Fed Funds Futures Forecast? -- Market Veering Wrong & Dudley Said So ~ Steve Blitz Morning Notes
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Thursday, July 30, 2009

Fed Funds Futures Forecast? -- Market Veering Wrong & Dudley Said So

No longer lurching from crisis to crisis, the capital markets can get back to displaying just how much they ignore facts to chase fantasy even during relatively calm markets. A current case in point is the pricing of the Federal funds futures. The Dec 2010 contract is forecasting a 1.75% funds rate and a 50/50 probability that the Fed will hike rates to 2.00% at its Dec 14 meeting.

The pricing flies in the face of two bits of evidence. First, this is going to be a long, slow, halting recovery for a number of reasons. Chief among them is that the private sector is lacking the firepower to use leverage to boost growth. Government is trying to replace the loss of private borrowing with public spending but the impact is going to be limited.

Second, the Fed is clear that it will take its time and, in all likelihood, too much time to unwind its largesse. Even if they are unwinding in 18 months, betting near certainty that the funds rate will be 175 to 200bp above current levels by year-end 2010 is the kind of wager that keeps the lights on in Las Vegas.

Take these words from Bill Dudley (President of the New York Fed) given yesterday at the Association for A Better New York Breakfast Meeting --

I’m going to suggest that the balance of risks is still tilted toward weakness in growth and employment and not toward higher inflation. I will also argue that it is premature to talk about “when” we are going to exit from this period of unusual policy accommodation. . . . .

. . . . there are a number of factors which suggest that the pace of recovery will be considerably slower than usual. In particular, I expect that consumption—which accounts for about 70 percent of gross domestic product—is likely to grow slowly for three reasons. First, real income growth will probably be weak by historical standards.

Second, households are still adjusting to the sharp drop in net worth caused by the persistent decline in home prices and last year’s fall in equity prices. This suggests that the desired saving rate will not decline sharply. That means consumer spending is unlikely to rise much faster than income. In other words, weak income growth will be an effective constraint on the pace of consumer spending. . . . .

. . . .Perhaps most important, the normal cyclical dynamic in which housing, consumer durable goods purchases and investment spending rebound in response to monetary easing is unlikely to be as powerful in this episode as during a typical economic recovery. . . .

. . . . If the recovery does, in fact, turn out to be lackluster, the unemployment rate is likely to remain elevated and capacity utilization rates unusually low for some time to come. This suggests that inflation will be quiescent. For all these reasons, concern about “when” the Fed will exit from its current accommodative monetary policy stance is, in my view, very premature.

There was more in this speech about the technicals of the Fed's alphabet soup of programs that restored liquidity to the capital markets and that the central bank now has the ability to really reign in credit by paying interest on nonborrowed reserves. The mechanics are correctly laid out, the idea that the Fed will have the foresight they haven't displayed since Volcker was Chairman is another story.

No Federal Reserve started to raise rates before industrial production had risen several months in a row and the unemployment rate was falling. There is nothing going on now or likely to go on, in terms of the economy and policy, to support the high probability bet being made in the Fed funds futures market.

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