How many Fed Funds cuts are priced in? At least 100bps. Below is the forward 3-month LIBOR rate based on Eurodollar futures. Note 3-month LIBOR is currently 5.58%.
- 12/07: 5.12%
- 3/08: 4.74%
- 6/08: 4.60%
- 9/08: 4.58%
I note that for longer dates, I don't like using the Fed Funds futures contract, as it tends to get pretty thin past 3 months or so. Thinly traded derivatives contracts are notoriously technical, which can lead you to make bad conclusions. For illustration, see the ABX.
Anyway, for what its worth, the JAN Fed Funds contract stands at 95.50, implying 4.50% funds. Also, the 2-year Treasury is currently 116bps through target Fed Funds. All these imply several cuts.
But as a portfolio manager, I don't get paid to interpret futures contracts, I get paid to make profitable bets. And now I believe the balance of risks is toward higher intermediate term rates. The 10-year Treasury is currently at 4.50%, or 75bps through Fed Funds. Under normal circumstances, there is a positive spread between the 10-year and Fed Funds. So using the classic arbitrage-free pricing theory, Fed Funds would have to average somewhat below 4.50% over the next 10-years to make owning the 10-year profitable.
This is an important point, because merely having more than 100bps of Fed Funds won't necessarily cause the 10-year to fall much. Going into 2001, it was widely expected the Fed would cut rates. According to Bloomberg's economist survey conducted in December 2000, the average economist expected approximately 75bps in cuts during 2001. In fact, the Fed cut 475bps. Quite a miss by the economists. But what happened to the 10-year?
(The orange line is the 10yr and the white is FF)
On 1/3 the Fed first cut for the first time. The 10-year closed at 5.16% on that day. By the end of the year the 10-year rate had fallen a whopping 11bps to 5.05%. This despite a serious recession, a terrible stock market, dramatically wider corporate bond spreads, and the 9/11 attacks.
To be sure, the 10-year fell more dramatically in 2002 and 2003 as the Fed kept cutting rates and a deflation scare set in. But my point is that in December 2000, several Fed cuts were priced in. So as the Fed actually did cut in 2001, all that happened was the curve steepened. The 10-year moved very little. Even as the Fed blew way past everyone's expectations, long-term rates remained stubbornly high. A long duration strategy would not have paid off, at least not unless it was coupled with a steepener stance as well.
So back to my point about the average Fed Funds rate being less than 4.50% to sustain a rally in the 10-year. Even if we imagine that the Fed cuts 150-200bps next year, we know that eventually the Fed will be back to hiking again. The market will assume that as well. That's what happened in 2001. The market saw the Fed actions as temporary, assuming that eventually rates would rise again. It was only when it became clear that Fed Funds was going to stay ultra low for a long period of time that the 10-year finally rallied significantly.
Even if Fed Funds gets quite low, like 3%, it has to stay there for a while to produce a long-term average below 4.5%. Fed Funds at 3% for 3 years then 5% for the remaining 7 years still produces an average rate of 4.4%.
This analysis is quite simplistic. I'll say that all my work on the macro situation points to a fairly weak economy in 2008. But at the same time, it doesn't suggest a weak enough situation to reproduce the deflation scare of 2002-2003. And I think that's what it will take to move the 10-year meaningfully lower.