By Michael Wallace
All roads lead to the Federal Open Market Committee (FOMC) policy decision on Wednesday. Treasuries had a good run last week, particularly the long end of the yield curve. And as the markets set up for this pivotal meeting, risk is building that either a quarter or half point cut may be taken bullishly by bonds and bearishly by equities.
Bonds won the battle last week, but the asset war will rage on as firework displays are readied ahead of the long U.S. holiday weekend to commemorate the Fourth of July.
Fed funds futures, a vehicle for investing pros to make bets on rate moves by the Fed, rounded out the week ambivalently, with the July contract doggedly sticking to its story of 46% probability of a half point cut, compared to about a 50-50 risk earlier in the week. Yet, the September contract reflects about 96% chance for a cumulative half point ease between now and the end of that month (the Fed meets next on August 21).
THE END IS NEAR.
While the size of the next rate cut is nearly a toss-up, many of those contacted in S&P MMS's Weekly Economic Survey on Friday believe the Fed's accompanying statement will hint that the end of the easing cycle is approaching. Given policy lags of at least 6-9 months, carrying on at the present hypersonic policy pace risks diminishing returns if long yields back higher and could goose the economy just as it's recovering next year. For this reason MMS is going for a more incremental quarter percent approach at the next two meetings and easing bias retention.
Yet either way the outcome could signal more gains for the bond. A quarter point cut is less inflationary and could signal more to come, while a half point move could signal an end to the easing cycle or that the Fed is more worried about a recession than the market.
Greenspan's Senate Testimony on financial markets showed obvious signs of concern over tightening credit conditions and deterioration in asset quality with the slowdown. He also mentioned Fed "sensitivity" to increasing evidence of global sluggishness, while rising energy and labor costs did not seem to be passed on, squeezing corporate profit margins.
Recent equity declines have junk bond investors worrying again about corporate default risk. These are not words that suggest the Fed is ready to hit the brakes yet, and Greenspan will have another opportunity after-the-fact on Thursday to guide expectations with a speech on energy and the economy in Chicago. Minutes of the May-15 FOMC meeting will be released the same day.
A LOOK AHEAD.
Most of the main economic indicators this week, including existing and new home sales, durable orders, consumer confidence, claims, and University of Michigan consumer sentiment, look to come in on the damp side. Then the clock starts ticking for the payrolls vigil the following week.
Volumes and activity should tail off pretty quickly following the midweek FOMC meeting as dealers settle in for the long weekend, which suggests the bond may burn white-hot like a Roman candle before petering out.
Wallace is a Senior Economist for Standard & Poor's