wmeubank@ocp.kcmo.com
A.G. EDWARDS & SONS, INC.
One North Jefferson, St. Louis, Missouri
(March 26, 1997)
DEBT INSTRUMENTS:
At long last, the Federal Open Market Committee (FOMC) decided to raise
interest rates at its
March 25 meeting. The Federal Reserve increased the fed funds rate by 25
basis points (bp), leaving the discount rate unchanged. The market's focus
will now shift to the May 20 meeting. Given the cautious nature of the
Greenspan Federal Reserve, we expect steady policy at the next meeting.
However, it is unlikely this latest rate move will be the last.
A variable which has given reasonably good signals to Fed Funds adjustments
during Chairman Greenspan's tenure is consumer confidence.
Real Fed Funds Model
______Real Fed Funds
_ _ _ _ _Forecast
This chart shows our model of inflation-adjusted fed funds and consumer confidence. We generate a real fed funds by subtracting the interest rate by the yearly change in the Consumer Price Index (CPI). Consumer confidence is data from The Conference Board. According to our regression model results, using a four-month lead, consumer confidence explains almost 80% of the variation in fed funds.
When the model's deviation falls below 65 bp, the Federal Reserve is engaging
in an easy monetary policy. With the recent increase in fed funds the model
shows a deviation right at 65 bp. Current policy would still be considered
easy, but tightening. Our analysis assumes inflation remains at 3% into
the end of the first quarter. The model's forecast, shown by the dotted
line in the chart, shows a real fed funds rate of 3.75% by June. Assuming
3% inflation, we could see a fed funds rate of 6.75%. We do not expect
the Federal Reserve to make such a dramatic move by May. History does suggest
consumer confidence can be volatile. The very act of boosting rates could
bring confidence off its highs, and lower the forecast. However, given
the current deviation and forecast, expecting this will be the last hike
in rates is problematic. We expect further rate hikes this summer.
My favorite trade in this scenario is to buy June 97
Eurodollars/sell June 98 Eurodollars. We are in the trade at 60 bp, risking
to 40 bp with an objective of 150 bp. We are recommending new entries at
70 bp, risking to 50 bp with the same objective. If the market begins to
discount future rate hikes past the May 20 FOMC meeting, the deferred Eurodollar
contracts should weaken against the front month and widen the spread in
our favor. Bill O'Grady
Added to the WWW 04-15-97
Last updated on 04-15-97
Hosted by:
One Crossroads Place
610 West Maple Ave, Suite WWW
Independence, MO 64050
(816) 252-4080
sysop@kcmo.com