Commentary by Caroline Baum
June 10 (Bloomberg) -- For the past six months, the federal funds futures market has been a haven for widows and orphans, minus the benefit of coupon-clipping.
With the Federal Reserve’s benchmark overnight rate set at 0 to 0.25 percent since December and the economy still in need of life support, there was little reason, or impetus, to bet on changes in monetary policy.
Daily moves of one-half of a basis point -- and that was on a big day -- in fed funds futures were purely technical in nature, a function of the contract’s cash settlement to the average effective funds rate for the delivery month.
That changed last Friday with the release of a less-bad employment report for May. The loss of 345,000 jobs last month, following six months in which the declines averaged 643,000, and a half-point jump in the unemployment rate to 9.4 percent was enough evidence, as far as interest-rate futures traders were concerned, to anticipate the beginning of the end.
So excited were traders to think Fed policy might once again have an implication for interest rates (a price) instead of being a reflection of the size of the Fed’s balance sheet (a quantity), they trashed the June 2010 contract to the tune of 58 basis points. The price of the September 2009 contract suggested a possibility of a rate increase in three months while November’s gave a tightening move a high probability.
The fireworks weren’t limited to the fed funds futures market. Eurodollar futures saw record volume, with 6 million contracts traded electronically and on the floor of the exchange combined on June 5, according to CME Group data.
Rear-View Forecasts
The yield on the two-year Treasury note rose 34 basis points, a one-day increase topped only four other times since 1982, according to Jim Bianco, president of Bianco Research in Chicago. Its most recent drubbing, for 44 basis points, took place on Sept. 19, 2008, the day the Treasury’s Troubled Asset Relief Program was announced.
A year is a long way off, to be sure. If this crisis has taught us anything, it’s that so many economic forecasts improve with the benefit of hindsight. The best and the brightest assured us that housing wasn’t a bubble, that the subprime crisis was “contained,” and that the banking system was sound. None of these assertions turned out to be true.
Human nature being what it is, Fed policy makers will probably want to see flowering crocuses, not just their green shoots, before starting to wean the economy from an IV-drip.
History Repeats Itself
The last thing Fed Chairman and Great Depression scholar Ben Bernanke wants to do is “abort the recovery by premature tightening,” which is what his predecessors did in 1936 and 1937, says Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago. “At what other time has a 345,000 job loss been a reason to celebrate?”
Kasriel thinks it will take until mid-2010 for Bernanke to have confidence that the recovery is for real. Most economists, unlike traders, are saying later rather than sooner.
“We may have more reason to believe a turning point is coming, but we haven’t seen it yet,” says Lou Crandall, chief economist at Wrightson ICAP LLC, a research firm in Jersey City, New Jersey. The market “over reacted to Friday’s payroll data.”
At some point, these “hiccups” will hold a message for the Fed instead of transmitting noise that can be dismissed. Crandall thinks tightening is a 2010, not a 2009, story.
‘Exceptionally Explicit’
Maybe the reaction is just a bad case of jitters over the existence and execution of the Fed’s exit strategy. It’s true that the Fed’s balance sheet will show some natural attrition as financial institutions resume their traditional lending function and the Fed imposes a penalty for using its various lending facilities. (In the old days it was considered a privilege, not a right, to borrow from the Fed’s discount window.)
Fed officials talk exit strategy in the same breath they reassure the markets to expect an “exceptionally low” funds rate “for an extended period.”
Instead of turning up the volume on “exceptionally low” in an effort to soothe the market, the Fed should try to be exceptionally explicit on what the egress will look like: Whether it will focus on the excess reserves banks are currently holding, which have the potential to multiply and become inflationary, or on the good old-fashioned funds rate.
Then there are the financial experts in Congress. While grilling Bernanke won’t be as much fun as playing pinata with bank CEOs, House Financial Services Committee Chairman Barney Frank and Senate Banking Committee Chairman Chris Dodd will surely offer him some exit guidelines, especially if the unemployment rate -- up 4 percentage points in the past year to 9.4 percent -- crosses the 10 percent threshold.
After all, they have to look out for the real widows and orphans.
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