Tuesday, July 18, 2006

Where The Bond Market Is, It Can't Be On August 8, 2:15pm

The reaction to today's PPI data, along with recalibrated expectations for tomorrow's events, put back a reasonable sense of fear into investors that the Fed will raise rates another 25 basis points at the August meeting. The market went from a less than 50/50 chance of a tightening to a 60% chance of a 25bp hike. The congnoscente now wait for black or white smoke to rise from Capitol Hill at 10:01AM, with the outcome somehow dependant on the CPI data released that morning. Will core be .3 or higher? A lot of silliness to believe that Fed action in August depends on one data point or that Bernanke will do anything more than keep his options open while expressing optimism for the economy (good for stocks) and vigilance on inflation (good for bonds). More on this at the end of this posting.

The current pricing of the market embeds a pattern of expectations for Fed action that, when the time comes, the market won't be there. Fed funds and Eurodollar futures and their options are priced to an expectation that the Fed is August And Done. If you believe that to be the case and buy the two-year all you earn is the coupon -- nothing more when you bet with the forwards.

The August and Done scenario, however, can only be true retrospectively. Prospectively, if the Fed goes in August what are the odds that investors, advised by the same cognoscente who, last summer, were predicting Fed eases this summer, will hold September expectations to 0? Most likely we go to 50/50 at first, 25% at best if you are bullish.

Understand, however, that if the Fed goes in August and then the market prices in a 60% probability of going in September, 25% in Oct, 10% in Dec and 5% in Jan, the two-year goes up 22 basis points in yield (my guesstimate, certaintly no guarantee). If the market, after the Fed goes in August, expects a 6% funds rate, my guess is that the two-year moves 37 basis points higher. All the other maturities move the same in yield terms, more or less.

The only way to get a rally in the market is if the Fed SKIPS August and the market follows up with an expectation for no more tightenings, or perhaps even the potential for an ease. In that case, the market can rally anywhere from 15 to 25 basis points or more if the ease expectations creep into this calendar year.

The upshot is that if you own a two-year Treasury and want cap gains in the near term, your investment is a bet that the Fed skips August. If that makes you uncomfortable, change your investment.

I am not predicting what the Fed will do, I am just trying to define the risk.

Personally, 60/40 is about right for August and I really do not expect Bernanke to give us much more guidance outside of that. For those of you thinking he might do a rewrite after the CPI number (actually he will have it tonight, as will the White House) remember this -- the Fed understands the lead/lag relationship between inflation and growth. The worst inflation year in a business cycle is usually the first year of recession. What will, as a consequence, drive the Fed to act or not act is not the CPI data released tomorrow morning per se, but their internal forecast of the economy. IF they are confident that 5.25% is enough because the past tightenings plus high energy costs pull nominal GDP growth under 6%, then they are done. If not, they aren't. And if you own Treasurys, you've bet they're done.

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