A Forex View From Afar

Do Not Trust The Fed Funds

Traders in the Fed Funds Futures see the overnight Fed rate reach 0.50% by November 2009, while by May 2010, currently the longest maturity, traders see the overnight rate reach 1%.

Currently, there are two possibilities running in the market. First would be that Mr. Bernanke does not want to repeat the mistakes made in the past, keeping the Fed Funds too low for too long and creating another bubble. Adding to this assumption is that fact that some investors are afraid that the ultra-low interest rates, together with the Fed expanding its balance sheets, will mean that the CPI read will go untamed as the economy recovers. However, at this point this is only an assumption, since the Fed is currently fighting deflation.

The second possibility that might explain why investors look at the Fed to raise interest rates over the next period is that, according to the latest forecasts, the economy is projected to pick up again in 2010, with a 2% growth rate. However, there are big questions as to how someone can really expect that to happen when every release is pointing to a deterioration of the current situation. Recently, the markets were trembling on rumors about the nationalization of banks. If you ask me, we have not even reached the middle of the crisis. By expanding this assumption, we could say that the Fed Funds Futures market has not fully priced in all the essential information, or expects a certain improvement in the current condition. We could say this is a typical contagion situation.

Speaking from a fundamental point of view, expecting the Fed to raise rates in the following period is a little too much. Mr. Bernanke is a follower of the inflation-targeting regime, even though we cannot speak of such a thing right now. However, monetary policy practice has shown that anchoring expectations is one of the most important tools a central bank has. As such, in his recent speeches, Mr. Bernanke assessed that the Fed Funds will remain low in the following period. If any sudden changes appear in the Fed’s monetary policy, the Chairman will certainly anchor expectations in his speeches and public appearances, since the financial markets do not like surprises. Nonetheless, the Fed Funds is set to remain low for a long period.

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