December 12, 2007
A curious market reaction
I'm trying to make sense of the strong reactions to yesterday's action from the Federal Reserve.
Yesterday the Fed approved a cut in its target for the federal funds rate, the rate at which banks lend Federal Reserve deposits to one another overnight. The previous target had been 4.5% and the new target is 4.25%. Although the size of the cut (25 basis points) is the same as that adopted at the previous FOMC meeting on October 31, the statement seems to reflect greater worry on the part of FOMC members about the severity of the coming economic slowdown and ongoing financial pressures. For example, at the previous meeting, there was one dissenting vote-- Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, voted on October 31 to keep the funds target unchanged. Yesterday, Hoenig voted with the majority to bring the target down another 25 basis points, but there was a new dissenting vote, this time from Eric Rosengren, President of the Federal Reserve Bank of Boston, who voted to cut by 50 basis points rather than 25.
Stock prices fell like a rock on the news, with the S&P 500 down over 2.5% within a few hours. One interpretation of that response was offered by Scott Anderson of Wells Fargo:
This seems to have disappointed some on Wall Street who were looking for a little more in their Christmas stockings this year from Santa Bernanke.
Was Wall Street really expecting a 50-basis-point cut? Looking at fed funds futures or options, you might have thought this was a significant possibility. For example, the graph below is the interest rate implied by the January fed funds futures contract, which historically has proven to be an excellent predictor of the monthly average fed funds rate. This had been trading at 4.18% prior to the meeting. Since the FOMC is not scheduled to meet again until January 29/30, one might have read this as implying a 30% chance of having seen a 50-basis-point cut from yesterday's meeting:
But here's the curious thing: as of this writing, the price of that contract still has not budged more than half a basis point from where it stood at the close of trading last Friday. Fed funds futures traders seem not to have been surprised in the least by the outcome of Tuesday's meeting.
If you believed that the Fed was going to stop at 4.25% yesterday, why trade January futures at 4.18%? One thing people sometimes forget is that these contracts are settled based not on the target announced by the Fed, but rather on what the average effective fed funds rate actually turns out to be over the month. This number can differ from the target for several reasons. If, as currently appears likely, everybody is counting on another 25-basis-point cut at the January 29/30 meeting, the trading desk of the Federal Reserve Bank of New York would have a difficult time keeping the effective rate at 4.25% on January 28-- there are strong arbitrage pressures for it to trend down if everybody knows it will be at 4.0% in a few days. For this reason, even if the target is not changed until January 30, the average effective fed funds rate over the month is likely to come in below 4.25%. In addition, particularly given the current financial tension, the Fed's operating rules could easily produce an average rate a bit below its target. Plus there's a nonzero chance of an intermeeting cut, if we indeed see further financial deterioration. My guess is that these factors, rather than an assumption the Fed was going to go all the way to 4.0% at yesterday's meeting, account for the recent pricing of January futures and options contracts.
Which brings us back to the original question. If that's the case, then why did the stock market appear to be so shocked that the Fed only cut its target yesterday by 25 basis points?
Here's the official Econbrowser answer-- Beats me!
Posted by James Hamilton at December 12, 2007 08:33 AMdigg this | reddit
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Tracked on December 12, 2007 08:06 PM
one explaination is the statement. as in "if things aren't good what happened to the greenspan put". never mind that there may be no such thing. wall street loves two word explainations. even if false.
Posted by: oops at December 12, 2007 09:06 AM
Um, the Fed announced more than one rate decision. That other rate, the discount rate?, there was lots of hope that the Fed would cut it by 50 bps. That was going to be taken as the Fed leaning toward offering more help. The Fed only cut the discount rate by 25 bps, and sounded pretty neutral in the statement, even though it didn't overtly mention balance between risks. That stuff matters.
Oh, but problem solved today, right?
Posted by: kharris at December 12, 2007 09:36 AM
The Fed is acting like a teenage girl who does not want to go to the prom with you, but doesn't want to reject you either. Last night's text-message via Steve Leisman on CNBC and today's 'wait - wait, we didn't really want a 300-pt reaction' announcement show they are continuing to react immaturely to every adverse market repsonse stemming from a Fed action.
Either they are deliberate or they are just idiots - neither of which is very impressive and all of which is a concern for when things are more challenging and the general market is not but a few %-points from highs.
