The dramatic decline in the yield on short-term Treasury bills on Monday further strengthened market expectations that the Federal Reserve will soon embark on an aggressive series of interest rate cuts.
By the close of trading the market was pricing in roughly one-and-a-half quarter-point cuts by the Fed’s next scheduled policy meeting on September 18, and three quarter-point cuts by the end of this year.
Traders said the market was pricing in a significant probability that the Fed would cut rates before the September meeting, though it is very difficult to estimate this precisely.
That all adds up to a perfectly plausible scenario. But there remains considerable uncertainty as to what the Fed will actually do.
Fed officials are watching the action in the T-bill market carefully but are likely to view it as, at least in part, the mechanical result of a process they already knew was under way.
Investors have started to pull billions of dollars out of risky investments, including some hedge funds, and as funds liquidate assets to meet redemption requests, the cash needs to be put somewhere. At present, it is piling into the T-bill market, where the supply of securities – in the short term – is fixed, pushing down yields.
This pressure will probably continue for several weeks as the backlog of redemption requests is cleared.
The more unsettling aspect is the added pressure from asset-allocation shifts within the $2,700bn money market fund sector, with “enhanced” funds trying to increase the share of pure government debt in their portfolios.
On the face of it, the market appears quite sure what the money market woes and dysfunction elsewhere in the credit markets mean for interest rates. But it would be wrong to infer from this a high degree of certainty as to where rates are heading.
Traders and policymakers alike believe that the interest rate futures market is being used by investors to hedge positions taken in other markets.
It may not, therefore, give a true picture even of investors true expectation of the future rate path.
Policymakers, meanwhile, are still marking to market their own estimates of what the turmoil means for the economy. For now many still see the impact as being mostly one of increased downside risks to growth, with smaller revisions to the base case forecast for growth.
In all likelihood the tightening of credit conditions will push the Fed to ease by between a quarter point and a half point this year, to leave overall financial conditions as they were before the turmoil began.
More radical scenarios, though, tend to assume that the Fed will have to take additional action to unblock the financial system, and prevent more extreme spillovers to the economy.
Much depends on how long the market turmoil continues – a judgment the Fed has no great informational advantage in making.
Policymakers will remain flexible in their thinking. But they cannot afford to ignore what the market is pricing in, even if this is distorted by hedging. The pricing in of assumed rate cuts has reduced interest rates along the government yield curve, providing an important counterweight to tightening of credit conditions.
The last thing the Fed wants to do now is to kick away that counterweight by questioning the rate cut assumptions.
For now – while policymakers remain deeply uncertain – they are acquiescing in market expectations. If markets remain fragile, they will find it difficult to break away from that stance.