Probability of A Rate Cut for The March 21, 2007 FOMC Monetary Policy Meeting Is Now At 79%

The U.S. economy is still sending mixed signals. For example, Gross Domestic Product (GDP) for the third-quarter was recently revised up from 1.6% to 2.2%, and the most recent Beige Book report from the Fed indicates that most of the country is still enjoying moderate growth. On the flip side, consumer confidence continues on a downward trend, and orders for durable goods fell by 8.3% last month. Furthermore, we may still have to worry about inflation. Here's a clip from a recent speech made by Fed boss Ben Bernanke before the National Italian American Foundation in New York:

"...Looking forward, core inflation seems likely to moderate gradually over the next year or so. Some of the factors that pushed up core inflation in the recent past--in particular, energy prices and shelter costs--appear likely to be more neutral in the coming year, and inflation expectations remain contained. Moreover, if, as seems most probable, the economy grows at a rate modestly below its potential for a time, pressures on resource utilization should ease a bit.

However, as with the outlook for economic activity, there are substantial uncertainties about the inflation forecast. In the case of inflation, the risks to the forecast seem primarily to the upside. Given the current level of inflation, a failure of inflation to moderate as expected would be especially troublesome..."

Housing Sector Continues to Slide

More evidence that the housing market is still sliding came in this week:

• Tuesday's Existing Home Sales report for October, '06 showed that preowned-home sales enjoyed a modest gain last month, and the sales numbers also beat economists' expectations. But the median sale price on a used home was down by a very significant 3.5% when compared to used-home sales from October, 2005.
• Wednesday's New Home Sales report for October, '06 showed that sales of newly-built homes are down when compared to September, 2006, and are down significantly when compared to new home sales from September, 2005.

When will the housing correction bottom out? No one knows for sure (of course, if you're in the market for a new home, then the current housing situation is good news, especially because the inventory of new and existing homes continues to rise, and mortgage rates are still consumer-friendly.)


10-Years Treasury Note Yield vs. The Federal Funds Target Rate

President Bush's economic advisers recently lowered their expectations for GDP growth next year: the 2007 GDP forecast is 2.9% right now, whereas, back in June, the same group of advisers were predicting 3.6% growth for 2007. Basically, the forecast is for strong growth throughout the economy, except for the U.S. housing market.

2.9% is a decent number, especially if inflation remains tame. So maybe Bernanke and his Fed colleagues have raised rates to just the right level, i.e. the neutral rate (the neutral rate is a Fed Funds Target Rate that neither stimulates nor inhibits U.S. economic growth, and is the rate that's associated with a stable U.S. economy.)

Or, maybe not.

Maybe today's Fed Funds Target Rate of 5.25% is a bit above neutral, which would mean that the Fed may elect to lower the Fed Funds Target to 5% some time next year. That's what investors are thinking.

When investors foresee an economic slowdown ahead, they tend to move their money from stocks to the relative safety of government treasuries. As the demand for e.g. 10-year treasury notes rises, the yield on the 10-year note -- i.e. the interest paid to the investor -- falls (and vice versa.)

Treasury yields are great indicators of where the economy is headed, especially when the yield on the ten-year note is compared to the Federal Funds Target Rate. If the yield on the 10-year note is trending lower than the Fed Funds Rate Target, then it's a pretty safe bet that the economy will be slowing in the coming months. The difference between the Fed Funds Target Rate and the 10-year treasury yield is known as the "spread."

The last time the Fed started cutting interest rates (so as to spur economic growth) was on January 3, 2001; on that day, the Fed Funds Target Rate was 6%, and the yield on the 10-year treasury note was 4.92%. That's a spread of 1.08 percentage points.

Right now, the spread is 0.792 percentage points, and it's been widening ever since June 29, 2006; June 29 was the date of the last Fed rate hike. Here's a chart to demonstrate the current trend:

If the gap between the 10-year treasury note yield and the Fed Funds Target Rate continues to widen, then the U.S. economy is more likely to cool in the coming months, which, in turn, would make it more likely that the Fed will elect to lower interest rates in 2007.


