FED WATCH: Bond Mkts Price In Easing, Defying Fed Stance
06 Mar 14:55
By Michael S. Derby
Of DOW JONES NEWSWIRES
NEW YORK (Dow Jones)--Bond markets are pricing in a Federal Reserve interest
rate cut most economists maintain won't happen. That's leading many to wonder
what side will have to give first.
Markets may realize they've gone to far in their pessimism and have to sell
off to get yields more in line with the real course of monetary policy, or Fed
Chairman Alan Greenspan may have to start preparing the ground for yet another
easing of interest rates sometime this spring.
So far, economists and bond strategists agree the market is more likely to
have gotten it wrong, although they add that the mispricing has been done for
understandable reasons.
Eurodollar futures contracts and fed funds futures are progressively pricing
in greater odds of a Fed rate cut at the late June policy meeting. The fed
funds contracts see a modest 20% chance of a rate cut at the upcoming March 18
meeting, but reflect a 70% chance of an easing by June 25.
Meanwhile, the Treasury market's prime short-term interest rate measure - the
two-year note's yield - continues to carve out historic low after historic low.
While the issue was under some modest pressure Thursday, its yield stood at
1.44%. That's one of the closest spreads to the Fed's overnight fed funds
target rate of 1.25% in several months.
Nasty Numbers
"The market clearly has been looking at the economic data" and believes that
recent softening in manufacturing, rising unemployment insurance claims and
other factors portend even more weakness down the road, said Gemma Wright,
market strategist at Barclays Capital in New York. With that in mind, she said,
many traders and investors believe the central bank will have to respond with
more stimulus.
The number of U.S. workers filing first-time applications for unemployment
benefits climbed to a two-month-and-a-half month highlast week.
But so far, nothing out of the Fed suggests that it will be cutting interest
rates any time soon.
For one, with interest rates so low, financial markets are effectively
providing an additional leg of stimulus to the economy that the Fed would in
any case welcome. There's also no evidence the Fed believes any additional rate
cut is necessary.
Since late last year, central bank officials have both in public comments and
in the policy statements that have followed gatherings of the Federal Open
Market Committee, tied soft economic performance to uncertainty over the
looming war in Iraq. They expect a resolution of that conflict to allow the
nation's solid economic fundamentals to take charge and power a much stronger
and enduring recovery.
Indeed, in testimony before congress in early February, Greenspan flagged the
sway of uncertainty over the economy, telling legislators he doubted that the
economy needed any more help from additional tax cuts targeted at spurring
short-term economic growth.
Fed governor Ben Bernanke said in a speech late last month that "although
areas of financial weakness are certainly present in the economy, as in every
recession, the financial problems that currently exist do not seem sufficient
to prevent an increasingly robust economic recovery during this year and next."
U.S. monetary policy makers' consistent stance underscores their growing
divergence from much more pessimistic financial markets.
"There is some disconnect" between markets and the Fed, and it has a lot to
do with the numbers that the two camps are looking at, said Stephen Stanley,
senior market economist at RBS Greenwich in Greenwich, Conn.
He reckons the markets are paying too much attention to issues like falling
consumer confidence and the claims data. Markets may also be losing sight of
the extent to which real economic performance is being obscured by war worries,
he said.
The Price of Fear
Some strategists argue thatjust as economic performance is being distorted
by war prospects, so too have market price levels. The rally in two-year notes
and its relationship to monetary policy has been subsumed by a mad dash by
investors toward risk-free investments.
Gerald Lucas, senior government bond strategist with Merrill Lynch in New
York, said a notable slice of the bond market pricing levels are simply
insurance against a more messy outcome to the war. The Fed funds contract, for
example, "reflects a downside geopolitical risk" that builds on some real
expectations of Fed easing, Lucas explained.
Most strategist believe that if the war comes relatively soon and passes with
minimal surprises, it's likely that fixed-income prices will fall to reflect
the diminished safe harbor concerns first and foremost, and also the reduced
odds of more rate cutting.
But if the economic data don't improve, it may well have to be the Fed that
changes its tune.
"I think (the Fed has) got to begin to start worrying here," said Chris
Rupkey, economist at the Bank of Tokyo-Mitsubishi in New York. "They didn't
expect the economy to lift until we got past the Iraq crises," but "I don't
think they realized they'd be faced with such a darkening storm in the data."
Rupkey says that it's a good chance the Fed could over coming months
recognize the deterioration not so much with an easing, but by changing its
balance of risks statement to say economic risks lie on the downside.
-Michael S. Derby, Dow Jones Newswires; 201-938-4192;
michael.derby@dowjones.com
(END) Dow Jones Newswires
03-06-03 1455ET |
