Fed steps up its hints that the exit strategy is coming

The FOMC at its meeting earlier this week kept its federal funds rate target unchanged at zero to 0.25% and said that the funds rate is likely to remain “exceptionally low” for “an extended period.” However, the FOMC’s post-meeting statement contained a more upbeat economic assessment by saying that the economy has “picked up” since the last FOMC meeting in August. That added to Fed Chairman Ben Bernanke’s recent comment that the recession “is very likely over.”

The big news out of the FOMC meeting was that the Fed slowed its $1.45 trillion mortgage security purchase program so that it would now end at the end of Q1-2010 rather than at the end of this year. That should delay and soften the upward movement in mortgage rates that is likely to accompany the end of the Fed’s program. The Fed last month did the same thing with its $300 billion government security purchase program by extending the program until the end of October. The important thing is that the Fed is signaling that the end of these programs is definitely coming. The bond market is particularly happy to see the government securities program end because that program represents the blatant printing of money and monetization of the Treasury’s debt.

For the bond market, though, the biggest news surrounding the FOMC meeting was actually the press report on Tuesday that the Fed has started discussing with bond dealers how it can execute large-scale reserve repo agreements when the time comes to drain reserves. Those talks provided the bond market with more confidence that the Fed is developing serious plans for an exit strategy from its extraordinary liquidity measures. The Fed has yet to remove any of its $1.2 trillion in extra liquidity, however in coming weeks and months it is likely to slowly ratchet up its talk about exit strategies and will probably start to withdraw its liquidity in Q1. The Fed is likely to start withdrawing liquidity even before it raises interest rates, something that the ECB has already indicated it plans to do. That would allow the Fed to get a jump on curbing monetary expansion and keeping the bond market happy, without drawing negative attention from the public and politicians with a highly-publicized rate hike.

The numbers below represent the Commercial Net Traders positions taken from the weekly Commitment of Traders (COT) report released by the Commodity Futures Trading Commission each Friday. You will find a 12-month high and low with the past 2 weeks of data. To see the past 52 weeks of commercial data please visit www.pricecharts.com. Simply open Analysis under the Resource category at the top of the screen and click on the Commercial Tracker on the left side selection menu. You will find this to be a very interesting presentation of the commercial COT information.

Commercial Net Tracker instructions
This form tracks the Commitment of Traders (COT) data for the commodity futures market. This form "looks" at the most recent five weeks of COT data and provides visual indications of the data. A. If the current value is at a 12-month low, the cell will display a red/burgundy background. B. If the current value is at a 12-month high, the cell will display a green background. C. If the current value went from net negative to net positive, the cell will display a blue background (indicating a bullish condition). D. If the current value is both a 12-month high and also went from a net negative to a net positive, the background will be green. You should view the data with green backgrounds to determine if they also went from net negative to net positive.

To view the entire year of commercial data please visit www.pricecharts.com.

Fundamentals:
10-year T-note prices are consolidating just under their recent four-month high. The 10-year T-note yield is fluctuating in the lower half of a range bounded by July’s four-month low of 3.26% and June’s 11-1/4 month high of 4.00%. Bullish factors for T-note prices include (1) the unexpected decline in August existing home sales (-2.7% to 5.10 million versus expectations of +2.1% to 5.35 million), (2) the post-FOMC statement that said the Fed will extend its mortgage security purchase program until Q1-2010, three months later than originally scheduled, and that the FOMC will leave interest rates "exceptionally low" for an "extended period," easing concerns that the Fed would begin an interest rate tightening campaign, and (3) the prediction from Goldman Sachs that the 10-year T-note yield may fall back to 3% because inflation will stay muted, that Asian central banks will continue to buy government debt, and that policy makers will delay stimulus-exit strategies. Undercutting T-note prices was the unexpected decrease in the latest weekly initial unemployment claims which dropped to a two-month low (-21,000 to 530,000 versus expectations of +5,000 to 550,000).
FOMC expectations—Market expectations for Fed policy were unchanged for the remainder of the year but were pushed back for a tightening of monetary policy to mid-2010 and beyond. The market expects no significant chance of a Fed rate hike at the remainder of this year’s meetings. However, the market is then expecting a slow rise in the funds rate to 0.50% by June 2010, to 1.00% by November 2010 and to 2.00% by June 2011.

Legend:
CC  - consecutive closes
UTL - uptrend line
DTL - downtrend line

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