Market Correcting Fed View

Last week's US employment report triggered a sharp shift in Fed expectations. The market was aggressively pricing in Fed tightening. We warned of the risk that the Fed's statement following this week's FOMC meeting would reaffirm, in some fashion, the commitment to keep rates low for an extended period. The market is already adjusting in the anticipated direction, but there seems to be scope for additional scaling back the likelihood of Fed aggressiveness.

Following the better than expected jobs data, the Dec Fed funds futures implied a 31.5 bp average effective Fed funds rate. The FOMC meeting is slated for Dec 16. Consequently assuming that when the hike comes, the new Fed funds target becomes 50 bp (up from 0-25 bp, ahead of which we would not be surprised to see the effective Fed funds rate firm to the upper side of the range), then the market was pricing in about a 40% chance of a hike before year end. Now the contract is implying an average effective rate of 27 bp. Even allowing for some year-end pressure, this contract seems 5 bp or so rich.

The Feb Fed funds contract, which is useful gauge for expectations for the Jan 27, 2010 FOMC meeting, as there is no meeting in Feb, implied a yield of 53 bp on Friday and is now 42 bp. Although the contract moved in the right direction, we suspect it is still rich by around 17 bp.

The March contract implied a yield of 66 bp on Friday and is now implying 53.5 bp. Again the movement over the past two days is in line with our thinking, but not nearly sufficient yet. The risk is that there has to be further unwinding of Fed tightening expectations. The market then remains vulnerable to the event risk posed by the two day FOMC meeting that begins today.

Shifting interest rate expectations and differentials are important to our constructive dollar outlook. However,in the past week the Germany 2-year yield has risen 7 bp more than US 2-year yield. And as this note points out, the risk is that the market has gotten ahead of itself in pricing in Fed tightening, which also warns of the near-term downside risks to US interest rates.