Fed Rumors Roil Markets

There is talk in some quarters, following an informal meeting of several primary dealers with Fed Chief Bernanke, that a 50-basis-point rate hike next week is possible. It seems unlikely on the face of it that Bernanke, after seemingly having lapsed from his clear and transparent communication goal in late April, would convey private information to bond traders.

Nevertheless, the fed funds futures were under pressure again Thursday.

Here is what we know for sure: Thus far this month, the fed funds effective average, counting Fridays as three days as is necessary, is just below 4.98%.

Assuming that the Fed would have reached its target on average over the month, fair value for the June futures contract on a 25-basis-point rate hike next week is 94.99, or 5.01% yield. However, given that the average effective rate has been below target, fair value is probably closer to 4.99% or 95.01 in terms of price.

The June contract is changing hands near 5.035% or 94.965. This would suggest pricing is consistent with about a one-in-five chance of a 50-basis-point rate hike on June 29. We can further fine-tune our analysis by looking at the July contract. Again, for all days in the future, it is only reasonable to assume the Fed reaches their target on average.

Assuming a 25-basis-point rate hike next week, fair value for the July contract would be 5.25% or 94.75 in price. The contract is currently trading at 5.28% or 94.72%. This implies about a one-in-eight chance of a 50-basis-point move.

I do not believe the Fed will move by 50 basis points, though we can see a case for it and suspect that all those traders looking for another 25-basis-point hike in August (which is pricing in about a 90% chance of a 25-basis-point hike at the August FOMC meeting) can also see a case for 50-basis-point move in July.

If the Fed does deliver a 50-basis-point rate hike, I suspect it would likely signal a pause, the dollar and the long end of the U.S. curve might move higher in response, and U.S. shares would likely fall. Then, given the correlation of global equity markets, a drop in the U.S. would likely weigh, to varying degrees, on other equity markets as well.

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Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.