The Latest Odds

As of right now, the investors who trade in Fed Funds Futures have odds at around 79% (according to current pricing on contracts) that the Federal Open Market Committee (FOMC) will elect to lower the benchmark Fed Funds Target Rate by 25 basis points at the March 21^ST, 2007 monetary policy meeting.


Summary of the Latest Prime Rate Predictions:

• In all likelihood, the Prime Rate will remain at the current 8.25% after the December 12^TH and January 31^ST FOMC monetary policy meetings.
• Current odds that the Prime Rate will be cut to
  8.00% on March 21^ST, 2007: 79% (somewhat likely)
  
  
• NB: Prime Rate = (The Fed Funds Target Rate + 3)

The odds related to Fed Funds Futures contracts -- widely accepted as the best predictor of where the FOMC will take the benchmark Fed Funds Target Rate -- are continually changing, so stay tuned for the latest odds. Odds may experience a significant shift on the release of the following economic report:

• Friday, December 8, 2006: The Labor Department releases the Employment Situation report for November.

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Probability of A Rate Cut for The March 21, 2007 FOMC Monetary Policy Meeting Rises to 40% On Housing Starts Report

It was just yesterday that odds on a rate cut for the March 21, 2007 Federal Open Market Committee (FOMC) monetary policy meeting dropped as low as 6% on encouraging news about inflation. But today, the probability that the Fed will reduce the benchmark Fed Funds Target Rate by 25 basis points in March jumped back up to 40%. Why the significant shift today? Well, if you are guessing that it has something to do with the slumping housing market, then your guess is right on target.

Earlier this morning, the Commerce Department released their report on New Residential Construction (a.k.a. Housing Starts) in October, 2006:

• The initial estimate of privately-owned housing starts last month: 1,486,000; this is 14.6% lower than the revised estimate from September, 2006. Economists were expecting 1,675,000.
  
• The initial estimate of single-family housing starts last month: 1,177,000; this is 15.9% lower than the revised estimate from September, 2006.

The housing market continues to slide, and the Fed is certainly paying close attention to it.

Speaking in Delaware yesterday, Eighth District Federal Reserve Bank President William Poole said that Fed officials are paying "special attention" to housing, and that he's concerned about all the home-purchase cancellations going on.

Bottom line: if the Fed decides to lower interest rates some time next year, the housing market is likely to be a significant, contributing factor behind that decision.

For some perspective on how influential the housing market is on the U.S. economy, consider this: the waning housing market reduced the U.S. Gross Domestic Product (GDP) figure by 1.1 percentage points last quarter.


The Latest Odds

As of right now, the folks who trade in Fed Funds Futures have odds at around 40% (according to current pricing on contracts) that the FOMC will elect to lower the benchmark Fed Funds Target Rate by 25 basis points at the March 21^ST, 2007 monetary policy meeting.


Summary of the Latest Prime Rate Predictions:

• In all likelihood, the Prime Rate will remain at the current 8.25% after the December 12^TH and January 31^ST FOMC monetary policy meetings.
  
• Current odds that the Prime Rate will be cut to
  8.00% on March 21^ST, 2007: 40% (somewhat unlikely)
  
  
• NB: Prime Rate = (The Fed Funds Target Rate + 3)

The odds related to Fed Funds Futures contracts -- widely accepted as the best predictor of where the FOMC will take the benchmark Fed Funds Target Rate -- are continually changing, so stay tuned for the latest odds. Odds may experience a significant shift on the release of the following economic reports:

• Tuesday, November 28, 2006: The National Association of Realtors releases the Existing Home Sales report for October.
  
• Wednesday, November 29, 2006: The Commerce Department releases both the preliminary Gross Domestic Product (GDP) report for Q3, 2006, and the New Home Sales report for October.
  
• Friday, December 8, 2006: The Labor Department releases the Employment Situation report for November.

