Saturday, June 24, 2006

Fed scare puts speculation and volatility back in the market

Fed scare puts speculation and volatility back in the market
By John Authers
Published: June 24 2006 03:00 | Last updated: June 24 2006 03:00
Copyright The Financial Times Limited 2006

Only a few weeks ago, the Financial Times was writing that next week's meeting of the Federal Reserve's open market committee was one of the least predictable in years. At the beginning of this month, the price of futures contracts written on the Fed Funds rate showed that the market rated the probability of a 25 basis point interest rate rise at exactly 50 per cent.

Now, we appear to be heading for an anticlimax. As Fed chairman Ben Bernanke and several of his fellow governors made it ever clearer that they thought inflation was already too high, in a campaign to "jawbone" down inflation expectations, so the market got the message.

According to Fed Funds futures, the chances that the Fed will raise rates by at least 25 basis points next week are precisely 100 per cent. There is also a probability of about 80 per cent that the Fed will raise rates again in August. And, most intriguingly for the market, bonds and currencies have been changing hands for the past couple of days on the back of a rumour that the Fed might even raise rates by 50 basis points next Thursday.

This bubble of speculation dates back to suggestions earlier in the week that Mr Bernanke had used a regular meeting with representatives of the bond market's biggest broker-dealers to introduce the possibility of a 50 basis point rise. The argument in its favour is that it could work as an "over and out" move - demonstrating the Fed's hawkish credentials, but allowing the market more certainty going forward.

However, the arguments against are rather stronger. First, Mr Bernanke has admitted to Congress that he was unwise to talk privately about future monetary policy to Maria Bartiromo of CNBC. It would have been very, very much more foolish to tip off brokers who between them accounted for most of the trading in the bond market. Give traders information, and they will trade on it.

Further, it would be difficult to make it an "over and out" move, as it is yet possible that data between now and August would show that more tightening is necessary. And finally, the markets are febrile enough as it is. However it was packaged, a rise of that magnitude would run the risk of sending a message that the Fed was seriously scared, rather than a message of icy resolve. It has not raised by 50 basis points since early 2000. And there is enough fear in the market as it is.

Thus we are set up for an anticlimax. Thursday might conceivably see some relief at a rise of "only" 25 basis points. But the likelihood is that the market will return to the game of deciphering hidden meanings in the choice of vocabulary in the accompanying communiqué, which the Fed may well choose to make more hawkish.

The sense of anticlimax may be accentuated by the high drama that has preceded it. The last FOMC meeting - which left open the Fed's options on rates - triggered the most volatile passage for the US stock markets since the invasion of Iraq in early 2003.

The correction since the last FOMC meeting has been dramatic enough - 9.5 per cent in the Nasdaq Composite, 6 per cent in the S&P 500, and a thumping 12 per cent for the Russell 2000 index of smaller companies, a sector which is at last underperforming the biggest blue-chips after a bull run that has lasted several years.

But the best measure of the pain the market went through as it was dragged, kicking and screaming, to acknowledge that the Fed will be clamping down yet further on the supply of cheap money, comes from the VIX index.

A measure derived from the movements of futures written on the S&P 500, the VIX had been dwindling steadily since 2003, when it reached a level of 45.

For the past year it had scraped along at a level of about 10. But volatility finally returned this month. It reached 24 last week, and while it is now down to 16 again, the almost universal expectation is that it will remain high until the Fed embarks on monetary easing once more.

That creates opportunities, particularly now that variance swaps and other instruments allow volatility to be traded almost as an asset class.

But it also demonstrates exactly what scares the market.

After years of easy money, the Fed, with other central banks, is at last crunching liquidity. And Wall Street does not like that one little bit.


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