The FOMC is expected to give us a decision on interest rates this Wednesday, September 23 around 2:15 PM EST.  One tool we prefer to use for determining the direction of Fed Funds is long standing 30-Day Fed Fund Futures contracts traded on the CME.  We are seeing a mix of several events culminating here over the question of whether the target Fed Funds should be at this 0.00% to 0.25% or near-0% as it has been now that things are getting less-bad and even getting better.  The notion here is that the announcement for the Fed Funds target will remain as it has been.  And contrary to all of the other noise, this might not be the last FOMC statement without a formal exit from the Federal Reserve from its free money policy.  But there is also the notion that rates could get higher and faster than what the Fed Funds Futures are predicting.

Be advised that there are many variations that traders use for interpreting this data.  You cannot just deduct the figure from 100.0 and see what the implied Fed Funds rate is by then calculating what percentage is for each closest 1/4 of a percentage point.  However, that is still the most common metric used for eyeballing what the market thinks will happen to Fed Funds in any given month.

The FOMC has been sounding less and less doom and gloom of late.  Ben Bernanke went as far as to say that the recession is technically over.  Tim Geithner said he is eager, “no one is more eager than me…”, to get off the free money and bailout climate we have been on.  And Fed presidents and governors are talking about the return of growth in presentations, despite how ‘fragile’ and ‘not out of the woods yet’ implications they make.  And the Fed and Treasury have slowed on the endless asset and securities purchases.  There is a single driving force that is keeping the rate artificially low here and that is the army of unemployed.  Throw in a rise in poverty levels to boot.

The thing that is keeping the FOMC and others from sounding too positive is that the Fed has a dual mandate, one of protecting the environment from inflation via rates and other tools, and one of keeping employment strong.  The army of unemployed is still more than 6 million via continuing jobless claims.  The weekly jobless claims have yet to break under the 500,000 level, and that figure has to realistically get closer to around 400,000 before there will be any real pass-through of employment.  The official unemployment rate was 9.7% and we are not expected to see a drop yet as many are still calling for unemployment to hit 10%.  And the unofficial unemployment of those forced to work only part-time, on small contract, and those working in jobs far under their qualifications is over 16% by some counts.  While unemployment is considering a lagging indicator that is one of the last to see an improvement during the start of economic recovery, it seems that the bet is that Ben Bernanke and friends are not going to tell about 10 of every 100 workers that they now have to cope with a tightening bias on rates on top of their misery.  But there is also the notion to add in that employers can milk more from their current workers rather than bring back more laid off workers.

After running some calculations through, there is expected to be no change in Fed Funds this Wednesday.  In fact, according to Fed Fund futures, there is not even a 50% chance that the 0.00% to 0.25% target will even get to a 0.25% rate until November or December.  January 2010 gets close to a 90% chance of a 0.25% rate, but it is not until February 2010 that the 0.25% threshold is formally expected.  Maybe the bets are that the unemployment will cap out at 10% and not stay there for very long, but the opinion of the day is that we still face a jobless recovery with those experiencing the growth again still being very frugal and very cautious and informed when they make purchases.

Where this gets interesting is that there is close to a 60% chance of a 0.50% Fed Funds rate by April 2010 and an implied 100% chance of 0.50% Fed Funds rate by May 2010.  The interesting notion of Fed Fund futures is that the farther out you go the less and less traded these contracts become, ultimately making them less useful.  That being said, the thinly traded September 2010 Fed Fund futures contract suggests that rates will be 1.00%.

You can see the whole Fed Fund Futures pricing matrix here at the CME and can run correlating prices on each contract.  Again, we do not subscribe solely to the remedial calculations and we prefer to use a blended pricing for determining these percentages for our own opinion on where rates are.  But the figures herein are the basic calculations.

The pressure has been building.  We are very comfortable in the notion that the Fed would rather see 1% higher inflation than another 1% in unemployment.  Either way, our own take is that the near-0% has to come off soon.  And if you look at history, there is almost never a “one and done” on the rate hikes.  The hikes are also rarely spread out too far from each other because the numbers have already started getting better by the time the FOMC makes its change.  There is also a possibility that the FOMC will have to use rates as a tool to defend the US dollar in an effort to keep it from becoming the Gringo Peso. Much of that will also been seen in where commodity prices, priced in US dollars, will head.   We have also seen a 50%+ recovery in stocks, and the latest Fed report said that the US population saw a gain in its wealth in the second quarter for the first time in two years.

A fair guess is that if there are no blow-ups in major corporations from this October’s earnings season and no major reversal events of the unexpected nature come in, then we’ll have an official interest rate figure again on Fed Funds by the end of 2009 and be back up at 0.50% in the first quarter of 2009.  If we are looking at a sooner than expected return to higher rates, then our second guess is that rates will be at 1.00% going into next summer rather than at the end of it.

JON C. OGG
September 20, 2009

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