Take for example the current group of interest rate predictions that are circulating in the bond market. In mid-May the markets were practically sure, based on the predictions in the futures market, that the Federal Reserve would be lowering the overnight interest rate before year-end. The chances of an increase were zero, according to the futures market. Fast forward to the middle of June, a mere 30 days later, and those predictions, as shown in the futures market are completely reversed.
How can that be? What has changed in the last 30 days to completely reverse the predictions? The recently announced economic statistics have not been that far out of line with what was predicted (guessed.) Globally, the world economy appears to be heating up, and that has foreign central banks either raising their overnight rates or at least signaling concern. Members of the Federal Reserve have been making speeches, suggesting that inflation is expected to “moderate gradually.” However, they are still concerned that the “risks remain to the upside.” Nothing new there!
As we have discussed in recent FYIs, some of Wall Street’s largest dealers, such as Goldman Sachs and Merrill Lynch, had made predictions that the Federal Reserve would lower the overnight rate by 25, 50 even 75 basis points by year-end. They now have withdrawn those predictions, and expect the overnight rate to remain at 5.25 percent until the first quarter of 2008. These changes were made reluctantly, and I am willing to wager, with great trepidation.
I have a theory: I believe the Federal Reserve is very much concerned with the global economy heating up, even as our own economy is held down by the housing woes in the U.S. Why is that a concern? Because we are running a deficit that is over fifty percent financed by foreign governments. If these economies are expanding and causing their central banks to increase their overnight rates, we are going to be forced to keep our rates elevated in order to remain competitive. In other words, we will be more concerned about the global economy than we are with our domestic economy. Ultimately, we need their money.
How does this play out as far as the overnight rate is concerned? I believe the Federal Reserve may find itself forced to do nothing and leave the funds rate at 5.25 percent, despite its preference to lower the rate. They will continue to talk tough on inflation, even as the inflation rate is being contained. The markets will raise the rates further out the yield curve in order to attract buyers for the Treasury debt, which will produce an even steeper yield curve.
That’s my prediction, at least for now.
