Fed Day. As per my post yesterday, the Treasury curve is pricing in multiple rate cuts for next year. In order for the Treasury market to rally, the Fed would have to do one or more of the following:
- Not only pause at this meeting, but make it clear that there will be no additional rate hikes for the rest of this year. This would be in stark contrast to the very measured language of the last two years. Even if they pause now, they are likely to leave the door open for more hikes if need be.
- Emphasize economic weakness in an attempt to ready the market for rate cuts in 2007. Why would they do those so soon? If they need to cut rates in early-mid 2007, they can certainly wait until closer to that time to warn the market.
- Hint that the Fed may get involved to prevent a housing market collapse. This would imply that Bernanke & co. would cut rates in order to take pressure off housing prices. Such talk would be self-defeating. People would hold off buying houses in the hopes that mortgage rates would soon fall. Bernanke also does not want to be seen as interfering in asset prices. If the Fed thinks that housing is a problem, they can cut rates without implying that they are targeting housing prices.
- Dismiss the continued pressure from energy prices as being irrelevant to inflation. This would not be consistent with the Fed's stated belief in expectations theory. Even if the economists at the Fed believe energy prices will not cause inflation, the public remembers the 1970's and associates energy prices with inflation.
I believe the Fed will sound more hawkish than the market currently expects, and therefore I'm bearish on Treasuries today.