Trader’s Narrative

Late last week we got the latest figures from the Reuters/University of Michigan survey. Consumer sentiment continues to recover with the preliminary June 2009 number at 69% - compared to 68.7% for May 2009. The consensus of economists was for a larger recovery but there is no doubt that US consumer sentiment is slowly recovering from the drubbing it got a few months back. Things were so extreme that we hadn’t seen such low consumer sentiment since 1980!

But there was another data point that got my attention from the Reuters/University of Michigan survey. There was an increase in the number of people expecting an increase in interest rates from 36% in May to 53% in June.

With those that expecting the opposite shrinking from 19% last month to just 10% now. This differential is the largest since August 2007 (red arrows in chart):

Keep in mind that bond yields and bond prices move inversely. So a fall in yield would be accompanied by higher bond prices.

As you can see in the chart, the red arrow doesn’t coincide exactly with the 2007 summer peak in yields but then again, if we go back we find that the chart consistently trends downwards. In fact we could look back 10, 15, 25 years and more and still find that yields in a downtrend. Of course within this macro-trend there have been some very sharp counter rallies - of which the early 2009 rally stands out.

Today we’ll be keying off only one market tell: the scheduled Federal Reserve rate cut decision.

I’ve been following a simple model of the Fed’s actions: approximation of the 90 day US government T-Bond yield. At yesterday’s close, the 3 month US Treasury Bond’s yield was 2.280% and in overnight trading they were a bit lower at 2.20% (last time I checked).

Here’s a recent graph comparing it with the Fed rate (in blue):

If only they’d listened to me when I suggested they cut, way back in the summer of 2007!

The Fed is now way behind the curve and in a desperate (some say futile), last ditch effort to forestall a recession in the US economy. I know this sounds crazy but they would have to cut 125 basis points to bring the Fed target rate in line with the bond market - see above graph.

The odds are that we will get a generous rate cut. But probably not that generous. According to Federal Fund futures, we have more than a 70% chance of a 50 basis point cut and about a 30% chance of a quarter point cut. But really, no one knows what the Fed will decide.

All I know is at 2:14 pm today, the futures will go nuts. Since the market is clearly expecting (and needs atleast) a 50 basis point cut, anything less will be a major disappointment. If we get anything more, we could be riding a rocket. The market is clearly in a very oversold condition and a catalyst like an unexpectedly larger rate cut would be all it needs to recover. If we do get exactly 50 basis points, we could flail around and end the day unchanged for the most part.

In any case, the first directional jab is usually a head fake, or has been in the past. So unless you really really have to don’t trade around the decision time.

If you do, just know the risks. Including the risk of losing internet connectivity, losing power, etc. Believe me, you don’t want to be stuck in a position that can move against you mercilessly unless you have planned for every contingency.