Which Way is the Economy and the Fed Going?

September 20, 2006 at 1:18 pm  ·  Category: Federal Reserve, Macro Economics, Market Commentary

The Fed decided today to leave the federal funds rate at 5.25%.   

The interesting thing is that the bond market is pricing in rate cuts in the next year or so.  Justin Lahart, author of the Wall Street Journal’s daily “Ahead of the Tape” column on the front page on the “Money” section, had some interesting things to say about this this morning (subscription required):

The Federal Reserve has quickly gone from bond market foe to friend.  Hedge funds and other speculative investors are betting it stays that way.  For their sake, they better be right.

What matters most today is how the market is positioned for the Fed.  Treasury bond prices have rallied on the Fed’s change in stance.  The yield on the 10 year treasury note has gone to 4.73% yesterday from 5.25% in late June.  That suggests bond investors expect the Fed actually to lower short term rates in the months ahead to combat a slowing economy

This swing in sentiment is even more evident in bond futures markets [see chart].  At the beginning of June, noncommercial futures traders – generally hedge funds and other speculators – were making more bets on falling 10 year treasury prices than on rising prices… Now the ‘net long’ position of speculative tradres has swung to a record high.  That means there are alot more bets that bond prices will rise than there are on falling prices.  It also means that if traders suddenly find they misread the Fed or economy, a lot of people will be changing course in a hurry.

That could get messy. 

(A quick note on bond prices and yields.  Bond prices and bond yields move in opposite directions.  That is because the coupon on a bond is fixed at issuance.  As the interest rate environment changes the bond’s price changes to reflect the new market information.  When a bond’s price rises, that means you have to pay more for that fixed coupon which means that your yield (coupon/price) goes down.  That is why treasury prices have risen in anticipation of Fed rate cuts and why so many noncommercial futures traders have gone long (bought) treasuries in anticipation of the same – if the Fed cuts rates, bond prices will rise as their fixed coupons will become more valuable in the new environment and people will be willing to pay more for the bonds.)

Why are traders so confident that the Fed will cut rates?  According to Greg Ip’s article on today’s Fed pause, it seems like many of them are extremely bearish on the housing market (subsription required):

Thomas Joseph Marta, fixed income strategist at RBC Capital Markets, says while the Fed and his own firm’s economists are optimistic the housing slump won’t significantly hurt the rest of the economy, market participants are far more pessimistic.  ‘I’ve heard traders says, ‘Look, the Fed’s wrong,’ he said.  ‘Traders are reacting viscerally to housing.  Housing is something you see when you’re driving home from the train station – it’s very obvious, very visible.’

Still, some economists think the Fed is wrong and the bond market is right.  Paul Ashworth, senior U.S. economist at London based Capital Economics, said if housing construction’s share of economic output falls to the same level it hit in the early 1990s, after the last housing boom, ‘you’ll get a substantial drag on growth.’  He expects growth to fall to 1.5% next year from a projected 3.3%. 

I tend to agree with the bond market.  I think housing will be worse than many people expect.  But I wouldn’t go out and buy bonds just yet.  This isn’t a bad bet for people who want some income but all this seems already to be priced into bonds.  Another way to play this would be to buy gold.  As the Fed pauses and then starts to cut rates (i.e. print money) that will be bullish for gold. 

Posted by Greg Feirman  ·  Trackback URL  ·  Link
 

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