Friday, September 29, 2006

Poole Q&A -- A Gift To Those Looking For An Ease

In response to a question regarding the market's expectations of Fed policy next year, Poole gave an interesting resaponse. He noted that having the 10-year yielding 60 basis points under funds was not a tenable relationship for the long run. The trader, he added, is looking for less inflation and weaker growth and expecting the Fed to aggressively drop rates to a level below 4.65% (10-yr yield). Poole added that market forecasts, as honest and as good as they can be, do not have a good track record.

If inflation eases off, as the FOMC hopes, and real growth stays at or near potential, the Fed will not have to ease agressively and the 10-year yield would have to rise up to the funds rate or higher.

My italicized bold highlight informs us that IF the above scenario comes true, the FOMC is already set to give the market back the last 25 basis point hike.

In sum, if you think the Fed has done enough to quell inflation and not squash the economy, price in a 25bp cut for next year and short the 10-year. As for the timing of the move, considering that they want to see a solid pattern of data and are willing to wait until they get it, a March ease looks like the best bet.

Unless the unexpected occurs.

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