Monday, January 31, 2011


January 25-26, 2011

Déjà vu: June 2003 FOMC

Martin McGuire (312)-338-2480
Jack Rodeghier (312)-347-4914


A sense of repair is gripping market participants as the series of stronger economic data continues. Fed staff too, has been surprised by strength in production and spending into the 4th quarter 2010 but have not yet been willing to significantly alter their expectation for moderate growth this year. The upcoming FOMC meeting brings new voters, but all members will carry with them fresh, three year projections for GDP, inflation and employment. This data will be used by Chairman Bernanke in his semi-annual monetary policy address to Congress in February.

The Fed has done much to combat the risk of deflation. Price action in short and long rates as well as in equities may be saying the Fed has done enough.

Just the Right Medicine

When a doctor prescribes medicine, he takes into consideration the patient’s size, strength and general condition. We might expect a similar appraisal from the Fed in its application of accommodation. Certainly, a good deal of adrenalin was given to revive the ailing economy and financial markets back in 2008 and with a bit of coaxing, the patient economy became ambulatory and has shuffled about the hospital grounds for the last couple of years.

After some concern for relapse this past summer without symptoms actually witnessed, the Fed has administered another dose labeled QE2. Most doctors hold dear to the notion, ‘first, do no harm’, though more than a few have been accused of excessive medication. When the Fed sent the patient home this time with his prescription, it sternly warned the ‘governing’ family (Obama administration and Congress) that they needed to do their part in the recovery. ‘Get your house in order’; the doctor warned, so that the patient can function on his own as he cannot be sustained by QE forever.

So spirited was the reaction of the patient in the early days after the latest QE treatment that some wondered if the prescription was actually needed. Others argued that it was the ‘governess’ having cleaned house, dusted off tarnished old tax breaks and spruced up the halls with some new spending packages, that gave rise to the positive reaction.

Some expect further business friendly legislation coming from Congress given mid-term election gains by Republicans, recent tax and spending plans have given rise to these expectations for greater fiscal support.

The FOMC meets on January 25-26 and will again discuss how the patient is progressing. Some of the attending practitioners will say the patient may become hooked on this QE drug unless he is soon taken off these meds. Other members will rightly counter that under the current plan the patient is only given a 6 week prescription and if necessary, the dosage can be altered when the committee reconvenes on March 15. Importantly, most FOMC voters however will not want to upset the household unduly with concern for possible changes in the prescribed medication plan which expires at the end of the second quarter as confusion now might stall recent gains.

The greatest likelihood is for there to be no changes made to the current QE program at the upcoming meeting. This program started less than 3 months ago which is not enough time to judge it a success or failure. There are 5 months remaining and if at a later date it is seen as not providing substantive benefit it can be altered or terminated.

How Does the Chart Look Doc

Without the ‘chart’ prop in hand, a doctor might instead be forced to look the patient in the eyes when he spoke. Maybe this is why doctors and market ‘technicians’ alike, use charts. Fully warned, we share some charts that we believe tell a story you will find interesting.

In the days leading up to the November 2010 FOMC, market participants were struggling, not with concern that the Fed would announce a new plan to purchase treasury securities, but rather how large that program would be. It was widely believed that the amount would be well above $500b and some expected double that amount. Given the rise in treasury prices in the months leading to the November FOMC date and subsequent reaction, we look to the past as a prologue to gauge relative sentiment then and now.

Our reference date is June 25, 2003. Having driven the fed funds policy rate from 6% in January 2001 down to 1.25% in November 2002, the Fed paused until the June 2003 meeting. It was widely expected the Fed would lower the fed funds rate at that meeting, a strong minority of Fed watchers were calling for the Fed to ease by 50 basis points (ECB cut by 50 bps to 2% 2-weeks earlier).

Instead however, the Fed lowered the fed funds rate by only 25 basis points, thus disappointing many market participants. Both short and long rates moved significantly higher over the next 6-8 weeks.

Price action for the rolling fifth quarterly Eurodollar future, U.S. 10 year treasury yield, the S&P equity index and UST2/10 yield spread following that decision can be seen in the accompanying charts.

Importantly, close monitoring of recent price action prompts us to highlight the similarities between the post-June 25 2003 and post-November 3 2010 periods. While the yield changes were nominally larger in 2003, the direction and timing matches well.

The Eurodollar future eventually fell (higher implied yield) much further by the 110th day following the June ’03 meeting. Conversely, the 10-year treasury yield fell significantly, correcting sharply from a post-FOMC spike of +120 bps to only +55 bps before 100 days passed from our reference date. The shock of less than expected Fed accommodation apparently held sway longer at the front end of the curve.

