Credit mkts to gain if Fed cuts, but economy nags

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LONDON, Oct 29 (Reuters) A likely 25 basis point U.S. rate cut this week should give credit markets a boost, strategists say, but sooner or later both debt and equity will have to price in the reality of a gloomy economic outlook.

Soft economic U.S. data, volatile equity markets and fears about hefty losses -- particularly for financials -- on assets linked to subprime mortgage debt have led markets to fully price in a cut to 4.5 percent on Wednesday.

''It's not what they (the Fed) do, the market pretty much expects the cut, it's what they will say that will affect volatility going forward,'' said Raja Visweswaran, a credit strategist at Bank of America.

But others predict that if the Fed makes another 50 basis point cut, as it did in September, that could intensify concerns about just how weak the economy is, while no Fed action at all would equally spook markets and send spreads wider.

''The market's danger this week is that we get a little bit carried away with the prospect of rate cuts and leave ourselves open to being disappointed if we don't get one at all,'' a trader said.

The shock half percentage point cut last month was aimed at easing liquidity problems as the commercial paper market froze.

This time round though, the move will be driven by deteriorating economic conditions linked to the subprime crisis, notably weakening U.S. house prices and tighter consumer lending terms.

''The last time the Fed cut they did it to provide liquidity to facilitate the market. This time there is weakness in the underlying economy,'' said Mehernosh Engineer, a credit strategist at BNP Paribas. ''The U.S. earnings picture this quarter has been almost a disaster and the forward guidance isn't strong.'' SHORT BUT SWEET RALLY Spreads rallied for about a week after September's cut.

''I think we'll get what we saw last time and that is a bit of a relief rally,'' said Jeroen van den Broek, a credit strategist at ING. ''It will only be marginal though, over a couple of weeks, by up to 5 or 6 basis points on the Europe iTraxx index. That may head back to the 30 basis points level.'' The investment-grade iTraxx Europe index was at 37 basis points early on Monday.

But markets have yet to realise that the Fed cannot ''save the day'' by continuing to cut rates in order to save risky assets, said Neil Murray, head of credit at Scottish Widows.

''It might provide some support but certainly not the extent of the rally we saw in September. People are realising that there are more issues in the subprime market than they thought previously'', he said.

IGNORING RISKS Earnings this week from UBS and Deutsche Bank -- which have already warned on profits -- could stall any potential Fed-fuelled rally if they report further writedowns.

Investors are particularly nervous after a mammoth .9 billion write-down by Merrill Lynch last week for collateralised debt obligations linked to subprime assets -- over LONDON, Oct 29 (Reuters) A likely 25 basis point U.S. rate cut this week should give credit markets a boost, strategists say, but sooner or later both debt and equity will have to price in the reality of a gloomy economic outlook.

Soft economic U.S. data, volatile equity markets and fears about hefty losses -- particularly for financials -- on assets linked to subprime mortgage debt have led markets to fully price in a cut to 4.5 percent on Wednesday.

''It's not what they (the Fed) do, the market pretty much expects the cut, it's what they will say that will affect volatility going forward,'' said Raja Visweswaran, a credit strategist at Bank of America.

But others predict that if the Fed makes another 50 basis point cut, as it did in September, that could intensify concerns about just how weak the economy is, while no Fed action at all would equally spook markets and send spreads wider.

''The market's danger this week is that we get a little bit carried away with the prospect of rate cuts and leave ourselves open to being disappointed if we don't get one at all,'' a trader said.

The shock half percentage point cut last month was aimed at easing liquidity problems as the commercial paper market froze.

This time round though, the move will be driven by deteriorating economic conditions linked to the subprime crisis, notably weakening U.S. house prices and tighter consumer lending terms.

''The last time the Fed cut they did it to provide liquidity to facilitate the market. This time there is weakness in the underlying economy,'' said Mehernosh Engineer, a credit strategist at BNP Paribas. ''The U.S. earnings picture this quarter has been almost a disaster and the forward guidance isn't strong.'' SHORT BUT SWEET RALLY Spreads rallied for about a week after September's cut.

''I think we'll get what we saw last time and that is a bit of a relief rally,'' said Jeroen van den Broek, a credit strategist at ING. ''It will only be marginal though, over a couple of weeks, by up to 5 or 6 basis points on the Europe iTraxx index. That may head back to the 30 basis points level.'' The investment-grade iTraxx Europe index was at 37 basis points early on Monday.

But markets have yet to realise that the Fed cannot ''save the day'' by continuing to cut rates in order to save risky assets, said Neil Murray, head of credit at Scottish Widows.

''It might provide some support but certainly not the extent of the rally we saw in September. People are realising that there are more issues in the subprime market than they thought previously'', he said.

IGNORING RISKS Earnings this week from UBS and Deutsche Bank -- which have already warned on profits -- could stall any potential Fed-fuelled rally if they report further writedowns.

Investors are particularly nervous after a mammoth $7.9 billion write-down by Merrill Lynch last week for collateralised debt obligations linked to subprime assets -- over $2 billion more than it initially estimated.

A disappointing non-farm payrolls report on Friday could also turn sentiment and set spreads on a longer-term widening trend, with many arguing that credit derivative indexes are inadequately assessing economic risks.

''Credit indexes are saying there is no real concern, the same goes for equity markets. But longer term there are substantial concerns and the Fed does need to act,'' said van den Broek at ING.

''The data on delinquencies are quite shocking. The U.S. housing market seems to be a moving target which nobody has quite caught up with.'' REUTERS SR BD2108 billion more than it initially estimated.

A disappointing non-farm payrolls report on Friday could also turn sentiment and set spreads on a longer-term widening trend, with many arguing that credit derivative indexes are inadequately assessing economic risks.

''Credit indexes are saying there is no real concern, the same goes for equity markets. But longer term there are substantial concerns and the Fed does need to act,'' said van den Broek at ING.

''The data on delinquencies are quite shocking. The U.S. housing market seems to be a moving target which nobody has quite caught up with.'' REUTERS SR BD2108

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