In financial market trading, as in poker, the keys to winning are reading the subtle signals from the other side and not becoming a victim of your own mind game.
Most investors don’t have a seat at the table where the Federal Reserve squares off with financial market players. But when one side overplays a hand, you can be the loser.
Long-term interest rates, used to set mortgage rates for buying and refinancing homes, have crept up for two months, even as traders and economists assured themselves that the Fed was not about to push short-term rates higher.
Slightly higher long-term rates helped curb the typically upbeat start to the new year on Wall Street. The trend hints that traders, trapped in their game plan, are worrying more about what the Fed is thinking than about what it is doing.
On Tuesday, the Fed’s interest-rate policy committee is scheduled to begin a two-day meeting. Afterward, according to the consensus of experts, the Fed will leave its short-term target rate at 5.25 percent, where is has been since June.
Current betting suggests the Fed pause will hold until May, when a rate cut is said to be likely.
This is not idle speculation. Billions of dollars are wagered every day on the outlook for Fed interest-rate actions. When the bets are winners, investors and the economy benefit from improved market stability. When the bets go wrong, the risk of loss increases.
Long-term interest rates declined from July through November, as forecasts of a Fed rate cut swelled along with anxiety about the housing sector. Given the housing slowdown, the central bank had no incentive to dash traders’ rate-cut hopes.
“The market, in effect, does do the Fed’s job for it,” said Ray Stone, economist at Stone & McCarthy Research Associates. “One might argue that when there was a lot of talk about the Fed easing a month or so ago, that caused a little lull in rates, and maybe that gave the economy a little boost.”
Now, said Paul McCulley, chief short-term bond trader for Pacific Investment Management, traders might be overconfident in predicting the Fed will trim rates.
Either the Fed will “validate” the market consensus–or not, he wrote. If the Fed declines to ease rates, investors would be in for an “interlude of melancholy,” as traders back out of their rate-cut bets and push stock and bond prices lower, he wrote.
Recent reports indicate that the economy is doing better than expected, a prospect that is beginning to fuel fears of inflation and an increase in long-term rates.
“We think they will ease around midyear, but we have to concede that the most recent data have come in on the strong side of our expectations,” said Stone.
On Monday, for example, the Chicago Fed posted the first month-to-month gain in its Midwest manufacturing index since July. Makers of vehicles, machinery and food and wood products registered greater output.
William Strauss, senior economist at the bank, said the uptick probably reflects a rebound from the fall slump, but, “in general, business conditions still remain fairly upbeat for manufacturing. The outlook, according to our contacts, seems to be for a fairly good year for 2007, but not the same rate of growth as we saw over the last couple of years.”
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bbarnhart@tribune.com
