A.G. EDWARDS & SONS, INC.
One North Jefferson, St. Louis, Missouri
314-955-3050
(March 9, 2000) FINANCIAL INSTRUMENTS: How high will fed funds rise? At this point, the market has factored in a 6% funds rate, compared to the current target of 5.75%.
Fed Funds And Market Expectations
This chart shows fed funds, represented by the bold line, and a forecast based on the one-year constant maturity T-bill. It is not a very good forecasting tool, per se, but it does do an excellent job in measuring the market's sentiment toward monetary policy. For example, the forecast dramatically overshot the actual Fed funds rate during the 1994-95 tightening cycle. During the Asian economic crisis, it anticipated easing which never occurred. However, it does suggest what market participants think the central bank will do. And, at this point, the market thinks the Federal Reserve will tighten "one more time" to 6%. We also use fundamentally-based model of Federal Reserve behavior.
Fed Funds And Forecast
This chart shows fed funds, again represented by the bold line, and a forecast based on the unemployment rate, the core GDP deflator, and binary variables for the 1987 market "correction," the Savings and Loan crisis of the early 1990's and the LTCM-Russian crisis of 1998. Each one of the "crises" lowered the forecast by approximately 100 bp. This model is currently signaling a 6.25% target by May. Thus, the market's expectations and our model are in relatively close agreement; that is, one to two more 25 bp rate increases are on the way. However, it is interesting to note that during the last two major tightening cycles, the Federal Reserve moved rates higher than our model would have suggested. In the 1988-89 tightening cycle, the forecast was well below actual. The same phenomenon occurred in the 1994-95 tightening cycle. Actual fed funds rose higher than our model forecasted. We consider this a policy overshoot.
The key question is if a policy overshoot will happen again. Perhaps Greenspan has learned from past mistakes and will not excessively tighten credit. We tend to think he won't this time. In referring to the expectations graph, during the 1988-89 cycle, note the Federal Reserve tended to follow market expectations, and reversed course when expectations declined. In the 1994-95 cycle, the Federal Reserve actually did not tighten as much as the market expected. In both cases, the Federal Reserve did not lead expectations, but tended to follow them.
Assuming one-year Treasury yields to not spike higher, we expect the Federal Reserve to tighten another 25 to 50 bp, and this will probably end this cycle. If the cycle is coming to an end, we prefer to hold long positions in deferred Eurodollar futures. However, we intend to wait on a specific recommendation until the expected tighten occurs.
Bill O'Grady