Where We Are Now

Fed statments be damned, the market remains undeterred in its quest to price in an ease next year. Spurred by softer data and ignoring the FOMC mantra to wait and watch, the traders and investors whose money flows determine fixed income prices pushed the probability of a 25bp ease by May of 2007 to near certainty. It seems that the whole course of the economy is now determined by manufacturing in the geography covered by the Philadelphia Fed. That might be true, and housing may be causing the economy to implode like a cheap tract house in Arizona, or it could be some wishful thinking on the part of market participants growing weary of negative carry.

Here below is the current state of probability affairs as lifted from the Bloomberg page set out by my partner, Stan Jonas, and used to help feed the trading strategies of our fund (this is not a solicitation, etc, etc, etc, merely full disclosure on my part)



The interesting point here is the Thur column which lays out the probablities implied by current pricing. The market is setting the odds at 1 in 3 of a cut in January, 1 in 5 in Mar and 2 in 5 by May. Cumulatively it adds to certainty by the May meeting.

As for expectations between now and year end, the no change view has gone from 66% to 82%. In that 18% betting on one move or another, it was 2 to 1 or 3 to 2 in favor of a tightening. Today it swung the other way and sits at 2 to 1 in favor of an ease: 12% to 6%. These numbers are garnered from the Fed funds digital options that trade on the CBOT.

It seems that once the Fed stops, the market just has to believe the next move is an ease. History favors this view, no doubt, but when everyone sees it, something else suprises. The only real indicator to me that the economy is slowing is the drop in oil to $60/bbl. Since I believed growth and not a contrived shortage was driving the price up, I have to remain consistent in my logic.

There is, however, another aspect to lower yields and reduced oil prices. They are in and of themselves a buffer to weaker growth. Knowing this, the Fed shows no inclination to micro-manage the economy by changing rates 25bp from neutral (where we are now). With Fed funds neither constraining or subsidizing growth in the aggregate, the Fed seems perfectly content to let the economy fluctuate around some trend path, pushed and pulled by shifts in relative prices. Let market participants draw strong trends from single data points, the Fed will have none of that in its own decision making process.

The Fed is out of the way, the bigger disappointment to the market will not be that they have tightened too much but that they did just enough.