Bonds moved with Fed funds futures

Bonds price moved up with the changing expectations of the Fed funds futures. The chart shows the changing probability of the Fed funds futures over the month of October. The market has priced in the move to 4.5%, a 25 bps change. A close look at the bond futures chart would show that the bond market has rallied in tandem to the changes in these probabilities.

Currencies have followed a similar pattern. The dollar firmed earlier in the month until the probability of Fed moved significantly higher. The dollar decline matched the view for lower rates.

Are traders in Fed funds futures driving monetary policy?

The Fed funds futures had a significant change in October from not having a firm view concerning a cut in the Fed funds rates to an expectation that a 25 bps cut is almost a lock. Using the futures contract price, there is only a 6% chance of no change by the Fed. The continued credit crisis and tepid growth drove this change in expectations.

So what does the Fed do with this information? We know that the Fed watches closely the Fed funds futures, so if the market is expecting a 25 bps change the Fed may have to give it to them. It is the unanticipated portion of a change that causes a reaction in the market. The Fed’s desire for transparency and clarity means that it would not like market uncertainty about its actions.

The Fed does not work in a vacuum, so if it sees that the market is pricing in a change it has to consider the implications of not changing the rate. The reaction by the markets will be swift. There should be an immediate equity sell-off as well as rates rising along the yield curve. His type of reaction is not what the Fed wants during a fragile period. So if the market wants a cut the Fed may have to give them a cut regardless whether this is what they think it is what is needed in the long-run.

You have to have a view on housing -

You have to have a view on housing to make any macro decisions. In a word, the housing market is bad. But everyone already knows that information. Now the issue is the impact of a bad housing market on the US overall and world economy. When you start looking at residential housing as a portion of GDP and household wealth, the story gets more complex. A recent speech by Bill Poole, president of the St Louis Fed, provides good background information on this issue.

http://www.stlouisfed.org/news/speeches/2007/10_09_07.html

Some facts:

The value of residential real estate is just over $20 trillion and mortgage liabilities are worth about $9.8 trillion which means that the net value of residential real estate is close to $11 trillion dollars. The net value of the assets is positive. Now, there will be spillover effects from a decline in housing from defaults, foreclosures and forced liquidation, but the value of housing is a positive contributor to household wealth.

Yet, the value of residential real estate is only half the value of financial assets for each household. While for many a home is their leading financial assets, overall, household net worth is tied to cash, equity, and bonds through savings and retirement accounts. The non-housing portion of household wealth is double the net value of housing. There is a wealth effect from changes in the housing stock, but the impact may not be as immediate as many would expect given all of the subprime stories in the newspapers. Lower wealth will affect consumption but the link is not as direct as many may expect.

Residential construction represents about 30% of total private investments. Nonresidential construction is approximately 20%. There has been an increase in nonresidential construction since the peak in the housing market. The declines in residential investment have been offset by gains in the nonresidential area. While these offsets are not one for one, the investment sector has been cushioned by growth outside residential construction.

Construction represents about 7.7 workers but is still just over half of the number of workers in manufacturing. Health and education are also much larger sectors for employment. Construction is 5.5% of total non-farm payroll, so a loss of a significant portion of these jobs may not have a significant impact on overall employment if there are strong gains in other sectors.

Housing usually peaks before he beginning of a recession. On average it leads a recession by three quarters. Clearly, this time between the housing turndown and the decline in growth of the overall economy has been delayed. This delay is what is unusual for this business cycle. The size of this decline dwarfs many previous housing cycles but the run-up was also greater.

The impact -

These facts do not minimize the hazard faced from a housing credit problem, but some of the effect has been and will be muted by growth in other areas of the economy and by the mix of assets held by households or their net worth. Spillover effects across sectors are significant and the hardest to measure. For example, the hosing decline has had a high impact on equity values for retailers.

The impact on employment may be muted because of potential gains from manufacturing which is a larger sector than the construction area. A slow growth scenario in the US is most likely if the subprime problem can be muted.

Unfortunately, monetary policy cannot be focused on only the housing market. The continued lowering of interest rates to help the housing markets will also have spillover effects in other areas of the economy and on the international side through its impact on the dollar. These spillover effects may have a greater impact than contagion from housing.

These spillover issues will be driving Fed behavior at their meetings this week.

What will cause home sales to go up?

Existing home sales saw a significant decline month over month and have fallen off a cliff from over 7 million units are year in the summer of 2005. We are at the worst levels since the index was available. Sales are running at about 5 million units annually. There is also a glut of homes on the market at 4.5 million units, so we have almost a year supply not including the new homes that are coming on the market. There are also 2.2 million vacant homes in the US. It is going to take some times to stabilize this market, more than a year if there is not an adjustment in prices to entice new buyers. We do not know how many homes have not even been put on the market because of diminished expectations.

The decline in sales suggests that there is a mismatch between price expectations of buyers and seller. If buyers perceive there will be further price declines they will delay any purchase. Sellers on the other hand do not want to realize a loss or a perceived decline from the high value for their homes.

Sellers are suffering from the full extent of behavioral biases which will cause them to hang onto their homes in the hope that their value anchors will be reached. Inventory and sales will not move until sellers realize that the value of their property has declined and buyers believe that there is no reason to delay their purchase.

The change in perceptions of sellers and buyers for long-term assets which have gone through a large and sustained increase will not happen overnight. Both parties will have to realize that the new equilibrium price level for homes is permanent and not transitory. This housing drag will exist through at least 2008.