The global credit crisis has raised plenty of fears about the willingness of banks to lend to businesses and consumers. Of more concern is the willingness of banks to lend to each other. Bank liquidity worries are one of the reasons behind the Federal Reserve's recent string of interest rate cuts. The negative response by investors to the last interest rate cut of 25 basis points to 4.25% provides clear evidence that we are not out of the woods yet. The London Interbank Offered Rate (LIBOR)  is the latest source of worry to market watchers, as it has spiked to historic highs of late and no amount of central bank soothing or liquidity injections has reduced the risk premium for bank-to-bank loans. These short term loans that range from overnight to three months in duration are the mechanism that banks use to shore up reserves. The open question remains whether additional rate cuts will cure what amounts to a loss of confidence in the banking system. A return to what passes for normal in the markets will simply take time and transparency to achieve.

The bond market continued to benefit from the headwinds facing the economy and the stock market during the fourth quarter of 2007. The Federal Reserve also chipped in by lowering interest rates two more times during the quarter for a total drop of .5 % in their target rate for fed funds. Combined with the .5% drop in September, the target rate has fallen a total of 1% from 5.25% to 4.25%. The yield on the ten year Treasury note fell from 4.56% to 4.04% by the end of the quarter. There is no question the Federal Reserve Board has their work cut out for them at this juncture as they endeavor to promote sustained economic growth without fostering inflation. A number of the more recent economic indicators have begun to flash some ominous warnings.

The chart above reflects a real mixed bag of economic activity through the first eleven months of 2007. It is somewhat disconcerting that the index declined 7 out of the 11 months reported thus far. However, of more concern are the recent numbers. The index has averaged a 1.2% decline over the last six months. This is the first six month period to average more than a 1% decline since the 2001 recession. Additionally, the index has declined for two straight months. A third straight monthly decline would qualify as an official warning for a recession based upon the history of this index. The next report is due on January 18^th.

 

 

Another economic indicator flashing yellow is the ISM Index. The chart for the index for the past year is shown above. This index is meant to track the health of the manufacturing sector of the economy. The index itself is a diffusion index. This means any reading over 50 implies an expanding economy and a reading below 50 implies a contractionary economy. The most recent reading for December was reported January 2^nd at 47.7. A review of the chart reveals a steady decline from the high of 56 in June of 2007 to the December reading well below 50. Historically, readings for this index at the current level or lower have been associated withrecessionary periods.

 

Our desire is not to spread doom and gloom as we enter a new year. There is some good news as well. Consumer spending has been incredibly resilient. Interest rates are relatively low and likely headed lower. Corporate earnings, excluding certain sectors, are still positive. As always, we will continue to monitor these developments on your behalf and manage your portfolio according to your stated objective.

In 2008 through 2010, some lucky investors will qualify for the new 0% capital gains tax rate.  The 0% rate is the result of certain tax legislation that was passed over the last few years as part of President Bush's tax cuts.  In general, you may utilize the 0% rate if your taxable income from sources other than capital gains is less than $65,100 for joint taxpayers or $32,550 for single taxpayers.  Retired clients who have not yet started taking required minimum distributions from their IRAs will have the greatest opportunity to use the new 0% rate. 

Here is how it works.  Assume we have a retired couple with $30,000 of ordinary income for the year as a result of their Social Security and some bond interest.  Because their ordinary income is below $65,100, their first $35,100 of capital gains for the year will be taxed at 0%.  Capital gains above $35,100 would then be taxed at the standard 15%.

Also, adult children who fall into the two lowest federal income tax brackets may also be able to use the 0% rate.  This creates a good opportunity for clients who are interested in gifting appreciated stock to their adult children or grandchildren.  You may be able to gift the stock to the kids, and the kids may be entitled to use the 0% tax on a portion of the capital gains.

If you are interested in talking about whether the new rate may apply to your situation, please contact your portfolio manager.  We will work with you and your tax advisor to determine the appropriate course of action.