Fed funds futures, widows, and orphans

Caroline Baum at Bloomberg comments on the new life in the fed funds futures market after last week's "less bad" payrolls number caused traders to think short-term interest rates might be headed higher sooner rather than later.

For the past six months, the federal funds futures market has been a haven for widows and orphans, minus the benefit of coupon-clipping.

With the Federal Reserve’s benchmark overnight rate set at 0 to 0.25 percent since December and the economy still in need of life support, there was little reason, or impetus, to bet on changes in monetary policy.

Daily moves of one-half of a basis point -- and that was on a big day -- in fed funds futures were purely technical in nature, a function of the contract’s cash settlement to the average effective funds rate for the delivery month.

That changed last Friday with the release of a less-bad employment report for May.

This will likely be the first of many false starts for this futures market which, over the past few years, has proven to be quite bad at predicting interest rates more than a couple months out.

When the Fed modifies or removes this little sentence from the policy statement that follows the conclusion of their FOMC meeting, all hell is likely to break loose.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

And don't look for another "baby step" rate raising cycle to begin before there is clear evidence that another asset bubble is being inflated.

The last thing Fed Chairman and Great Depression scholar Ben Bernanke wants to do is “abort the recovery by premature tightening,” which is what his predecessors did in 1936 and 1937, says Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago. “At what other time has a 345,000 job loss been a reason to celebrate?”

Kasriel thinks it will take until mid-2010 for Bernanke to have confidence that the recovery is for real. Most economists, unlike traders, are saying later rather than sooner.
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Maybe the reaction is just a bad case of jitters over the existence and execution of the Fed’s exit strategy. It’s true that the Fed’s balance sheet will show some natural attrition as financial institutions resume their traditional lending function and the Fed imposes a penalty for using its various lending facilities. (In the old days it was considered a privilege, not a right, to borrow from the Fed’s discount window.)

Fed officials talk exit strategy in the same breath they reassure the markets to expect an “exceptionally low” funds rate “for an extended period.”

Instead of turning up the volume on “exceptionally low” in an effort to soothe the market, the Fed should try to be exceptionally explicit on what the egress will look like: Whether it will focus on the excess reserves banks are currently holding, which have the potential to multiply and become inflationary, or on the good old-fashioned funds rate.

Then there are the financial experts in Congress. While grilling Bernanke won’t be as much fun as playing pinata with bank CEOs, House Financial Services Committee Chairman Barney Frank and Senate Banking Committee Chairman Chris Dodd will surely offer him some exit guidelines, especially if the unemployment rate -- up 4 percentage points in the past year to 9.4 percent -- crosses the 10 percent threshold.

After all, they have to look out for the real widows and orphans.

Fed funds futures just got interesting again - don't expect that to last too long.