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Curve Watcher


Through open market operations, the effective federal-funds rate has been significantly lower for the past few days than the 5.25% target.


I'm a curve watcher, I'm a curve watcher...
Watchin' curves go by, hey, my my
I'm a curve watcher, I'm a curve watcher...
Here comes one now

There was a dramatic rally on the short end of the yield curve over the last few sessions as the following chart (with thanks to "Bart" at Now and Futures) shows.

Click here to enlarge.

Note: IRX is a discount not a yield. The other lines are true yields. The difference is not that significant for the purpose of this analysis.

The long end of the curve barely budged and that is simply not helping those whose mortgage is about to reset.

Let's take a look at the entire curve as it sits as of August 15, 2007, with thanks to Bloomberg.

Click here to enlarge.

The above chart shows that the yield curve has normalized. But has it really?

Let's look at the chart from the perspective of the Fed Fund's Rate.

Click here to enlarge.

Inquiring minds may be asking if this plunge on the short end of the curve is a signal the Fed is about ready to cut interest rates. Before I address that question, I will say some curve watchers believe the Fed has already cut interest rates.


Yes, already. David Greenlaw at Morgan Stanley noted that although the Fed Fund rate is officially 5.25%, as a result of various Fed open market operations:

"...the funds rate averaged 4.51% yesterday [August 14, 2007], and then opened at 4.75% this morning [August 15, 2007]. Indeed, the cumulative average for the 2-week maintenance period that ends today is 5.04% -- well below the official 5.25% target."

Greenlaw went on to call this a "temporary" easing of policy on the part of the Fed.

Bennie from Heaven

The Wall Street Journal picked up on the Fed Funds story in Bennie from Heaven?

Following the release of consumer-price inflation data, which were in line with expectations, futures contracts traded on the Chicago Board of Trade are no longer implying a 0.25 percentage point cut in the federal-funds target come September - they're betting on a 0.50 percentage-point cut.

Through open market operations, the effective federal-funds rate has been significantly lower for the past few days than the 5.25% target. Robert Brusca of Fact and Opinion Economics believes the Fed may allow for ongoing shortfalls (such as yesterday, when the average rate was 4.54%), and then use that as an excuse to cut interest rates. Joel Naroff of Naroff Economic Advisors believes rates should be cut, saying, "to me, the risk remains the economy, not inflation, but I doubt the Fed will change course before the September 18 meeting without an even more major deterioration in financial conditions."

Rate Cut Odds Soar

Click here to enlarge.

The above chart is thanks to the Cleveland Fed.

That's quite a dramatic change. On July 20 the odds the Fed would stand pat in September were over 90%. Those odds have now shrunk to about 35%.

Sorting It All Out

Inquiring minds just might be asking "Has the Fed effectively cut rates already?" I managed to get a hold of Paul Kasriel at the Northern Trust on Wednesday to see if he could shed some light on this situation.

Kasriel had already seen the reports and offered a simple explanation: "In the face of a liquidity crisis, the Fed does not want to see overnight rates spike up towards 6% again. They are attempting to ensure that does not happen by providing more than enough short term liquidity."

In other words, this was not likely a purposeful move by the Fed to drive rates way lower and it does not signal any likelihood of an emergency between meeting rate cut. Paul is looking for the first cut in October.

As of now, Kasriel thinks as I do: "A recession is baked in the cake. It's simply too late for the Fed to do anything about it." For more on that idea, please see Will Rate Cuts Save The Economy?

Here's a hint: they won't.

Finally, I asked Kasriel what will determine the severity of the recession. The answer came in a flash: jobs. Both of us think unemployment rates have only one way to go and that is up. How far up the unemployment rate climbs is the key to how bad things will get. If you haven't done so already, add jobs to the things you are watchin'. A sudden spike up in the unemployment rate may signal the official start of a recession.

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