Fielding a Possible Yield Curve Ball

The yield curve's inversion probably won't impact the Fed's move much, but hedge funds might be hurting.
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Past as Prelude?

Late last week, the talk among traders was all about how the seemingly arcane goings-on in the fixed-income market were rippling through all facets of the financial markets (yes, including Internet stocks and other tech favorites). Despite the best efforts of

CNBC

(were they making up for lost time?), chatter about the

yield curve was reduced to a (hoarse) whisper today, contributing to the market's

snapback.

The most prominent rumor

Friday concerned a West Coast-based hedge fund that is supposedly facing potentially debilitating losses in interest-rate swaps soured by the yield curve's inversion. While that's obviously an extreme -- and thus far unproven -- situation, the odds are high that a variety of shops are facing some unpleasantness right now, today's relative quietude notwithstanding. That's because the yield curve's inversion alters the "normal" relationships on which rate-sensitive derivative products are pegged. Like it or not, there is a trickle-down effect that affects the equity market.

"The market is so very odd. It's an 'Invisible Hand' situation," Edward Gurin, president of

Thermopylae Group

, a Manhattan-based privately held asset management and investment banking firm, said Friday. "It's not of the

Long-Term-Capital-Management

scale this far, but we spent months wondering what the problem was," before

revelations of that hedge fund's ill-fated bets came to light.

The

Federal Reserve's

actions (implicit or

otherwise) during the Long Term Capital crisis in 1998 created a

moral hazard in the eyes of some market watchers. No one seriously suggests current problems threaten the world's financial stability, but the question begs whether

Alan Greenspan

& Co. will take the yield curve's inversion into consideration when the central bankers meet on Feb. 1 and 2.

"The

Fed

considers everything," but the yield curve will be little more than "background noise" when the rate-setting body gathers, Jim Bianco, president of

Bianco Research

in Barrington, Ill., said today.

"If any market-based thing plays into the Fed's decision, it's the 8% selloff in the

Nasdaq

last week," he said. "That will have as big an effect on Fed thinking as the yield curve, if not more so."

Meanwhile, many on Wall Street believe a 25-basis-point rate hike will spark a rally because of those still fretting about a half-point hike.

"The greatest thing going for the Street is that many still expect a 50-basis-point hike," Charles Payne, president of

Wall Street Strategies

wrote in an email this morning. "If we don't get it, a relief rally could help investors recover from earlier losses."

Perhaps we saw a bit of a jump-start on that process today, but did those who spell relief "25 basis point" set themselves up to go plop-plop, fizz-fizz later in the week?

Bianco notes the federal funds futures contracts are now pricing in a 31% probability of a 50-basis-point rate hike, up from just 20% last week. (See this recent

column by

James Padinha

for more on how such probabilities are derived.)

"It's not probable, but 50 basis points is not such a long shot," Bianco said. "It isn't like the

odds of the

Rams

winning the

Super Bowl" (which were 200-to-1 before the season started, by the way).

Moreover, the bond maven says 50 basis points would be the best thing for the fixed-income market because it would prove the Fed is "serious" about slowing down the economy.

"The stock market's hope is we repeat 1999, with quarter-point moves and the bond market acting like someone is pulling off a Band-Aid one inch at a time," Bianco said. "The bond market likes slower growth, and within that, a weaker stock market. What's good for the stock market is not good for the 30-year bond. And vice versa. Is Alan a stock trader or a bond trader this week?"

Juding by today's action, it seems Wall Street is betting Greenspan has at least one more gift left for the magi (a.k.a. the stock market).

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback at

taskmaster@thestreet.com.