Ahead of the Fed

Short-dated interest rate futures improved from a defensive tone earlier in the week and one that many onlookers blame on the potential for the FOMC to turn hawkish in its statement later this afternoon. However, the response to the November jobs report from chairman Bernanke makes me suspect that the Fed is more likely to lay it on thick that rates won’t change anytime soon and as such will maintain its language to include the term “extended period” in reference to the outlook for monetary policy.

While the Fed currently predicts unemployment in 2010 somewhere between 9.3% and 9.7% that’s only a minor claw back when you consider the 7.3 million jobs lost since December 2007. Yet today’s final meeting of 2009 is set against a background of a possible growth rebound to 4% in the present quarter.

Bond yields came in marginally on the possible view that the recent sell off might have gone too far. Earlier in the week the 10-year yield rose to 3.6%. Meanwhile housing starts in November rose at an annualized pace of 574,000 units while inflation data also came out inline with forecasts.

The odds of a rate increase by June have shortened since the FOMC met last month largely on account of the sharp decrease in job reductions. At the time of its last meeting rate futures showed the chance of mid-year rate increase at 48%. Heading into today’s announcement the chances have increased to 55%.

Former fed vice chairman, Alan Blinder writing in today’s WSJ warns that growth risks are skewed to the upside given the potential for plant and equipment spending by companies to commence under a regime of a very low cost of capital. He thinks GDP growth could rebound to a 4% pace during 2010.

The chances of a change to monetary policy are currently slim even as the Fed is possibly deep in the middle of a discussion on precisely how and when to start removing emergency stimulus measures. However, the market is fast coming around to the view that global central banks will shift at some point during 2010. As always, markets are swift to discount such moves well in advance and in order to start feeling any vindication over a bond rally, we’ll need to feel ongoing waves of deflation pressuring consumer prices lower.

Eurodollar futures – rallied around six basis points and reversing several down days as investors took bearish bets ahead of the Fed. Following today’s data the yield on the 10-year note eased to 3.56%, while the shorter are of the curve settled down in a flattening fashion. The December 2010 contract is currently trading at 98.73 or 1.27%.

European short futures – German bunds are at session highs reversing an earlier yield rise.  The March future is trading up 27 ticks at 122.75 to yield 3.20%. A larger than expected demand for one-year cash at the final 12-month cash tender from the ECB attracted demand for €96.9 billion at a variable rate. Economists were predicting €75 billion from Eurozone banks. I suspect that the ECB’s generosity today is helping to lift sentiment or at the very least the large demand is a sign that the need for liquidity is greater than feared. The rise to a near two-year high for purchasing managers indices indicating strengthening manufacturing and service sectors was a welcome indicator, yet not one that was sufficient to dent interest rate optimism today. The head of the Austrian central bank and ECB member also lowered interest rate expectations today by saying that thanks to low inflation, there is no need for higher monetary policy during the next couple of quarters.

British interest rate futures – Optimism spread to British rate futures despite a shock gain in employment. Economists had predicted job losses through November of 12,500 but the surprise addition of 6,300 jobs provided comfort today. 10-year yields slipped a basis point o 3.88% while short-dated yields slipped between two and five basis points. The December 2010 contract carries a 1.86% yield.

Australian rate futures –Here’s where the action was once again overnight. Slacker than expected third quarter growth underwhelmed investors, while a speech from the RBA’s deputy governor contained language that appears consistent with a neutral stance on monetary policy. Two year yields collapsed dropping 14 basis points to yield 4.305 as fixed income investors moved to lock in to prices before they rise further pushing yields down. 90-day bills expiring beyond June 2010 surged about 20 basis points sending yields down commensurately. The December contract now yields 5.15%.

Canada’s 90-day BA’s are rallying in line with the Eurodollar curve with investors likely to shadow any movements resulting from the Fed’s statement. The December 2010 contract shows a 1.58% ahead of the statement from Washington.

Andrew Wilkinson
Senior Market Analyst
Interactive Brokers Group