When I began my career as an actuarial trainee in 1986, I didn’t know much. When I began working in fixed income as an actuary back in 1992, I didn’t know much. When I entered my first investment department and bought my first bond (institutionally CMAT 1999-1 A4) in 1998-99, I didn’t know much. When I was made a corporate bond manager in 2001, I didn’t know much. When I went to work for a hedge fund in 2003, I didn’t know much. It is probably still true today, because “the markets always find a new way to make a fool out of you.” I’ve made my share of mistakes, and then some. But for the most part, I have been a fast learner.
So, what I write in this post is a little speculative. I don’t know as much as I would like to. About seven years ago, I had a conversation with a more experienced colleague about Fed funds futures. It went something like this:
David: Fed funds futures do a really good job predicting Fed moves.
Colleague: Yes, they do.
D: What if Fed is using Fed funds futures to set policy?
C: Huh? You mean let the view of market participants set policy? They would never do that.
D: They certainly could never let it be known that they do that, if they did. There would be too much money chasing the Fed funds futures markets in order to influence policy.
C: The Fed would never do that. Why would they give up their discretion?
D: Perhaps Greenspan might do it in a misguided free-market attempt to let the markets dictate monetary policy, rather than removing the punchbowl, as was said in the ’60s.
C: I think you are wrong here. The Fed is a complex institution and can’t be boiled down to a simple futures market. They take a lot of different things into account before making their decisions. The Fed funds futures market is just very good at sensing the various forces that affect the Fed, and the collective wisdom of the market is very good at predicting the Fed. After all, there is a lot of money on the line.
D: Okay, you’re probably right. One last thing. How much would it be worth if you knew that the Fed followed the Fed funds futures markets, and no one else did?
C: If you had enough money to manipulate the Fed funds futures market, that would be worth a lot. But the Fed sets its own policy, and does not want to be manipulated, so that’s not happening.
D: Thanks. I think I get it.
C: You’re welcome.
I’ve talked before about the Fed outsourcing monetary policy before to the markets. I consider it a possibility that the FOMC uses Fed funds futures to set policy. After all, even with the TAF, the Fed uses Fed funds futures to set a reservation yield for the auction. Even if it is not true that the Fed uses Fed funds futures to set policy, the futures work really well when one tries to predict what the Fed will do.
Now, perhaps this is a bad argument for a different reason: the Fed funds futures market trades alongside all of the short-term debt markets — eurodollars, CP, T-bills, etc. In order to truly move Fed funds, you would have to move much more, and it is unlikely that any single player could do that. The market as a whole could do it, though, because it is bigger than the Fed. But if that were true, no one would be manipulating. The FOMC would simply follow the judgment of the marginal short-term fixed income investor, which wouldn’t make the policy correct, because markets a a whole make forecasting errors.
Back to the Present
I will say it now, the FOMC will cut 50 basis points today, the stock market will rally, and the yield curve will steepen. The explanatory language will make the requisite bows to both sets of risks, but will say that current weakness justifies the cuts. Now, I don’t like this forecast for a few reasons:
- The yield curve has enough slope already. 138 basis points between 2-year and 10-year Treasuries should be enough to allow the banks to make money over the intermediate-term.
- The NY Fed has left Fed funds on average 6 basis points higher than the target since the emergency cut. Why the incremental tightness?
- Total bank liabilities and MZM have been growing at 10%+ rates over the last year. That level of credit growth should be adequate for our level ofnominal GDP growth.
- The Fed hasn’t done a permanent injection of liquidity since 5/3/07, and was sparing with them early in 2007. The behavior there is unusual to say the least. Why not be be more conventional if you are loosening monetary policy?
- Economic weakness is noticeable, but isn’t severe once one gets outside housing and related industries.
At some point, the Fed has to break with the futures market, and deliver a surprise to the markets as a whole, whether positive or negative. Even breaking out of the 1/4% steps would break some of the models used to analyze the FOMC. How about a 3.1% Fed funds rate? This is a digital era where stocks trade in penny increments. The FOMC can move into that digital world as well.
I was taught in economics class (way back when) that policy moves that were anticipated had no effect. Well, eventually the Fed either needs to take back its mandate that it delegated to the markets, or inform the markets that their best estimate of their policy is wrong, and deliver a surprise. A little confusion, a little lack of transparency would benefit the markets over the long haul, and help to reinstate a sense of risk that has been lost among many market participants.
Eventually this will happen, and it might happen tomorrow, but the money on the line says “Cut 50 bps,” and so I don’t argue. Compared to the market, I don’t know much.