Wednesday, April 30, 2008

The Fed and looking away to the future

The Treasury market has spent most of April backing away from financial disaster levels. The 2-year Treasury closed at 1.34% on 3/17, the day Bear Stearns was bailed out/purchased by J.P. Morgan. On Friday the 2-year traded as high as 2.50%. Similarly, the 5-year closed at 2.20% on 3/17, and traded as high as 3.24% on Friday.

When the 2-year traded down to the 1.30's it reflected a number of problems, including fear, illiquidity in other rates product, and the expectation that the Fed would continue aggressive rate cuts. Since then all three of these elements have backed off to some degree. But one thing that hasn't changed at all is the fact that the real economy is quite weak. It may be that the worst of bank writedowns are past us, but housing prices are showing no signs of bottoming. Yesterday, the Case-Shiller index showed home prices declined by 12.7% in 20 large metro areas over the 12 months ending in February. Inventories remain high, and there are still many delinquencies that are going to turn into foreclosures. While it does appear that we are now working through the housing problems, the fundamentals simply don't support a turnaround in the very near term.

We also know that in past recessions, unemployment tends to remain high, or even continues to rise, even after the economy starts growing again. This pattern will be present in this recession as well. Yes I know, 1Q GDP came out positive this morning, but there was a significant inventory effect. I'm going to keep calling this a recession until I'm really proved otherwise (which I doubt). Anyway, even if you presume a relatively mild recession, we're going to have elevated unemployment for a while.

So where does this leave the Fed? Today we got a 25bps cut, with the statement still sounding quite dovish. Those that are calling this statement "hawkish" are speaking relative to recent statements. Unless the Fed's favorite inflation gauges start rising, or the Fed really believes inflation expectations are rising, there will be no impetus for hikes any time in 2008.

Look back at the 2-year Treasury. The long-term spread between short-term inter-bank lending rates and Treasury rates is about 40bps. So if Fed Funds were going to remain at 2.25% for the next 2 years, fair value for the 2-year Treasury would be 1.85%. So with the 2-year actually in the 2.30% range, the market seems to be expecting Fed Funds to average something like 2.70% over the next 2-years.

Feels to me like that expectation is a bit high. If the Fed holds at 2% for 9 months, the Fed would have to hike 112bps immediately thereafter for Funds to average 2.70%. The hike would have to be more extreme if we used a discounting method rather than a straight average. Of course, there are any number of patterns that could justify current rates, but all of them would involve aggressive Fed hikes by early 2009.

And to assume the Fed starts hiking aggressively in early 2009 also assumes that housing and employment start showing some real signs of improvement by then. I'm not going to say it can't happen, but that seems like a very optimistic scenario. In other words, it seems that the odds of the recession being deeper or longer than what is priced in is relatively high, whereas a more optimistic scenario is just not very realistic.

As I said in a previous piece, inflation is the wildcard. If we see some real pass-through effects from food and energy then the Fed will have no choice but to hike rates. At that point the yield curve would flatten severely, possibly even causing the 10-30 year maturities to rally while the 2-7 year maturities sell off.

But in the short-term, it looks like the 2-5 year part of the curve is relatively cheap. If you have cash sitting around, now is probably a good entry point.

9 comments:

Anonymous said...

Why is the 2 yr. treasury yield historically 40 bps LOWER than fed funds, which is an overnight rate?

Anonymous said...

AI: The long-term spread between short-term inter-bank lending rates and Treasury rates is about 40bps. So if Fed Funds were going to remain at 2.25% for the next 2 years, fair value for the 2-year Treasury would be 1.85%. So with the 2-year actually in the 2.30% range, the market seems to be expecting Fed Funds to average something like 2.70% over the next 2-years.

Something weird in your math...

I assume you meant to say 2yrs should yield around 40bp over Fed Funds (on average) -- in which case a 2% FF rate would imply 2yr Trsy at 2.4% -- or 10bp CHEAPER than today?


