The prolonged increase in U.S. inflation and accompanying decline in the value of the dollar has brought about obvious changes in the rhetoric of Federal Reserve officials, to the extent of triggering an aggressive sell-off in Fed fund futures contracts. In March the contract anticipated continued easing to 1.5% and at one point in mid-June, the December contract traded to 9719, an indication of more aggressive tightening.
As U.S. annual inflation held up above 4.0% in the spring of 2008, with successive records in oil prices showing little signs of dissipating, the Fed took matters into its own hands by changing tack. By upgrading its inflation preoccupation at the April and June FOMC meetings, the Fed made it clear that containing inflationary pressures, rather than shoring up weak economic growth, was its main policy priority. At one point in June, Fed funds contracts were pricing a 100% chance of a rate hike by end of the year, at a time when unemployment, housing and manufacturing were deteriorating to levels typical of a recession. Are futures traders getting too far ahead of themselves, or is the Fed wrong in shifting its focus? Will they really commit to fighting inflation in the face of a weak equity market?
On June 3, Fed Chairman Ben Bernanke shook the currency market by taking the unusual step of talking up the dollar, but after what seemed to have been a historic speech, the dollar recovery was quickly eroded by the fundamental realities of the U.S. and global economy. European Central Bank president Jean-Claude Trichet hit the wires signaling a July rate hike as Euro zone inflation surged to twice the ECB’s mandated maximum level. The euro surged across the board, sending the dollar lower against most European currencies. The dollar eventually lost all of its post-Bernanke gains when the U.S. labor report showed the unemployment rate jumping to 5.5% from 5.0% and payrolls posted their fifth consecutive monthly decline. On the same day, the dollar’s decline accelerated after an Israeli official said an attack on Iran was “imminent,” prompting a record $10 increase in the price of oil.
The dollar sustained renewed pressure in the rest of June amid deterioration in economic reports. As a result, the Dow Jones Industrial Average and the S&P 500 responded by intensifying their declines to reach three- and two-year lows. Although Fed funds futures had lowered expectations of a 25-basis point rate hike by year end from a 100% probability, odds remain as much as 75% of similar tightening by year end. Such pricing seems flawed considering the Fed never raises rates without a considerable decline in the unemployment rate from its cyclical peak. With the unemployment rate firmly standing at a four-year high of 5.5%, and with every labor market indicator pointing to further deterioration ahead, a Fed hike would be a grave economic blunder. The spread between 10- and two-year yields shows a renewed steepening in the yield curve, suggesting prolonged strains in the financial system and weakness in the overall economy leading to a resumption of the easing cycle.
Traders must realize that the calculated probability of interest rate decisions is derived from the price and effective yields of these contracts, which are a function of traders’ reactions to economic reports and Federal Reserve speeches. But lately, it’s been more a case of hawkish speeches than improved data. Because central banks’ managing of inflation expectations are vital to controlling actual inflation, the Fed hopes to support bond yields and stabilize the dollar via controlling the bond market’s expectations of inflation. The main risk to this strategy is that excessive strengthening in bond yields remains disjoined by deteriorating market and economic fundamentals. Despite the Fed’s tough inflation talk, we expect the next move in interest rates to be a decrease of 25 bps to 1.75% in October, with a likely subsequent reduction in December to 1.50%.
This analysis supports a long position in the Fed fund futures. Another and perhaps safer strategy would be to go long the December contract and go short the October or November. In July, Fed fund futures priced in a higher likelihood of a tightening by December than October, while we see further easing by year end (see “Tighten, ease or stand aside”). A spread would reduce the cost and work if we are right or if the Fed just remains on the sidelines.
Ashraf Laidi is chief FX strategist at CMC Markets and author of “Currency Trading and Intermarket Analysis: How to Profit from the Shifting Currents in Global Markets,” Wiley Trading.