You were right David... Tell your sister, you were right...

Both my and the market's reaction to the initial Fed release on March 21 were wrong. It sounded to me like the Fed made a fundamental shift in their rate strategy when they dropped the phrase "additional firming... may be needed" from their statement. Logically, if the Fed saw the need for a cut in the near future, they'd start by dropping that phrase.

Reading the actual minutes, released on Wednesday, you don't get the same impression. It sounds more like the Fed sees some increased risks to the downside, but also sees stubbornly high inflation indicators. Reading between the lines, I think the Fed wanted to acknowledge their willingness to cut rates if it indeed comes to that, but we aren't there yet. Conversely we could say the Fed wanted to let the housing bears (and member banks) know that they aren't ignoring the housing situation, particularly the growing sub-prime problem. If a little boost to liquidity would help, then they may well oblige. But we aren't there yet.

So while I was wrong, kudos to people like David Andrew Taylor who were right. David posted on his blog right after the release that he still read the Fed as hawkish. I was proud of myself for getting the initial market reaction right, but it looks like that was merely the initial skirmish. David won the war.

In terms of actual trades, this was a case where I may have been wrong, but still made money doing it. I had moved my duration slightly lower in the last week of March. Rates have risen between 10bps since then. I'm positioned for a steepener, and even though we've flattened from +6 (2-10) on 4/2 to +1 now, the bigger picture is the move from -19bps in November to +1 now. I'm also long financials, which have outperformed considerably the last 5 days. MBS are also having a solid month of April so far.

Most of my bets play out well in a low volatility environment, so the Fed on hold scenario is just fine by me. I also think the 10-year has to rise more from here, with no move from the Fed, I've got to think the 10-year moves toward 5.25% by year-end. Whether it gets there or not depends on whether some of the housing headlines calm down and whether inflation figures allow the Fed to remain on hold. If it develops where they could actually hike, then the curve re-inverts in a bearish fashion.

But taking everything on balance, I still like the Fed to cut twice by year-end. I think that inflation will indeed subside. At that point, the Fed can turn their eyes to the banking system, and will conclude that 50bps of cuts will take a lot of sub-prime related pressure off. If I'm right about that, I think the 2-year stays right where it is and the 10-year sells off to 4.90%.

If you read this post from the afore mentioned David Andrew Taylor, he makes a logical case for rising consumer spending from here, which would normally create inflation pressure. I believe monetary policy is no longer accommodative, and I think consumer credit conditions have tightened. Both of these should be disinflationary, and I think this is what will win the day. David is taking a Keynesian approach, while I'm walking down Milton Friedman's path. We'll see who is right.