Bernake: Everything is proceeding according to my design!

The Fed's statement today projects increased optimism that the economy will continue to grow at a reasonable clip while inflation moderates. You will excuse Ben Bernanke from patting himself on the back just a bit.

Its very hard to read that statement and think a cut is coming any time soon. As commenter Dimitri points out, there is no reason for an inversion if the Fed isn't cutting. And if the Fed isn't cutting, there is no way for bonds to rally in any meaningful way from here.

And yet, I'm feeling short-term bullish on bonds. Economic data has been too one-sided recently, and that never keeps up. I see the Fed cutting once or twice in 2007, probably late in the year. The cut will come not because the Fed is changing direction, more as a tweak. I hearken back to something William Poole said a couple months ago. Paraphrasing, he said that monetary policy should be as tight as it needs to be, but no tighter. Historically, we can see that is exactly the attitude the Fed often takes. Most of the recent rate tightening periods have been followed by one or two cuts.

So here are my trades: play a mild bull steepener with very low volatility. MBS are a good way to play this. Also long dated callable agencies, but I don't like that trade as much as MBS. Long dated callables get crushed if the curve does a bull flattener, whereas MBS still do alright. Favor 2-year bonds over floaters if you need to be short-term. Favor 5-7 year bonds over 2 and 10-year bonds.

Someday I'll do a whole post on callable agencies, which are very popular among retail investors, but are usually not as attractive as people think.