying Italian and Spanish bonds Monday. The other big fear for markets is that the U.S. economy is not strong enough to stave off a new recession.
What's the Fed to Do
Economists have speculated the Fed could reaffirm Tuesday that it will hold rates low for an extended time, and also now vow to keep its balance sheet bloated at nearly $3 trillion for a long time. There has been some talk the Fed could shift to buying longer-dated Treasurys when it replaces the mortgages that roll off in its portfolio in an effort to keep rates down.
But it is not likely the Fed will embark any time soon on another quantitative easing program. The last QE program expired at the end of June, when the Fed wound down its purchases of $600 billion in Treasury securities.
"Not only is the economy deteriorating, not only are a lot of people pricing in a recession, but there is very little that people expect the fiscal and monetary authorities to do, if that indeed is the case. There's a real risk if we go into recession that the Fed doesn't have any more bullets," said Dan Greenhaus, chief global strategist at BTIG.
Amitabh Arora, head of asset allocation research at Citigroup, said the Fed will acknowledge market conditions in its 2:15 p.m. statement. "I think tomorrow it will be an assurance that they are monitoring things," he said.
Arora said it appears the markets are troubled by twin concerns, particularly when you look at the financial sector. "I think that people are concerned about the financing markets and they are concerned there will be a forced deleveraging of the banking system because of the financing market. We have not seen any stress in the financing markets, yet," he said.
The other concern is that the economy is slowing. "Whether we see a snap back depends on why we sold off. If it's a growth reassessment, its not going to snap back quickly," if the economy is deteriorating, he said. "If it's a concern about the financing markets, and there's not a problem after three or four weeks, it will snap back quickly, and I think it's the latter."
However, Arora points out that when growth slows in one quarter, it often stays slow in the next quarter. "Sharp declines in equities prices usually go hand-in-hand with subsequent declines in growth rates, not necessarily recession, but growth rates. Our growth index suggests growth was 0.5 to 1 percent for June and July. That's not a forecast. That's what the real time data suggests," he said.
He also said the markets appear to be reacting to some fear that there are medium term consequence of the single-notch downgrade of the U.S. AAA rating that are as yet unknown. "Everything we've looked at suggests there should be no medium-term consequences except in a couple of areas, like student loans which are backed by the U.S. government," he said.
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