Fascinating discussion on the meaning of the Fed Fund Futures. While many economists have taken to stating this means a likely rate cut before the end of the year, some look at it quite differently:
"Lou Crandall, chief economist at Wrightson Associates, says while such action is commonly attributed to increased expectations of a Federal Reserve rate
cut, that would be a mistake. The real reason, he said, is that
investors are fleeing risk and seeking safety in Treasury bonds and
bills and other high-quality paper, sending their prices up and yields
down. As a result, the entire yield curve has shifted down. To maintain
parity with that lower yield curve, the implied federal funds rate also
has to drop, he says.
Mr. Crandall says, “99% of the universe,
including a lot of people in those trades, don’t do it because they
think the Fed will ease but because that’s the way the yield curve is
But wait a minute: isn’t that a violation of efficient
markets? If fed funds futures were out of line with a realistic
expectation of Fed action, couldn’t smart people take positions in the
mispriced futures and make a bundle six months later when it turns out
the Fed didn’t cut rates? And shouldn’t such arbitrage push
expectations of the Fed and pricing of futures back into line?
says Mr. Crandall, for two reasons. First, the Fed has gotten more
predictable but gives no guarantees on where rates will go, so there is
no assured profit on such a trade (so it wouldn’t really be arbitrage).
Second, “The amount of money backing people who have opinions about
where the Fed will be in six or nine months is dwarfed by the amount of
real money being invested in short-term credit markets.” Nervous
investors are willing to accept a lower yield than what might
ordinarily be justified based on the economics in exchange “for safety.
Market participants know that perfectly well. That’s why it’s called a
flight to quality.”
That makes good sense to this disbeliever in the efficient market hypothesis . . .
graphic courtesy of WSJ.com
Markets Expect Fed Easing? Not So Fast
Real Time Economics, August 1, 2007, 9:50 pm
Fed Keeps Its Focus on Inflation
Rate Cut Seems Unlikely Despite Data Suggesting Increased Risks to Economy
WSJ, August 2, 2007; Page A2