How To Trade Around The Fed
Should the geopolitical
uncertainty continue to weigh
on the economy for an extended period of time,
there is no doubt that the US Federal Reserve will be forced to act. Even in the
face of rising energy prices, the Fed will view a threat from an economic
slowdown as greater than from any temporary increase in inflationary
measures. But how much of a cut should the markets expect, and what will the Fed
do once it runs out of dry powder, as nominal rates are approaching zero, and
real interest rates are already negative–accounting for inflation?
Fed Fund Futures Mis-priced?
The July Fed Funds contract is currently pricing
in a 25 bps cut as a foregone conclusion, but there are two things wrong with
this picture.Â
- First, by the time the FOMC meets in late April, it will know
whether or not it needs to make any adjustments to short term interest rates, as
the war with Iraq will be in full swing and its impact on the US economy will be
assessable. Therefore, the Fed will act in April and not in July, as the futures
now suggest. - Second, economic studies suggest that, in low interest rate
environments, bigger rate cuts are more effective at countering economic
slow-downs–as can be evidenced by the Fed’s decision to cut by 50 bps last
November.
What Happens Once The Fed’s
“Dry Powder” Is Used Up?
There is a lot of speculation about what the Fed
will do to affect monetary policy once short-term rates bottom out. One
interesting idea floating around is that the Fed will start buying bonds across
the curve in order to force down longer-term interest rates. Unlike with the Fed
Funds rate, the Fed would not set a target rate for the bonds but would simply
purchase these issues until the rates move to certain levels. This means
that the generational low yields in treasuries could continue their descent
lower for the foreseeable future.
What Is The Best Way For
Investors To Profit From These Scenarios?
Fed, Bond Purchasing
Play-
Should the war with Iraq not go according to
plan, one way for investors to participate in a further decline in Treasury
yields is to purchase corporate bonds, as they offer higher yields than
Treasuries but will also benefit in price from further yield declines in
government issues. The easiest way to do this is to buy the iShares GS $
InvestTop Corporate Bond Fund
(
LQD |
Quote |
Chart |
News |
PowerRating), which can be bought and sold like
stocks.
The Fed Funds Play-
Again, should the war with Iraq not go according
to plan, and should the April Fed Funds contract is still be pricing in anything
less than a 50 bp cut by the time the Fed meets next month, go long the equity
indices before the meeting and expect a nice pop on the news. Then close the
trade out before the end of the day.
I will revisit this analysis next month.