Posted by: Michael Davey at December 12, 2007 10:45 AM
The market fell because the market was already expecting a rate cut. The price of a stock the day before the rate cut included the expectation of cut of 25 points and the POSSIBILITY of a 50 basis point cut. When the market got a 25 basis point cut the possibility of a 50 basis point cut no longer existed, resulting in a quick devaluation of all stocks.
Posted by: David at December 12, 2007 11:01 AM
The market was expecting action outside of the fed funds rate - a reduction in the premium on the discount window or innovative steps like those announced today.
It also seemed difficult to justify the fact that the S&P500 had climbed within 2.5% of its all-time high prior to the Fed decision, when almost everyone now seems to be predicting recession.
Posted by: nocountry at December 12, 2007 11:08 AM
David, according to your theory, the January futures price should have changed on the news, and it did not. That's my point.
Posted by: JDH at December 12, 2007 11:24 AM
Related -- Professor, aren't you worried about today's actions by the Fed, in which they will be accepting junk -- literally -- as collateral for loans to member banks?
The Fed will lend 80% of face value on non-AAA asset-backed securities? Stuff that no one wants to buy at any price? Criminal.
Posted by: jg at December 12, 2007 11:58 AM
Thanks for raising the issue - been wrestling with it myself. One partial answer - the credit markets were as smart as you say but the stock markets expected/wanted a 50 bps cut with strong new instrument statements and a lowering of the discount window.
It seems to me that the Fed is not just between a rock and hard place (inflation/dollar vs recession risks) but is facing a new problem in the structural breakdown of the credit markets due to the de-leveraging of the new instruments. A point I muse on in a terrible picture model on my web sit btw.
If you believe that argument then the markets (stock) are a) still not grasping the magnitude of the "crisis" (are any of us) but b) are beginning to get it. Which argument would align with today's upticks as the Fed tackles the credit market structural problems headon.
I hate this interesting times thing - let's here it for predictability.
Posted by: dblwyo at December 12, 2007 12:06 PM
Consider two scenarios that result in a 25 bp cut. Scenario 1 is the Fed believes that rate cuts help, but they are also concerned about the inflationary effects down the road. So in Fed "balancing the risks" fashion, the Fed optimizes by cutting by 25 bp. The market might disagree with the Fed's balance of risk assessments, but if the market proves right and the Fed proves wrong, it can cut further down the road.
Scenario 2 is one where the Fed really is really uncertain whether a rate cut will help, if at all. It doesn't want to stand pat, but given its lack of confidence about the efficacy of a cut, it doesn't want to go beyond 25bps given the risk that it could be engendering inflation in return for no tangible benefit.
These two scenarios may seem indistinguishable, but I don't they are. One is about having a finely-tuned sense of the policy tradeoffs, and the other is about groping along in the midst of great uncertainty. I think that the market reacted to the Fed's own sense of uncertainty about what to do.
Posted by: GWF at December 12, 2007 12:23 PM
There is perhaps a simple answer here - the traders were locking in their gains for the year. Once they saw that the Fed was not going to make deep cuts to the interest rate, there was no way to see how stocks would go higher.
The objective evidence for this is in the sell off in stocks and bonds at the same time. Interestingly, most of the medium to long-term bond prices topped out on November 26th, and have been falling since then. That money seemed to be flowing out of the safe haven of treasuries and in to stocks, given the stocks rise since November 26th. But even with the selloff over the past two days in stocks, which reversed the up-trend, we did not see a corresponding trend reversal in treasuries as people fled to safety. It looks instead like the traders are taking their money out of the market.
Posted by: kdp at December 12, 2007 01:36 PM
I'm very curious too about lending 80c on the dollar for AA and less MBS. The ABX for AA is 40c on the dollar right now. Speculating wildly, it would seem like there's a big incentive to find some sacrificial financial institution, load it up with everybody's MBS bonds, get 80c cash in exchange for all the bonds from the Fed, have the entity pay everyone their 80c and then Chapter 7 it, leaving the Fed holding the bag.
Maybe that's the intent - this is a mechanism to address the insolvency issues that seem like they are lurking at a number of financial institutions if their ABS's were marked to market. Essentially the Fed is underwriting the value of all ABS's at 80c on the dollar?
If so we should see some sharp upward movements in the ABX indices?
Posted by: Stuart Staniford at December 12, 2007 02:24 PM
That's a clever transaction, S-S-. Makes sense that this is the plan, too. Why not?
Posted by: jg at December 12, 2007 04:05 PM
Its not unusual for the Fed Funds and equities markets to incorporate different expectations about Fed policy moves.
