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.