The word on the street last Friday was that the federal funds futures market was pricing in a 100% chance of a rate cut by September. But the price of the fed funds futures contract represents a weighted-average of all the potential outcomes in the months ahead, it is not a point forecast.
As a result, suggesting the market was 100% certain the federal funds rate would be 5% in September was a misinterpretation. The 5% federal funds rate expected was a combination of a variety of different forecasts. Some investors thought the economy was crashing and expected many rate cuts in the months ahead, while others (like First Trust) believed the economy would remain in good shape and the Fed would not cut rates at all.
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In the midst of a stock market correction, a serious reassessment of the price of risk in world bond markets, and a seizing up of the high-risk mortgage market, the Bernanke Fed voted unanimously yesterday to stay patient and remain calm.
By keeping interest rates unchanged, and continuing to argue that inflation was the predominant risk for the economy, the Fed has officially told the market that the Greenspan Put is dead, or at least has a substantially lower “strike price.” Unless the Fed foresees financial market problems seriously affecting economic growth, it is unlikely to cut rates.
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Here we go again. Jittery financial market participants have extrapolated a case of indigestion, and some heartburn, into the “big one.” But, recent market action looks much more like a panic attack than a heart attack.
Yesterday’s market sell-off (small cap stocks fell 3%, and the Dow Jones Industrial Average was down 226 points), has convinced many that problems in the sub-prime market are spreading.
Significantly worse than expected Q2 earnings at Countrywide Financial, and problems in financing a few large leveraged business deals, have caused pessimistic market participants to fear an economy-wide credit crunch.
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Although the Federal Reserve left the target federal funds rate unchanged at 5.25% today, it made some important adjustments to the wording of its statement on the stance of monetary policy. The changes in language suggest an improved forecast for real GDP growth and a tougher standard for assessing inflation risk.
First, instead of dwelling on the fact that real GDP growth slowed in the first quarter, The Fed said growth “appears to have been moderate during the first half” of 2007. Given that the Fed, like everyone else, knew real GDP growth was 0.7% in the first quarter, calling growth in the first half “moderate” implies the Fed is forecasting strong growth in the second quarter. Otherwise, growth would not be “moderate” in the first half, but rather “slower than trend.”
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After hitting an all-time high of 13,676 on Monday June 4, 2007, the Dow Jones Industrial average fell 1.5% through Wednesday, and is down again today, along with other broad market indices.
In terms of reaction, analysts and pundits can be divided into three groups. The “Bears” argue the market was overvalued, is still overvalued, and that the US economy is in trouble unless the Fed cuts rates. In other words this is just the beginning of the bad times.
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