Subprime worries quickly reshaping rate ideas

CHICAGO (Reuters) - Prospects for a huge downgrade of subprime-related debt have boosted chances that the Federal Reserve will need to prop up the U.S. economy with a rate cut some time in the next year.

Short-term interest rate futures, which measure market expectations of likely Fed policy, jumped on Tuesday after Standard & Poors said it might cut $12 billion in debt tied to subprime mortgages.

Rival Moody's Investor Services later said it had cut ratings of 399 mortgage-backed securities and was eyeing downgrades on another 32.

S&P linked its move to a forecast for U.S. home prices to drop by 8 percent, likely triggering more defaults on home loans. That sent shivers from Wall Street to Main Street, helping to trigger a slide in U.S. equities.

The Fed's steady-as-she-goes interest rate policy has been helped by confidence that the housing market slowdown will work itself out over time and that troubles in the subprime mortgage market -- which caters to borrowers with poor credit -- would not contaminate the entire economy.

The U.S. central bank has held its target for the federal funds rate, the benchmark overnight lending rate, at 5.25 percent since June 2006, a period covering a string of eight Fed policy-setting meetings.

But with subprime woes now threatening to trigger a more across-the-board tightening of credit, financial markets are beginning to think Fed policy may need to respond.

RATE CUT BY MID-2008?

Interest rate futures followed Treasury debt prices higher on the S&P report. The implied prospects for a Fed rate cut by year-end FFZ7 ended at 34 percent compared with 6 percent overnight.

Bigger gains were logged for 2008 contracts, raising the chances for a central bank easing by mid-2008 EDM7 to 82 percent from just 26 percent.

"This sub-prime story is far from over, and we may continue to see credit spreads widen," said Rudy Narvas, analyst at 4CAST Ltd. in New York.

"Housing market concerns could continue to mount, and possible spillover effects into other parts of the economy remain a very big risk ... we could see the housing slump extend further out."

A longer, deeper decline in home prices will almost inevitably ensnare more homeowners, and could start having more impact on the segment of the mortgage market that serves more creditworthy borrowers.

Over time, U.S. consumers worried about stalled or declining home equity could spend less, slowing the retail-buying engine that powers the economy.

Last week, San Francisco Federal Reserve Bank President Janet Yellen stuck with the central bank's cautiously optimistic spin on the economy and the subprime issue.

"From the standpoint of monetary policy, I do not consider it very likely that developments related to subprime mortgages will have a big impact on overall U.S. economic performance," Yellen said.

ECONOMY ON THE CANVAS?

Still, some economists worry that a lengthy spell of sub-par economic growth could make the U.S. economy more vulnerable to blows such as the latest one being delivered by the subprime crisis.

U.S. gross domestic product rounded out a string of weak quarters with an annualized growth rate of just 0.7 percent in the first three months of this year.

And although second quarter GDP growth is forecast to be stronger when the government's first estimate is released later this month, the trend could be short-lived if the housing recession proves longer and deeper than expected.

Paul Kasriel, director of economic research at Northern Trust in Chicago, said history gave little reason to expect an "immaculate recovery" without the Fed's help, and made a case for rate cuts as soon as the fourth-quarter as "anti-recession insurance."

"We wish there had been some instances when year-over-year real GDP growth had not slowed to 2 percent or less and the Fed had not engineered declines in the federal funds rate," Kasriel said. "But we don't have such a case."