INTEREST RATE FORECAST
August 05, 2007
This week the Federal Reserve meets and for the first time in over two years Fed watchers are discussing the Federal Open Market Committee (FOMC) lowering short term interest rates as a realistic possibility. The Chicago Board of Trade offers futures contracts on the 30-day Federal Funds Rate (ZQ) with expirations from August 2007 to January 2008. The Chicago Board of Trade website (www.cbot.com) offered the following analysis of trading on the August expiration:
Based upon the August 3 market close, the 30-Day Federal Funds futures contract for the August 2007 expiration is currently pricing in a 12.4 percent probability that the FOMC will decrease the target rate by at least 25 basis points from 5-1/4 percent to 5 percent at the FOMC meeting on August 7 (versus a 87.6 percent probability of no rate change).
Summary Table:
July 31: 92.6% for No Change versus 7.4% for -25 bps.
August 1: 92.6% for No Change versus 7.4% for -25 bps.
August 2: 92.6% for No Change versus 7.4% for -25 bps.
August 3: 87.6% for No Change versus 12.4% for -25 bps.
August 6:
August 7: FOMC decision on federal funds target rate
This analysis is less provocative than other market watchers who are now flooding the news wires with their mantra that the Fed will lower rates to counteract panic in the stock market. The futures market is discounting a lower Fed Funds rate as indicated below, but the smart money is only allowing for a 12.4% probability of a lowered Fed Funds rate at this week's meeting.
Implied Rate on 30-day Federal Funds Futures Contract
August 2007 expiration: 5.22%
September 2007 expiration: 5.17%
October 2007 expiratiob: 5.10%
November 2007 expiration: 4.98%
December 2007 expiration: 4.90%
January 2008 expiration: 4.86%
This forecast should be a relief to the banking industry who may see a decent spread between short-term and long-term rates which improves their profit margins. The mortgage market may also see some relief as troubled lenders have a better operating spread and a lower prime rate may help lower delinquencies. Current U.S. Treasury yields (as shown below) have a narrow spread of 5 basis points between 90-day T-Bills and 10-year Treasury Bonds - a situation unwelcome by investors and lenders.
Friday's Closing Yields on U.S. Treasury Bonds
3 Month 4.74%
6 Month 4.76%
2 Year 4.60%
3 Year 4.58%
5 Year 4.64%
10 Year 4.79%
30 Year 4.92%
SUMMARY - It looks to us that the economic conditions will lead the Fed to lower rates later in 2007, we just don't believe the primary motivation will be to a volatile stock market or to save the U.S. housing market. The Fed has walked a tightrope in their statement's when discussing the risks of inflation vs the risks of slow economic growth, but this meeting may be the one where the Fed has to call-out it's primary focus for the remainder of 2007. Savings investors who have had an easy time of finding 5% to 6% returns on liquid investments, may have to start working again to maintain that kind of return on the cash portion of their portfolios.
