The severe illiquidity in corporate bonds of the last several days is no doubt concerning the Federal Reserve. After all, the Fed is the ultimate provider of liquidity, and Bernanke himself has publicly professed his belief that it was a liquidity crunch that perpetuated the Great Depression. Today, there is considerable debate over what the Fed will (or should) say about recent turmoil in the bond market tomorrow.
I think the Fed has been concerned with how tight spreads (and how loose credit standards) had become recently. Not only in the residential mortgage market, but in the corporate loan/bond market as well. Over investment and the subsequent need for a repositioning of capital is a common reason for recessions. So on one hand, many Fed economists are likely relieved to see credit conditions moving toward more normal conditions.
However, the severity of the credit crunch is concerning, and I'm certain Bernanke and Co. are watching carefully. Remember in the fall of 1998, when Long-Term Capital Management collapsed, Greenspan cut rates aggressively to stave off a liquidity crisis. By June of 1999, the Fed was hiking again. That was an obvious case of the Fed cutting to prevent a even wider contagion. This also is a classic example of the so-called Greenspan Put, which was the widely held belief that Greenspan was willing to bail out financial markets with easy money. Didn't happen in 2000-2002, but I digress.
Will there be a Bernanke Put? Tomorrow will tell us a lot. If Bernanke and his economist minions are sufficiently worried about the recent credit crunch, then they mention it in their statement. This would set up the possibility of a cut if things get worse. In turn, this would create considerable comfort in the credit markets. The shorts would get worried that a Fed cut will restore liquidity. The value buyers would see Fed cuts as limiting their downside. I really think a little nod in the credit market's direction by the Fed would go a long way. We don't need credit spreads to tighten, but we need stability. If the credit market can't stabilize, it really threatens to create a serious recession.
I will note, however, that there are a lot of traders expecting some mention of credit conditions in Tuesday's statement. So it may be that some degree of "nodding" is priced in. If so, then it will take more than one Fed statement to actually have any effect. In fact, I'm bearish on Treasuries tomorrow regardless. A dovish Fed statement would ease the flight to quality, while a hawkish statement takes away some of the cuts currently priced in.