Is the End of "Easing" Near?
Fundamentals
The Federal Reserve surprised most market participants Thursday afternoon by announcing a 0.25% increase in the discount rate. The discount rate is the interest rate charged to banks for emergency loans, and normally any changes in this rate are considered more symbolic in nature. But traders are taking a somewhat different stance this time, as many consider this the Fed's "first shot" at attempting to ease off the stimulus gas pedal and begin the interest rate tightening cycle. Fed officials were quick to emphasize, however, that this action was not the start of a broad tightening of credit, and that any increases in the Fed Funds interest rate were still a ways off. Before Thursday's announcement, it was generally believed that the Fed would remain "accommodative" with its interest rates policy -- at least until there were clear signs that the U.S. employment picture was improving, with new jobs being created month over month. The general consensus was that there would not be enough of an improvement in the employment picture to satisfy the Fed until late in 2010, or perhaps into 2011. Now, after the Fed's action, traders are beginning to price-in an increasing chance of a 0.25% rate hike in the Fed Funds rate as early as September of this year. Currency futures reacted strongly to the Fed's announcement, with the U.S. Dollar rising sharply -- especially vs. the Yen and Euro Currency, as traders took the Fed action as a signal that the U.S. economy would recover much more quickly than the economies of the European Union or Japan. Whether the Federal Reserve is ready to speed-up the tightening cycle will still be dependent upon upcoming economic data releases. One of the biggest concerns among some Fed officials is being able to keep the inflation rate in check, especially if the current accommodative stance is kept on too long. However, if Friday's release of the Consumer Price Index (CPI) for January is any indication, this fear may be premature. The CPI rose a modest 0.2% in January, with the so-called "core" rate, which excludes energy and food prices, actually falling by 0.1% last month. This was the first decline in the "core" rate since 1982! Although several Fed governors have come out saying that the Fed's action is not the start of something bigger, traders seemed more inclined to focus on what the Fed actually does, rather than what might be said.
Trading Ideas
Fed fund futures are used by traders to speculate on potential changes in the Fed Funds rate set by the Federal Reserve. To calculate what the market is expecting the Fed Funds Futures rate to be, you take the current price of the Fed Funds futures month you are interested in and subtract that price from 100. For example: a Fed Funds futures price of 99.50 translates into a Fed Funds futures rate of 0.50% (100-99.50 = 0.50%). Currently, the September Fed Funds futures are trading at 99.67, which relate to about a 62% chance that the Fed will raise the Fed Funds rate by 0.25% basis points by the end of September. Traders expecting an increase of this magnitude or more may wish to sell the September Fed Funds futures. Those who believe that the Fed will not likely hike the Fed Funds rate before September may choose to buy the September Fed Funds futures. Currently, futures contracts are listed out through December of 2011, allowing traders to speculate on Fed interest rate actions almost 2 years into the future.
Technicals
Looking at the daily chart for December 2010 Fed Funds futures, we notice that the uptrend line drawn from the December 31st lows has been broken. This indicates that the market is not anticipating any further interest rate cuts. Yesterday's surprise Fed announcement sent prices below the 20-day moving average, possibly signaling traders' anticipation of an interest rate hike by the end of the year. However, prices have failed to take-out support at the recent low of 99.36, despite the Fed announcement. Resistance is found at the contract highs of 99.50 made on February 5th.
Mike Zarembski, Senior Commodity Analyst
