Friday, December 01, 2006

The cut is coming... or so the market thinks

The 2-10 slope is 6bps steeper (less inverted) on the day, which is the biggest single day move in that slope since September 20, 2005. The slope is currently -10bps after trading as low as -19bps at various points in late November.

A bull steepener (which is where rates fall, but short rates fall faster than long rates) indicates cuts from the Fed will happen sooner than later. To understand this, think about why the curve inverted in the first place. It was because the market believed that a period of economic weakness and Fed cuts would eventually come to fruition. Therefore investing in longer-term rates would allow one to lock in attractive coupons. So while shorter-term bonds are more closely related to the current Fed Funds rate, longer term bonds anticipate cuts. Hence, short-term bonds carry higher rates than long-term bonds.

When the curve steepens, something about the above situation has changed. If the curve is steepening and rates are falling, then it must be that the eventually from above has turned into soon.

Is this right? I've been arguing that the economy is on better footing than the market is indicating. Today's weaker manufacturing numbers don't convince me otherwise. In order for me to be convinced, I'm looking for weaker consumer spending/income figures. Yesterday's initial claims figure isn't encouraging, but I think we need more data points to be worried about a recession.

Then again, I've argued that the downside potential for rates (upside for bond prices) is much greater than the upside for rates. If we do enter into a recession, I believe that the Fed will be forced to cut rates very aggressively, possibly down into the 2% range. This would create a major rally, particularly in the front end. That's why I'm positioned duration neutral and for a steeper yield curve.

4 comments:

Anonymous said...

When do the Fed's Governors quit talking up the inflation fears and finally talk about the weakening economy ..... when it's too late ? It seems as if they're putting themselves into a non-winning position by yelling "fire" so often

dimitri said...

How is the Fed going to cut soon w PCE Deflator at 2.4% and labor costs excelerating (and continuing to do so given the 4.4% unemployment rate?)

dimitri said...

sorry, i can't spell - i meant accelerating

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