The Federal government really sounds lost and confused. Treasury Secretary Paulsen has been saying this mess was contained for over a year now. The Fed Reserve told us everything was A OK back in November, but then did a crash easing in January -- at least in part due to not knowing about an out of control risk position at a French bank. Then the Fed orchestrates a bailout of a Wall Street firm while effectively becoming a prime broker.

And today they tell us things are looking up, but we decided to ease anyways.

Most Wall Street CEOs have made public statements saying the worst is over; we are in the later innings; etc... Then they announce massive write-offs, share dilutions, and a big pay increase for themselves.

I am not saying I buy any of these announcements -- just quoting the party line.

Is any of this behavior supposed to restore confidence in the markets, or are they trying to make us all panic?

James I. Hymas said...

I'm not sure how valid it is to take a long-term average of the 2-year/FF spread. It's very sensitive to economic conditions.

shankar said...

"....In other words, it seems that the odds of the recession being deeper or longer than what is priced in is relatively high, whereas a more optimistic scenario is just not very realistic...."

Well, I am glad you are changing sides. ;-)

We will not only see long and deep recession, but it will be associated with high inflation, a.k.a. inflationary recession. If you think stagflation was bad, wait for things to unfold in the next 6-9 months.

BTW, credit crunch has not gone away because the fed facilities are still expanding, treasury finances are dwindling down and although the US$ may show a short-term uptick, foreigners will stop purchasing treasuries precisely at a time when we need them the most.

Helicopter Ben thinks that by providing liquidity he can stop deflationary recession. In reality, he is leading us right into it.

The Fed is playing the depression book step-by-step - just as they did in 1929.


- Shankar

shankar said...

FYI (on Credit Crunch):

Bernanke Urged to Do More to Ease Bank Funding Costs.
http://www.bloomberg.com/apps/news?pid=20601087&sid=a6ewriPVRGEg&refer=home

Fed looks to extend debate on liquidity.
http://www.ft.com/cms/s/0/c18ed002-157f-11dd-996c-0000779fd2ac.html?nclick_check=1

I also think that the Fed probably looked at the employment number on Friday and didn't like what they saw.

steve said...

AI - having 'been with you' for quite awhile here as a reader, am i to take your most recent missive to suggest you are taking back some of your durational short? or suggesing 2/5s are 'cheap' 'ish, in fact a way to INcrease your short duration stance? Point of my question, I suppose, is that IF you are thinking pricing of rate HIKES too aggressive (which I currently DO think) and you need to get less short, money mangers I deal with simply find front end of curve too difficult to do so with -- cannot buy enough 2s or 5s to make a durational dent, so to speak. Perhaps your thinking more short term in nature, though? Ahead of the refunding supply, we're working on being IN steepening trades ... should unfold over next couple of weeks. Mid-May, seasonals start to shift in favor of bond mkt. At this very time, you've got coupon payments as well as maturing 3yr and 5yr notes adding about $70Bil TO Tsy space. Taken in context of quarterly refunding month -- usually produces 'healthy' month-end index 'extension trade' ....

All of this adds upto wanting to get less short duration middle of the month -- consider even a flattening bias (? counterintuitive and counterproductive to the Fed's mission?) and I'd think IF you were gonna get less short, you might EVEN consider using the longer end of the curve to do so?

Curious what your thoughts are as we kick off May?

Best,
Steve

muni investor said...

AI, a tangential comment. Just wondering about the Kentucky-Davis hearing. Do you know when it is supposed to take place ?
Thx.

Somnus said...

Inflationary concerns and a concern that the dollar is going the way of the Argentine peso are the only ways that the Fed increases rates.

But I sincerely believe that the role of pure, out and out dishonesty has to be given center stage.

Reported inflation such as the CPI will always conceal to the very best extent possible real inflation. They are lying now and they will continue to lie.

The dollar? How many people in the US track exchange rates? How many people give a [rhymes with sit]?

$4/gallon gas? It's not inflation. It's the Arabs. A problem to be solved by troops not rates.

Accrued Interest said...

I'm looking at T-bills vs. FF, so its not really a slope issue. Sorry that wasn't more clear.