Thursday, August 30, 2007

I have been expecting you

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.


moon said...

The dollar will come under pressure one would assume.
This dance of musical chairs has to stop at some point.Our fiscal house is not in order and our foreigner benefactors will want a higher risk premium as our treasuries become junk status

Anonymous said...

Today's well presented post included the statement:
I believe the balance of risks is toward higher intermediate term rates

So, in a previous post, when you wrote "I'm bearish on rates", that means you see more chance of higher yields than of lower yields?

I was confused because, if I were to say I'm bearish on the S&P, I mean I see more chance of lower stock prices than higher stock prices.

At this point I believe I was mistaken to understand the phrase "bearish on rates" to mean lower yields.

p.s. A commentor ("idoc") on Calculated Risk posted a link to your "I have been expecting you" post last night.

Accrued Interest said...

Calculated Risk is a great blog and it seems we have several readers in common. They just have 10x more readers in total...

Anyway, when bond guys say they are bearish on rates, they mean they think bond prices will go down. That means rates will go up.

Same goes for saying you are bearish on the spread of something. You expect the spread to widen. I know it can be very confusing, because I have to explain it to clients constantly.

The spread thing can get even more confusing, because if I say I'm bearish on spreads, I mean that in isolation of rates generally. So I could be bearish on Agency spreads, but bullish on rates. That might mean that the absolute price of Agency bonds increases, but the spread also increases, so Agencies wind up underperforming Treasuries.

Anonymous said...

tddg, thank you for your excellent blog and clear thinking and clear explanations. It was a real treasure to find.

Anonymous said...

What was the bloomberg command that you used to produce the graph?

Accrued Interest said...

Anon: Thanks for the kind words.

Chi: GT10 Govt FDTR Index HS (GO)

If you want them in the opposite order, type XCU (GO) HS(GO)

knzn said...

If you use ED futures to track expected changes in the fed funds rate, you may be mistaking an expected narrowing of the spread for an expected decline in fed funds. In this case I would guess that around 25 bps of your 100 bps are expected changes in the spread. (Note that, comparing 3m and 6m Treasuries with ED futures, the implied forward rates show a dramatic narrowing of the TED spread, by more than 100 bps yesterday, though I haven't looked today. I would guess that part of that expected narrowing will be between fed funds and ED.)

Regarding bonds, it sounds like you're looking generally for a steeper yield curve. If a recession hits, the curve steepens from the bottom, and if no recession it steepens from the top.

Accrued Interest said...

KNZN: I grant your point. But I think the 100bps priced into forwards reflects mostly declining rate expetations, and a little spread normalization.

Also, I do like a steepener for exactly the reasons you describe.

NA said...


If a 10-year doesn't move a lot when Fed is in the easing process; would you recommend more shorter durations like 2 and 5-year maturities?

Thank you!

Accrued Interest said...

Yaser: I miss your blog. Yes, I like 5-7 year bonds mostly. See, I'm in a position where I have to own a portfolio with an overall duration within a certain band. So I'm going to own something in various areas of the curve. But I'm going to be overweight 5-7 year bonds for the time being.