Ghosts of 1994: Gone but Not Exorcised

As Bill Gross, manager of the $76 billion (PTTAX Quote)Pimco Total Return fund said on CNBC after the announcement, if anyone was looking for signs that the Fed might pause, "it's not in there."

If the Fed continues to steadily tighten monetary policy in the coming year, the dislocations that were feared but avoided in 2004 might emerge after all.

Carrying On the Carry Trade

Indeed, hedge funds still are pouring money into so-called carry trades, borrowing in dollars to invest in assets abroad, be they emerging market bonds, commodities or other currencies. On a recent visit to London, Morgan Stanley analyst Andy Xie said he encountered hordes of hedge funds putting back on carry trades they had unwound earlier in the year. With borrowing rates in the U.S. below the rate of inflation, fund managers figure they can't lose by borrowing at low short-term rates and reinvesting in higher-yielding assets -- at least until rates go higher.

"The low fed funds rate is the source of enthusiasm for carry trades," Xie wrote last week. "The amount of liquidity with money managers, especially in hedge funds, is still significant. Another 100 basis points [1%] of rate hikes by the Fed could reverse this liquidity tide."

Following Wednesday's statement, most observers now expect that the Fed will engage in a relatively unusual December rate hike. Futures contracts linked to the fed funds rates for January have fallen from an implied yield of just over 2%, indicating no move at December's meeting, to 2.21% at the close on Wednesday, implying an almost certain move.

Looking farther out, fed funds contracts don't have enough volume to provide much guidance. Futures linked to the rate paid on eurodollar deposits have 10 times the trading interest but aren't a perfect analog. Still, they also signaled a shift in expectations as the December 2005 contract showed a yield of about 3.5% on Wednesday compared to 3.2% before Friday's report and close to 3% a few weeks earlier. The actual eurodollar interest rate is typically about 0.25% above the fed funds rate but an additional risk premium for future contracts muddies the waters. That said, the market is looking for at most 1% of additional tightening after the Fed presumably hikes the rate to 2.25% next month.