Markets Set for Big Fed Rate Cut as Turmoil Persists

By Mark Felsenthal and Jamie McGeever

WASHINGTON/LONDON (Reuters) - The U.S. Federal Reserve is expected to slash interest rates by as much as a whole percentage point at its policy meeting later on Tuesday as investors warily await investment bank results that could aggravate fears of a full-blown markets crisis.

Traders expect the Fed to cut rates aggressively in an effort to stop haemorrhaging in financial markets and boost the flagging economy. The Fed is expected to announce its decision around 2:15 p.m. (1815 GMT).

The Fed has cut overnight rates by 2.25 percentage points to 3 percent since mid-September as a rise in defaults on subprime mortgages has escalated into a financial crisis that this weekend claimed one of Wall Street's most venerable firms, investment bank Bear Stearns BSC.N, as a victim.

In the midst of what many analysts say is the worst financial crisis in decades, economists and traders expect the Fed to deliver its biggest rate cut since 1982.

In mid-morning trade in London, Fed funds futures contracts were fully discounting a one percentage point cut and indicated a one-in-five chance the Fed will slash benchmark borrowing costs by as much as 125 basis points.

Before the market open, however, investors will focus on the quarterly results from Goldman Sachs Group Inc (GS.N), the most profitable U.S. investment bank, and Lehman Brothers Holdings Inc LEH.N, the fourth-largest.

Lehman's stock closed down almost 20 percent on Monday, meaning it has lost some 50 percent of its value this year, as speculation mounts that it might be facing similar mortgage- and leveraged loan-related problems that led to Bear's demise.

Lehman and Goldman are expected to show how badly they were hit by the credit crunch in the three months ended Feb. 29 -- and any major shocks could send markets into another tailspin, especially given the vulnerability of the financial sector exposed by the firesale of Bear Stearns to JPMorgan Chase.

In this environment, markets expect aggressive Fed action.

"Just because we're in uncharted waters doesn't mean the situation can't get worse," Kenneth Broux, financial markets economist at Lloyds TSB in London, said.

"You've got to get rates as low as possible and leave them there. There aren't many alternatives," he said, acknowledging that there were inflationary risks involved in adopting such expansionary policies.

The Fed has already taken a series of radical steps in an attempt to stabilize the financial system.

It narrowed the gap between the discount rate -- the rate at which it lends directly to banks -- and the federal funds rate, the overnight rate banks charge each other for loans and the Fed's main policy tool, from three-quarters of a percentage point to a quarter point.

The U.S. central bank also unleashed a barrage of other unorthodox steps to provide liquidity, including $30 billion in financing to enable JPMorgan to buy Bear Stearns. In addition, it set up a new program to provide cash to a wider range of big financial firms through loans at the Fed's discount window.

Stability returned on Tuesday to European banking shares which have been battered by growing investor concern about the global financial sector's security.