Thursday, October 05, 2006

Risks Realized As Market Hears The Fed, What's Next?

It has taken two weeks of speeches and conversations from Bernanke, Kohn, Yellen, and today Poole in the FT, plus last Friday's employment data to finally get the market to understand the risk inherent in utterly convincing itself that the Fed is going to ease in the coming year.

The risk, as I have written in this Blog before, is that when you own a security such as the 2-year Treasury, you own the market's expectations. Now that the market has finally caught on to what has been obvious, the yield on the 2-year has backed up about 25 basis points since last Wednesday. And the back up isn't finished.

Before looking ahead, lets look at what the array of speakers had to say;

  • Don't short the Fed's resolve on fighting inflation
  • Unless downturn in housing extends to broadly damage the economy, the Fed isn't stepping in
  • If the Fed has to step in, it will ease aggressively to prevent recession
  • Current Fed funds is high enough to bring down inflation over time -- and we can be patient
  • At current market rates, the downturn in housing has probably plateaued
  • If the Fed is uncertain as to how the economy unfolds, why is the market priced with such certainty?
The employment data was the final piece to crack the market's illusion of what will be to what is going on. Briefly put, the upward revision to August to 188,000 new jobs pushed growth above the 100,000-125,000 that the Fed feels is concurrent with trend growth. The earlier benchmark revisions are interesting for revising equations, but not so much for the market. Trading today on what employment growth actually was last April is a bit silly. The impact has long been seen in the growth data. All that has occurred is that we now know better why spending held up.

Looking ahead, the market is coming to an interesting pricing pattern, as seen below in the table lifted from my partner Stan Jonas's screen on the Bloomberg:

The table tells us that the market has shifted from the EIJ (Ease In January) to Poole (based on his and his compadre's comments). Should the market shift to HLD (Fed on hold forever), there is still a 46 basis point back-up in the yield on 2-year Treasurys. In other words, you are still buying the ease potential.

What are the odds? A careful look at Poole and I come away with the sense that the market is pricing for an impossible outcome. The outcome presumes that the longer the Fed goes with doing nothing, there is an ease out there, somewhere, sometime. Eventually, perhaps, but the longer the economy grows at trend, so the Fed doesn't have to ease, why would the economy suddenly weaken when the natural momentum in the economy is growth? In other words, barring the unpredictable, if the economy is on track next spring, forget about any ease. If there is going to be an ease, it will be by January the latest or not at all.

What does that mean? Simply that the HLD scenario is very much in play IF you believe the economy is not going to slink into recession. Remembering this economy ends with a bang and not a whimper, a recession bet is a bet on the unpredictable. As I have written before, understand the risk before you invest. If you buy a 2-year Treasury, there is a 45 basis point risk if the economy grows such that the Fed has nothing to do but watch.

If you are inclined to trade the market, the March 2007 Eurodollar contract has all the action and expectations. Not wanting to run afoul of any rules and regulations, I will let you figure out what you can do.

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