Monday, November 27, 2006

Fed and Market Dancing Together For The Holidays

The Fed acts, the market reacts, the Fed reviews what the market does and speaks about it, the market reacts, perhaps something else in the world takes place, the market acts, the Fed reacts, the market reacts again, and the interest rate world converges to a single point. There is no arbitrary measure or guidepost to establish whether the point is too high or too low, for the short-term or the long haul. We just know that market and Fed have reached a conclusion that this is where rates should be for now. This is monetary policy today.

It would be nice to know why 5.25% is, as Poole noted in some q&a, "mildly restrictive" and how the FOMC came to that conclusion. We do know from that comment that once the economy slows to the point that inflation risk has lessened, rates will be pulled back to neutral. Before all that, the Fed will let us know whether the expectation in the market place for an ease is right or not.

Some insight to all this was given in remarks by Governor Kevin M. Warsh at the New York Stock Exchange, New York, New York on November 21, 2006 entitled "Financial Markets and the Federal Reserve"

"Today, I will discuss the role of financial markets in effective monetary, regulatory, and supervisory policy making by the Federal Reserve. In particular, I will discuss the potential for markets to inform the Fed's policy judgments--even as our policies also affect markets."

A good start. Later in his talk;

"Markets affect monetary policy predominantly through the information provided by asset prices. . . . At least as important, these prices also can provide some insight into the uncertainty surrounding likely outcomes. Monetary policy makers can use economic models and statistical techniques to extract the views of market participants about these key macroeconomic variables.

Let me cite a few simple examples of how we interpret asset prices. Through open market operations, the FOMC sets the target federal funds rate, . . . Interest rates for periods extending beyond that very short horizon, however, are established by market participants rather than the FOMC, although members of the Committee may be able to influence these longer-term rates somewhat through what is affectionately described as "open mouth operations." In this way, market-based interest rates reflect primarily the path investors expect for monetary policy. That expected path is of keen interest to us as policymakers."

Next, Warsh does my work for me by saying;

"Prices on federal funds futures and Eurodollar futures suggest that market participants expect the FOMC to cut the target federal funds rate about 50 basis points during 2007, a view consistent with expectations of a "soft landing." At the same time, market-based options prices on these interest rate futures indicate that implied volatilities are quite low, suggesting a surprising degree of certainty regarding policy expectations. Taken at face value, market participants appear to be reasonably certain of a benign outcome for both economic growth and inflation. In contrast, my own judgmental forecast includes a wider range of possible outcomes than is implicit in these market-based measures."

Now comes something interesting;

" . . . .Our own policies and actions affect market prices. As a result, when we look to financial markets for information, the information we seek may be shaped in part by our own views. The more that "market information" reflects our own actions, the less it is useful as a source of independent information to inform our policy judgments.

We need to be alert to this "mirror problem," in which markets can cease to provide independent information on current and prospective financial and economic developments. In the extreme case, financial markets keenly follow the Federal Reserve, the Federal Reserve is equally attuned to the latest financial quotes, and fundamentals of the economy are obscured. Under such circumstances, asset prices might teach us only about our skills as communicators. Fortunately, the prospect for profits--the critical underpinning of all markets--mitigates this problem."

Perhaps this is why Poole, after his talk to actuaries in Delaware, answered a question on the level of long-term yields with a question of why the bond market is a pessimist and equities an optimist.

Warsh, once again:

"Market-based information is surely important in determining good monetary policy. This does not mean, however, that the Fed's goal is to align its views with those of the markets or that it wants the markets' views to match its own. Instead, policymakers benefit greatly by listening to views expressed in markets that are at least somewhat independent of FOMC communications. We can further enhance the role of markets by enriching our understanding of the interplay between communication policies of central banks and market prices. Good communication by the Fed should help members of the FOMC interpret market prices. Unnecessary market uncertainty or misinterpretation of our assessments will only muddy the waters."

They will be making the waters still in the coming days as Feds speak and the November data start rolling in. Don't expect worried comments about the economy, but listen to what they are not saying. They have not said the market is wrong and they have not said anything about raising the funds rate. They have said the economy is cooling, housing isn't creating a recession, and inflation is cooling off nicely. Beckner, one of the Fed's chosen scribes, writes that the FOMC will shift its missive in the meeting prior to the ease.

What the market has priced in, and the Fed isn't telling us that the market is wrong, is an easing bias that starts with 10% chance of a 25bp cut in Jan, 30% for Mar, 30% for May, 40% for Jun and 40% for August (in round numbers). Since this all adds up to more than 100%, 50bp is in for next year -- see Warsh's comments above.

The odds of an ease have to rise as the year progresses, since the Fed has told us they will be easing but not when. The longer the time period, the greater the chance of capturing the ease. My guess, however, is that the ease, if it comes, comes in January. They will know everything they need to know. Watch the data, listen to the comments, read the Dec FOMC statement. The combination tells us Jan definitively.

The Jan/Feb spread in Fed funds futures closed today at 2. Earn 25 if the Fed goes, lose 2 if they don't. A pretty good risk/reward since Jan has the highest probability of getting Fed action and every other probability in 07 is contingent on what happens then. And given how policy is run, we will know Jan within the next 10 days or less.

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