It seems the doves are turning the market tide.*
Given the problems immediately facing debt markets and the Fed — S&P, debt ceiling, end of QE2 — you might have missed that the market’s implied probability for the Fed’s eventual move toward tightening has shifted considerably in just the last week or so.
These probabilities are extrapolated from the trading of fed funds futures on the CBOT. Barron’s spotted the big move at the end of last week after commodities prices pulled back, following Goldman’s commodities call(s):
The February 2012 fed-funds futures contract dropped the odds of a Fed hike at the Jan. 24-25, 2012, FOMC meeting to just under even money Friday, to a 44% probability. That was down from 62% Thursday and 70% a week earlier.
The thinking is straightforward: moderating commodity prices => a pause in rising inflation expectations and less actual headline inflation => less pressure to tighten sooner.
By now you’re well aware of this correspondent’s aversion to making causal connections where it isn’t clear they exist, but this is a reasonable possibility for at least some of the decline. (Though there are plenty others.)
Another, more intriguing suggestion was offered by a strategist quoted by Bloomberg on Monday:
“Investors are often left with the impression, which we believe is incorrect, that the hawkish side is more influential than it actually is,” said Roberto Perli, a former senior staff economist in the Fed’s division of monetary affairs.
“This might be one of the reasons why federal funds futures have systematically and incorrectly predicted an early policy tightening in recent years,” said Perli, now a managing director at International Strategy & Investment Group in Washington.
He’s right about the systematically incorrect predictions.
Back in December, we noted with some puzzlement that the market was pricing in a tightening by this August, which even back then — before Japan and MENA and oil prices and January snow storms — seemed entirely too early.
Has the market now caught up?
Here’s a snapshot from Bloomberg that they’ll probably make us take down showing the implied probabilities for tightening at each of the FOMC meetings starting next year:
The market is now pricing in just a roughly one-third chance that the Fed will begin tightening at the January 2012 meeting, and is estimating less than a 50 per cent probability that tightening will start even at the March 2012 meeting.
Caution is needed here, as these probabilities have swung wildly of late — which you can see not just in the difference between a week ago and now, but also in the swings between a month ago and a week ago.
But Perli (quoted above) is making the case that investors have constantly been on edge about when the Fed will tighten partly because of faulty communication by Bernanke and by those on the FOMC who are committed to voting alongside him. Not faulty communication about what they think, mind you, but about their intents and the extent to which their views are likely to win out.
This matters, because the expectation that monetary policy will stay looser for longer can be stimulative in itself.
So perhaps one of the messages that Bernanke might push at his pressers — the first is next week — is that the hawks may shriek louder, but the doves have the power.
The potentially more interesting question is what the expected tightening schedule would imply for bonds. We’ll tackle that in our next post.
* How the bloody hell does a dove turn a tide? Mixed metaphors. Spike or rewrite. – Ed ... No, I’m tired, shush.
Related link:
The rise in Fed funds futures rates – FT Alphaville