Fed Funds and The Dollar

The much stronger than expected US jobs data has triggered a large sell-off in the US debt market and is sparking sharp losses in European bonds as well. Of particular interest is the dramatic sell-off in the Fed funds futures as the market reassesses the trajectory of Fed policy in light of evidence of light at the end of the tunnel of long and deep job losses. Weekly initial jobless claims have long pointed to some improvement in labor conditions, but today's report goes a long way toward catching up.

The market still does not expect the Fed to raise rates in Q1 next year. However, a hike in Q2 is not being ruled out. The April meeting is late in the month and there is no meeting in May, but the May contract implies a 0.28 bp average Fed funds rate. That would seem to suggest about a 1 in 8 chance of a hike. The June meeting is on the 23rd. If we assume that the first 23 days of the month, Fed funds average about 0.25%, and the Fed hikes to 0.50% at the June meeting, fair value for the June Fed funds futures should imply a 0.31% yield and it currently is implying 0.32%. A week ago it was implying a 0.24% yield.

Aug is the first FOMC meeting in H2 2010. It is the first contract in the Fed funds strip that is implying a yield above 50 bp. The 51 bp currently being implied compares with last week's close of 0.345%.

The last FOMC meeting next year will be on Dec 14. The Dec Fed funds futures is implying a 0.915% yield, which means that by the end of next year the market is currently expecting the Fed funds target to be at 1.0%. A week ago it was implying about 0.75%.

We have consistently argued that the dollar's weakness is largely cyclical in nature, rather than structural. And that the key cyclical driver was the extraordinarily aggressive monetary policy and the amply dollar liquidity. When these are normalized, we expect the dollar to find great traction. The dramatic backing up of US rates is more than in Europe, resulting in a shift in rate differentials--between the US and Europe--which reduces how much one is paid for being short dollars in the short-term.