Tuesday, October 17, 2006

Bull Run In Bonds.......Incredibly In the Red Euros

One number (industrial production) and the market runs back towards the conclusion that recession or at least a Fed ease is on the way. While everyone is entitled to their opinion, market participants are, incredibly, betting that the Fed won't act until 2007:2Q at the earliest. Think about this. The grand poobahs of the market are looking at today's data, guessing on how weak the 3rd quarter was, adding to it forecasts for spreading weakness from housing and autos, and concluding that the Fed won't see what they do until next spring. You can't make this stuff up.

The table below, courtesy of my erstwhile partner Stan Jonas, is from his Bloomberg page (FFEP). It lays out where the market is betting and what happens if the bet shifts.

This morning's data helped to shift the market to the "Poole Scenario". This is based off of some of Poole's earlier comments that suggested (he would never tell, only suggest) that Fed funds were mildly restrictive and if inflation wanes and economic growth is comfortably in the 2.5% to 3.0% range, some give back is likely. He also let it be known that if the economy was starting to fall off a cliff, there would be no gradualism in the Fed's response.

That brings us back to today. IF you believe that the Fed will be easing because of a weak economy, an opinion based on recent data ..... Why believe that the Fed will wait until spring to ease?

There are plenty of Fed ease in January opportunities out there. The Jan digital is trading at 12, meaning you risk $120 to make $1000. Not a bad payoff. There is also the Jan/Feb Fed funds futures spread. Because of the Jan 31 FOMC date, any movement towards a Jan ease and the Feb contract will have all of the move -- by mathematical necessity. Of course a futures spread will hurt if the market switches to a tightening. In sum, its a bet on the Christmas season.

If you get a Fed ease in January, EIJ is the minimum move, a 17 basis point rally in the two-year Treasury. EJM is the more likely way the probabilities would line up if the Fed eases in Jan. That 100% in Mar can also be interpreted as 50/50 of a 50 basis point move. Remember, there will be no gradualism on the downside. In the EJM scenario, the two-year drops 44 basis points in yield and EDH7 is modeled to rally over 50 basis points. That Jan/Feb spread in Fed funds futures? You make 22 basis points, or thereabout.

Honing to the legalities of the day, these trades are mere suggestions, not suited for everyone, and the prices change minute to minute, and I am not guaranteeing anything other than that you will be paying your broker something if you put on a trade.

If the Fed is going to ease because the current spate of data indicates a rapidly weakening economy, they aren't going to wait until spring.

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