Tuesday, October 23, 2007

Waiting on the Fed –

Periods of market consolidation usually occur when investors are waiting for some information. It could be the employment number, corporate earnings, or in this case the Fed. Interest rates are the key driver of many global markets. (Of course, some will say when is it not?) A cut in the Fed funds rate will lower the interest differential between the dollar and other currencies. There is also the threat of higher expected inflation which will be negative for the dollar. Equity investors will look for more easing to help the stock market which has seen a spike in volatility in response to the unsettling news on the credit front. Commodity markets will also react to an easing under the premise that extra liquidity will drive up real asset markets.

The market has changed perceptions radically in the last week even with only mixed macroeconomic news. That is if you discount the housing market debacle. The Fed funds futures provide a mechanism for determining the implied probability of a Fed funds cut. The calculations are straightforward. While last week the probability was that the Fed would be on hold as measured by the futures and options markets, the current data shows that the Fed has a greater than 50% chance of seeing a decline of 25 bps. The change in expectations has pushed the dollar lower, commodities higher, and interest rates lower. Now the market will sit and wait for its expectations to be realized.

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