Thursday, September 21, 2006

Fed's a snore, market is a bore

Its been a long time since a Fed announcement day has left us with so little to talk about. Basically, the situation is exactly the same as it was yesterday morning. The Fed gave us no good hints about how it feels.

Supposed Fed mouth piece Greg Ip wrote in today's WSJ that the Fed seems more likely to hike than cut next, but "has become more confident that standing pat is justified." That is exactly what I have been saying. However, as I've been lamenting, and as Ip also mentions in his article, the bond market is clearly pricing in a greater likelihood of cuts than hikes.

So that makes it a good time to revisit the Fed Fund path analysis I've posted a couple times before (here and here). At those times I saw "too much too fast," as I pointed out that the market seemed to be pricing in multiple cuts. It occurs to me that markets are made by disagreements. If we all agreed on the value of things, no one would ever trade anything.

So I decided to model two scenarios. One where the Fed aggressively cuts rates in 2007, and one where they hike once then stay pat. I ran several iterations of both until I came to a pretty reasonable path, the average of which explains the current shape of the yield curve. Its admittedly simplistic, but it shows how the curve could reach equilibrium at current levels if the market viewed these two scenarios as having exactly 50% probability each.

In the first, the Fed hikes at the end of this year, then is basically on pause from then on. In the second scenario, the Fed cuts a total of 100bps in 2007, and another 50bps in 2008. This is fairly similar to UBS' forecast, so its hardly out of the mainstream.

My conclusion? Scenario 2 is possible, but I'd call it less than 50% probability. Scenario 1 seems much more likely. If you think these are the two most likely scenarios, but you think scenario 1 is 60% and scenario 2 is 40%, short interest rates.

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