Friday, June 5, 2009

Market to Fed: get ready to tighten


The headlines today are all about how job losses were a lot less than he market had expected (345K vs. 520K). But the biggest mover in the markets so far is the Eurodollar futures contract tied to what Libor will be in December 2010. As this chart shows, it fell almost 37 bps, which means that the expected Libor rate rose 37 bps. That rate is up by 50 bps between Wednesday and today. Since Libor is typically linked closely to the Federal funds rate, this implies that the market has suddenly adjusted upwards—by 50 bps—its expectation for where the funds rate will be at the end of next year. On Wednesday the market thought the funds rate would be about about 1.75%. Today it is thinking 2.25%. That's a big deal, suggesting that the market is now beginning to get comfortable with the idea of a recovery.

It should also be viewed as a warning shot across the Fed's bow: they better start gearing up for tightening, because they're going to have to abandon quantitative easing and start raising the funds rate. If they do it in 25 bps increments, they are going to have to raise the funds rate every 2-3 months or so, according to the market's best guess today.

It's also significant to note that gold dropped sharply today and the dollar rose. That's perfectly consistent with a market that is realizing that the Fed is probably not going to be forced to keep the pedal to the metal forever; that higher interest rates are coming into view. If the Fed gets the message and starts raising rates, that would be very good news indeed. Because otherwise, we are going to have a big inflation problem on our hands.

UPDATE: As the bond market gets ready to close, the Dec. '10 eurodollar contract is trading with a yield of 2.71%. That translates into an expected funds rate of almost 2.5%. The yield on the 2-year Note is up 35 bps. The yield on 2-year Treasuries has been pretty stable since the end of January at about 0.95%, and now it is suddenly up to 1.3%. Think of the 2-yr yield as the market's best guess for what the funds rate is going to average over the next 2 years. This is a clear sign that the economy is now in recovery mode. Stocks are nervous over the jump in rates, but shouldn't be. We are many, many months away from interest rates or Fed policy even beginning to pose a threat to the economy.

10 comments:

Donny Baseball said...

Scott-
Dick Bove's note today is entitled "Bernanke Does His Job" and posits that there are hints the Fed is backing away. He cites cessation of growth in Fed balance sheet, higher qaulity assets, slowing MZM growth, plummeting growth in M3.

Bove thinks we can't call it a done deal, but that these constitute early signs that Bernanke has a mop up operation in the works.

Jeff said...

Scott: What are your thoughts to Bill Gross's comments this morning stating that tightening and removing the money from the market will not happen anytime soon...only when we stop seeing all the job losses. He clearly is not in the camp that the Fed should start tightening sooner rather than later.

MW said...

Why not just look directly at OIS?

Scott Grannis said...

I've seen what could be hints of the beginnings of the mop-up operation, but so far they are only hints. They've got $1 trillion of heavy lifting (i.e., selling) to do to get rid of the extra assets they have taken onto their balance sheet.

What the Fed should do and what they end up doing are two different things. I think they should have started the mop-up operation already. Almost everyone who has looked at this issue objectively seems to agree that they won't move in a timely fashion, that they will err on the side of ease to ensure we don't get a double-dip recession.

I'm going to keep watching. If they don't move in a timely fashion, we should see gold over 1000 and the dollar making new lows. That will be the clue that we are staring a significant reflation in the face.

Scott Grannis said...

MW: OIS and the TED spread are pretty much the same thing; both are short-term indicators. Eurodollar futures give you a good look at where long-term expectations are, which can be much more volatile.

Scott Grannis said...

Donny: a further thought on the "hints." Slowing money growth is not necessarily a sign that the Fed is tightening. More likely, it is a sign that the public's demand for money is falling, and that velocity is rising. This is what is going to drive the recovery and the rise in inflation. The Fed needs to offset that by shrinking their balance sheet. They haven't done that yet.

dave said...

It's past time that the Fed reverse course with it's q-easing withdrawing liquidity from the markets until we see gold in the $550 price range . Stable money = low and stable interest rates.

The idea that the Fed is going to get back on the rate hiking see saw scares me. If I remember right that's part of the reason we find ourselves in the economic mess we are in.

Scott Grannis said...

You're exactly right. Erratic monetary policy that gets too tight (1996-2000) then too loose (2003-2005) then extremely loose (2008-current) is one of the major factors behind the financial crisis.

Bad monetary policy from the Fed and outrageously bad fiscal policy from the Obama administration are going to mean that the U.S. economy grows much slower in the future than it has in the past. We're going to pay a big price for these mistakes.

MW said...

I'm not sure I understand your response ("OIS and the TED spread are pretty much the same thing"). If you mean that one can take OIS, add the TED spread and get a Eurodollar rate, you're wrong --- you'd need a FRA/OIS spread (adjusted for convexity) not a TED spread. And Eurodollars trade out to 10y, while OIS trades out to 30y.

Given the above that, I'm interested to hear why Eurodollars are better than OIS for Fed expectations!

Scott Grannis said...

I meant to say that if you compare 3-mo Libor to 3-mo. T-bills (the TED spread), you get almost the same result as if you compare 3-mo. Libor to OIS.

You can use eurodollar futures out to 10 years to see what 3-mo. Libor is expected to be. In normal conditions, Libor tends to trade about 30 bps or so above the fed funds rate. Thus you can use eurodollar futures to back into the market's long-term forecast for the funds rate.