Recent FOMC efforts in implementing QE2 and the final 25 basis point reduction in the fed funds policy rate in 2003 were meant largely to combat an aged concern for deflationary prospects. In both instances, these deflationary concerns had already been forcefully addressed. As such, while appreciating the great differences between mid-2003 and late-2010, we are strongly attracted to the belief that the reaction function to late cycle accommodation may be similar.

The Fed had not acted soon enough to tame animal spirits during the binge and held too long to the application of a failed measured pace, ‘restrictive’ policy initiative thereafter. Following both of these unfortunate policy decisions, excess leverage and mal-investment came into vogue until the music stopped once again.

Scarcely after the credit crisis and consequent financial market dislocation began in mid-2007 we became quite certain that in the end, the Fed would ease too much and too late. This may be implied from the price action following the November 2010 FOMC decision to initiate $600b QE2 and the earlier decision by the Greenspan Fed to cut by just 25 bps when the committee surely must have known that it’s guidance leading up to the meeting had prompted many market participants to expect more (prior to the June ’03 FOMC, 47 of 257 economists polled by Bloomberg expected a 50 bp cut, compared to 104 who expected just 25, others expected no cut).

With the benefit of hindsight, it is clear that in the early summer of 2003 and again prior to November 2010, traders in net, both at the front and long ends of the curve were offside long. The unwinding of post-critical FOMC longs, then and now, has resulted in similar price action as inferred. The Greenspan Fed was given reason for pause in prescribing more anti-deflation medicine directly following the June 2003 FOMC, as ten year treasury yields jumped from 3.4% to 4.6% and the S&P index climbed 6%. Notably, within 40 days of the November 2010 FOMC ten year treasury yields jumped 1% from 2.5%. Since the November meeting the S&P index has climbed 8.4%.

Our expectation is that the FOMC statement will be constructive and friendly to bullish treasury positions because we do not believe there will be strong wording changes or implications for changing the treasury security buying program. Additionally, long treasury positions have been markedly reduced since mid-fourth quarter 2010 and we think there’s a good chance long positions return to treasury from spread product. While it is difficult to guess that one or more of the upcoming economic data releases will be weaker than the recent string of stronger than expected results, the risk now appears to be that market participants have adjusted positions for a stronger trajectory in economic growth than may actually develop. Finally, the predominance of put volume in treasury and Eurodollar futures indicate a growing interest in positioning for higher yields.

For reasons suggested above and because we believe there may be continued similarities to the UST10 post-June 2003 FOMC path, we believe there is a strong chance for as much as a 40 basis point decline in 10-year treasury yields over coming weeks. There are several ways we suggest clients consider positioning for this possible development.

First: +TYH1 121.5/122.5/123.5 call fly (7/64 last, Feb-18 ‘11 expiry) and/or +TYJ1 120.5/121.5/122.5 call fly (7/64 last, Mar-25 ‘11 expiry, TYM1 underlying), fly bodies are struck in the direct vicinity of UST10= 3%.

Second: +ED Green March mid-curve (2EH3) 98.50 and/or 98.625 calls, respective settles were .015 ($37.50) and .005 ($12.50) as of Jan-21. The last time UST10 printed 3%, on Dec.-6 ‘10, ED9 was trading 98.71 (1.29% implied yield vs 2.08% last). Green March options have 46 days ‘til expiry.

Lastly: Consider selling EDH2 (Red)/EDH3 (Green) calendar spreads (settle= 108.5 basis points as of Jan-21), stop just beyond recent high at 112 bps (Jan.-3), target midpoint of 6m range= 76 bps.

Fed Policy Action Expectations:

The statement released by the FOMC on January 26 will acknowledge continued and steady growth in production and spending. The major headwinds of weak residential and commercial real estate markets as well as slow job creation will find mention. There may be a positive nuance change in the description of deflationary risk. Likely no change will come to the wording of the treasury purchase plans. While there is a strong possibility, we do not expect either Fisher or Plosser to dissent. The market reaction to the statement is expected to be constructive.

We believe the FOMC may change the characterization of risk assessment to neutral at the September 20, 2011 FOMC meeting.

Current and Future Fed Funds Rate:

FOMC Date Funds Target Risk Assessment
January 26, 2011 0.0-0.25% Risk to Growth
March 15, 2011 0.0-0.25% Risk to Growth
April 27, 2011 0.0-0.25% Risk to Growth
June 22, 2011 0.0-0.25% Risk to Growth
August 9, 2011 0.0-0.25% Risk to Growth
September 20, 2011 0.0-0.25% Balanced Risks

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