Forex Investment and Currency Trading

FED is likely to satisfy the market’s reduced expectation of only a 25bp ease. Doing so would take advantage of the passing of the worst of the financial crisis, which the Fed largely addressed via the various non-rate liquidity provisions, as well as the breathing space afforded by the Fed’s historically fast pace of cutting rates. Assuming that the US economy dipped into recession during February 2008, data from recessions since 1973 indicate that the 225bp cut in the months leading up to the first month of the recession were the most extreme except for the 1981 experience, which was marked by higher nominal rates, not to mention volatility because the economy had just emerged from the 1980 recession. Alternatively, in real terms, the Fed had cut its target rate (net of core CPI) to a significantly lower level (70bp) than at the start of prior recessions (ranged from 200-450bp).

Pricing in of no rate cut is not realistic
However, the futures market has gone beyond merely reducing the call for a 50bp cut to pricing in a 15% chance that the Fed does nothing at all. This position appears entirely untenable. The Fed’s Beige Book report struck a clearly dovish tone, noting softening consumer spending, weakening labor markets, and tightening of lending standards that will squeeze consumers further. As to inflation, the report observed rising price pressures but little retail inflation. Furthermore, while the financial markets are showing some signs of life, normalcy is far from having returned. Banks reported more massive losses, and monoline insurers re-entered the news cycle with dismal earnings. The 4wk TBill yield plummeted to 0.56% at one point this week. The spread of 1-mo LIBOR over OIS (expected effective Fed Funds rate) has widened back to more than 80bp, a spread last exceeded during late-2007 prior to the Fed’s implementation of the TAF system and when markets feared a yearend liquidity crunch. In sum, the Fed has cut rates fast enough that it can afford to moderate its pace, but the situation remains problematic enough that the Bank cannot
afford to completely step to the sidelines.

Fed to cut further beyond April
Beyond the April meeting, market expects that the Fed will cut the Fed Funds rate to a cyclical trough of 1.50% in coming meetings. While inflation will probably remain sticky during 2008, generally consistent with the Fed’s call, market expects that the decline in economic activity and bottoming of the US dollar will eventually cause price pressures to abate. Meanwhile, market expects the growth data to show continued
deterioration until at least July, as any increased spending stemming from the May tax rebates will not likely show up until the reports for June activity. Additionally, even assuming the worst of the shock stemming from financial losses is past, the system will remain only marginally functional amid rising losses spreading not only within the large money center banks, but also to regional banks. Finally, hedge funds and real
money accounts will likely exhibit increasing signs of stress. In such an environment, neither the Fed’s tone nor its policy path is likely to change.

Pricing of Fed hike by year end is too early
The market prices in Fed tightening by year end (25bp from a trough of 2.00% back to 2.25%). This view is apparently guided by the elevated inflation pressures reported for the latest CPI and PPI reports. However inflation pressures tend to rise during the first months of a recession. Consequently, the Fed will likely
continue to look through the price pressures, focus more on the downdrafts to growth stemming from the squeeze of higher food and energy costs, and remain firmly on hold well beyond yearend. In a similar vein, “looking through” the current pricing of the market and establishing two positions. The first, a 2s10s US Treasury steepening trade, will take advantage of the cessation of the flattening impacts (safe haven unwind, deleveraging, increased short-end supply) and the continued steepening impetus (weakening growth, mounting financial losses, Fed focused on growth – not inflation). The second is a long Eurodollar futures December 2008 position against its Canada BA counterpart that partly reflects the view that the market’s outlook for the Fed is too hawkish.