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Probability of A Rate Cut for March 21, 2007 Drops to 6%

Between mid-2004 and mid-2006, Greenspan, Bernanke, and their Fed colleagues pushed the benchmark Fed Funds Rate from 1% to the current 5.25% in quarter-point increments, which has produced the desired effect of taming inflation without pushing the economy into recession (so far.) Investors and central bankers should be pleased with the latest inflation data: the October Producer Price Index (PPI) report suggests that wholesale prices eased at a pace that beat economists' expectations, and the October Consumer Price Index (CPI) report indicates that core consumer prices rose at a Fed-friendly 0.1% last month.

The latest inflation figures should be enough to quiet at least some of the murmuring related to price stability that's been going on at the Fed. Fed officials have expressed serious concern about inflation as recently as the last Federal Open Market Committee (FOMC) meeting, the minutes of which were released yesterday. Here's a clip:

"...All meeting participants expressed concern about the outlook for inflation. Most participants expected core inflation to edge lower, in part as the effects of the run-up in energy prices in recent years waned. And shelter costs were not expected to add materially to inflation going forward. Moreover, moderate growth in aggregate demand and the associated modest easing of pressures on resource utilization should also contribute slightly to the slowing in core inflation. Recent changes in core prices had declined slightly from earlier in the year. Nonetheless, nearly all participants viewed the current rates of core inflation as uncomfortably high and stressed the importance of further moderation. 

The available measures suggested that medium- and long-term inflation expectations remained around the levels seen for the past several years, although in the view of some participants these expectations were probably higher than would be consistent with their assessment of long-run price stability. Participants were concerned that inflation expectations could begin to drift upwards if core inflation remained elevated for a protracted period. Any such rise in inflation expectations and associated upward pressure on inflation itself would likely prove costly to reverse. Although some participants noted that the recent slowing in core inflation had helped to allay their fears of a further sustained increase in inflation, all participants emphasized that the risks around the desired downward path to inflation remained to the upside.

All meeting participants expressed concern about the outlook for inflation. Most participants expected core inflation to edge lower, in part as the effects of the run-up in energy prices in recent years waned. And shelter costs were not expected to add materially to inflation going forward. Moreover, moderate growth in aggregate demand and the associated modest easing of pressures on resource utilization should also contribute slightly to the slowing in core inflation.

Recent changes in core prices had declined slightly from earlier in the year. Nonetheless, nearly all participants viewed the current rates of core inflation as uncomfortably high and stressed the importance of further moderation. The available measures suggested that medium- and long-term inflation expectations remained around the levels seen for the past several years, although in the view of some participants these expectations were probably higher than would be consistent with their assessment of long-run price stability.

Participants were concerned that inflation expectations could begin to drift upwards if core inflation remained elevated for a protracted period. Any such rise in inflation expectations and associated upward pressure on inflation itself would likely prove costly to reverse. Although some participants noted that the recent slowing in core inflation had helped to allay their fears of a further sustained increase in inflation, all participants emphasized that the risks around the desired downward path to inflation remained to the upside..."

Have We Hit Neutral?

Short-term interest rates may be at just the right level, or as the economists and central bankers like to put it, the "neutral rate" -- a Fed Funds Target Rate that neither stimulates nor inhibits U.S. economic growth. Many Federal Reserve officials believe that we are at or close to neutral with the current Fed Funds Target Rate of 5.25%. On November 2, 2006, Federal Reserve Board Governor Susan Bies commented:

"...At 5.25, many of us think we're in that range..."

8.25% Will Be With Us for A While

The U.S. prime interest rate is very likely to remain at the current 8.25% right through the coming winter. The economy continues to send mixed signals: the job market is tight right now, and today's Philadelphia Fed Survey indicates that Philadelphia-area manufacturing is the strongest it's been in 3 months. Furthermore, today's report on Industrial Production showed an increase of 0.2% last month, which is exactly what economists were expecting.

On the flip side, many economists are predicting that the all-important housing market will continue to deflate for some time. More evidence of sluggishness in the U.S. economy was released two days ago by Commerce Department, in the form of the October Retail Sales report.

Bottom line: in this type of mixed economic environment, the Fed is likely to hold on interest rates for at least two more FOMC monetary policy meetings.


