Saturday, September 01, 2007

Fed still likely to stay on track with target rate at 5.25% for the rest of 2007 and probably well into 2008

Despite all of the "turmoil" in the financial markets and a credit crunch is some credit markets, the Fed will likely continue on its current path (including sporadic liquidity injections into the banking system) and stay on track to keep the fed funds target rate paused at 5.25% for the rest of the year and probably well into 2008.

Usually, in normal times, the fed funds futures market is a good indicator of what the Fed will do over the next month or two, but we are not in normal times right now and currently there is such a dramatic dislocation between what a lot of people fear or hope for on the one hand and what the calmer Fed is actually likely to do. So, I do report the fed funds futures here, but for now I do so with the caveat that they are completely out of whack. Yes, they do reflect what people hope and fear, but they are not predicting likely Fed activity.

In a lot of cases they are either speculative bets seeking to make a quick buck if the Fed does happen to cut rates, or actually legitimate hedges by holders of fixed income assets who are really buying insurance in case the Fed does happen to cut rates, but do not necessarily represent a core belief that the Fed really will cuts rates.

As of Friday, Fed funds futures contracts indicate the following probabilities for changes in the Fed funds target rate at upcoming FOMC meetings:

  • Before the September 18, 2007 meeting: 100% chance of a cut and 2% chance of a second cut
  • September 18, 2007: 100% chance of a cut and 46% chance of a second cut -- flip a coin, but leaning away from second cut
  • October 30/31, 2007: 100% chance of two cuts and 18% chance of a third cut
  • December 11, 2007: 100% chance of two cuts and 78% chance of a third cut -- third cut is likely
  • January 2008: 100% chance of three cuts and 8% chance of a fourth cut
  • March 2008:  100% chance of three cuts and 34% chance of a fourth cut
  • May 2008: 100% chance of three cuts and 54% chance of a fourth cut -- flip a coin, but leaning towards a fourth cut
  • June 2008: 100% chance of three cuts and 52% chance of a fourth cut -- flip a coin, but leaning towards a fourth cut
  • August 2008: 100% chance of three cuts and 50% chance of a fourth cut -- flip a coin, but leaning towards a fourth cut

So, the futures are telling us that a cut is a "slam dunk" before the September meeting, but I would urge caution in depending on that number since: a) the Fed has given no indication that it is leaning towards such a cut, and b) bets placed in the "heat" of a crisis are frequently unwound in the weeks following the crisis.

Note: Studies have shown that the fed funds futures market only has a high degree of forecast reliability about 30 to 45 days out (high out to 30 days, only modest reliability out to 60), so those probabilities beyond September are shaky at best and could easily change very dramatically.

What we saw these past four weeks was a simple knee-jerk reaction to a very real, but brief crisis. Wait a few weeks and the picture will change again.

And to repeat one thing that bears repeating: the economy is much stronger than many people on Wall Street are claiming it is. "Forecasts" of the economic impact of the so-called subprime crisis are way out of proportion to the likely impact, and that is even before election politics pushes the administration and Congress to offer a substantial safety net for struggling homeowners. There is simply no economic need for a fed rate cut either now or in the near future.

-- Jack Krupansky

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