Remember that Fed Funds futures discount discrete s.t. events, whereas the market discounts l.t. earnings. The market tends to focus on the Fed's implicit "promise" to forestall recessions (the so-called "Fed Put"), and it measures every Fed communication against that long term promise. In this vein, the Fed's policy statement was thought to lack sufficient commitment to the Fed Put, which explains why the market sold off.
Posted by: david pearson at December 12, 2007 05:55 PM
my day job is in the stock market and I'd agree with david pearson - different capital markets frequently discount very distinct outcomes, in part because arbitrage in the real world can be problematic. one clear example I remember from the past was the valuation of Fannie and Freddie paper during the last systemwide credit crisis of 1990-1991 -- in the second half of 1990, Fannie and Freddie equity shares sold off frantically in response to credit deterioration in the multifamily sector, while GSE credit spreads vs treasuries hardly budged (note: the credit-default swap market was non-existent at the time).
one other general observation is that the stock market tries to discount a lot more data that the simple math of the FF's rate and futures contract. this FOMC meeting was troubling in part because the equity market expected that the discount rate would be cut 50 bp even while the FF rate was cut 25 (though we now know why the discount rate doesn't matter to the FOMC or anyone else, we didn't know yesterday what the Fed would announce today) and because the FOMC statement made no sense and it appears that there are wildly divergent growth & inflation views amongst the FOMC voting members as well as the 12 Federal Reserve District Banks.
Taken at face value, the FOMC statement says that a potential stagflation scenario is developing and that the outlook is subject to more uncertainty than ever: "Incoming information suggests that economic growth is slowing"; ". . . elevated energy and commodity prices, among other factors, may put upward pressure on inflation. In this context, the Committee judges that some inflation risks remain"; and "Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation." The highlights I clipped are slightly selective, but that's really what the statement says, in a nutshell - growth is slowing and while core inflation moderated a bit IN THE PAST, higher oil and commodity prices may spark higher inflation going forward AND the overall outlook is more uncertain than usual.
Not to mention but that at the last couple of FOMC meetings only 6-7 of the 12 district banks have asked for the discount rate cut that's been approved by the FOMC. Hawks and doves fighting like that scare the children.
To an impartial observer trying to make sense of this, it appears that the FOMC is quite confused and speaking with multiple voices. Honestly, that doesn't bother me at all, because I've always thought that the market attributes far more insight and understanding to the FOMC than history shows is warranted. Regardless, the stock market wants the FOMC to feign insight and understanding even when there is none and instead what the Fed gave the market was a large dose of gibberish.
Posted by: Anarchus at December 12, 2007 06:42 PM
GWF - good alternate scenarios. Would argue it's a bit of both, that is, as Anarchus points out they see downside risks and inflation risks BUT, my major caveat, their biggest worry right now is credit market contagions (think Ebola) spreading across asset classes.
Anarchus - thanks. Good points - clear from market. Think it's also worthwhile reviewing the charts in the last minutes were the GDP outlook is for very low growth and that leading to inflation containment. The Fed has been very clear about the things they think are important to the overall economy - not market gyrations.
Another point - I do think this market contretemps is being grossly underestimated and tried to "walk back the cat" in some charts earlier this evening. take a look and comment if you like (blog is website). Hope I'm wrong because I scared myself.
Posted by: dblwyo at December 12, 2007 06:56 PM
"Buy the rumor and sell the news". The action was expected, when it became reality, deception set in. As it should be. The market behaves as always does.
Posted by: jaim klein at December 13, 2007 04:45 AM
Thanks Jaim Klein... You hit the nail on the head!
Posted by: MarkS at December 13, 2007 12:18 PM
The fed binary options were showing a 30% chance of a 50 BP cut. The binary options are settled based solely on the target rate, so none of the complications of the fed funds futures are present.
Why didn't the futures rate change on the announcement? Maybe the expectations of a mid-meeting cut went up, or the expectations of an actual fed funds rate less than the target rate went up.
I can't believe the fed funds futures market knew there'd be a 0% chance of a 50 BP cut, yet the binary options market was pricing in a 30% chance.
Posted by: Anthony at December 13, 2007 04:43 PM
There is another explanation that also deserves consideration. The economy is not weakening as the Fed expects because of the financial crises.
Consequently, the Fed is being too aggressive and creating inflationary pressures.
Not that I necessarily believe this, but it can not be rejected out of hand.
Posted by: spencer at December 14, 2007 10:44 AM