The Latest Odds

As expected, interest-rate speculators have reacted to recent inflation and manufacturing data. As of right now, the investors who trade in Fed Funds Futures have odds at around 6% (according to current pricing on contracts) that the Federal Open Market Committee (FOMC) will vote to lower the benchmark Fed Funds Target Rate by 25 basis points at the March 21^ST, 2007 monetary policy meeting.


Summary of the Latest Prime Rate Predictions:

• In all likelihood, the Prime Rate will remain at the current 8.25% after the December 12^TH and January 31^ST FOMC monetary policy meetings.
  
• Current odds that the Prime Rate will be cut to
  8.00% on March 21^ST, 2007: 6% (very unlikely)
  
  
• NB: Prime Rate = (The Fed Funds Target Rate + 3)

The odds related to Fed Funds Futures contracts -- widely accepted as the best predictor of where the FOMC will take the benchmark Fed Funds Target Rate -- are continually changing, so stay tuned to this weblog for the latest odds. Odds may experience a significant shift on the release of the following economic reports:

• Tuesday, November 28, 2006: The National Association of Realtors releases the Existing Home Sales report for October.
• Wednesday, November 29, 2006: The Commerce Department releases both the preliminary Gross Domestic Product (GDP) report for Q3, 2006, and the New Home Sales report for October.
• Friday, December 8, 2006: The Labor Department releases the Employment Situation report for November.

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Probability of A Rate Cut In March Drops to 11% on Employment Situation Report

The national Prime Rate is 8.25% right now, and it still looks like it's going to stay there for some time. That's because the economy is still sending mixed signals, which will most likely prompt the Fed stay on the sidelines and leave short-term interest rates alone for a while.

Today's jobs report was surprising to many economists. The Employment Situation report for October showed that 92,000 jobs were created last month, and though non-farm payrolls missed expectations (prognosticators had predicted around 130,000 new jobs for October), the Labor Department report also showed that the unemployment rate dropped to an impressive 4.4%. Furthermore, non-farm payrolls for months prior to October have been revised much higher than initially reported: from 51K to 148K for September, and from 128K to 230K for August. Clear signs that the economy is doing just fine, thank you very much.

Another reason for the Fed to worry about inflation: preliminary data indicate that there was no increase in productivity during the third-quarter, and Unit Labor Costs rose at a faster-than-expected pace.

But then again, other government reports released recently indicate that the economy is still on the wane. For example, Construction Spending fell by 0.3% in September, and the initial, third-quarter GDP estimates show an overall gain of 1.6% for the U.S. economy (economists were expecting 2.0%.) And, of course, there's the recent report on New Home Sales, which indicates that the all-important housing sector is continuing in a negative direction.

Bottom line: the way things look right now, we may have to wait until the flowers of spring start to bloom -- or even longer -- before the Fed cuts short-term interest rates.

The Latest Odds

Of course, investors reacted to today's employment news. As of right now, the folks who trade in Fed Funds Futures have odds at around 11% (according to current pricing on contracts) that the Federal Open Market Committee (FOMC) will vote to lower the benchmark Fed Funds Target Rate by 25 basis points at the March 21^ST, 2007 monetary policy meeting.


Summary of the Latest Prime Rate Predictions:

• In all likelihood, the Prime Rate will remain at the current
  8.25% after the December 12^TH FOMC monetary policy meeting.
• Current odds that the Prime Rate will rise
  to 8.50% on January 31^ST, 2007: 2% (very unlikely)
• Current odds that the Prime Rate will be cut to
  8.00% on March 21^ST, 2007: 11%
  
  
• NB: Prime Rate = (The Fed Funds Target Rate + 3)

The odds related to Fed Funds Futures contracts -- widely accepted as the best predictor of where the FOMC will take the benchmark Fed Funds Target Rate -- are continually changing, so stay tuned for the latest odds. Odds may experience a significant shift on November 14^TH, after the Fed releases the minutes from the October 25^TH monetary policy meeting.

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