Fed Fund Rate Ticks Up As Dollar Continues To Strengthen

by: Jay Norris

While an interest rate of 0.16% in Fed Funds may not seem like an uptick, it's been enough of a move to produce a 15-month low for the front month futures contract - Figure 1 -- which is relevant because it backs up Fed heavyweights Lacker, Fisher, and Kocherlakota, who have publicly come out for higher interest rates sooner rather than later. When Fed Fund futures go down short-term interest rates go up.

Click to enlarge.

Figure 1. Fed Fund Futures Contract

Historically the Fed exerts more control over the short-end of the yield curve, i.e.: the Fed Funds rate, than the long-end of the curve: 10 and 30-year treasuries. And while that may not be completely true right now, given the Fed's "Twist" operation to lengthen the maturities on its own portfolio to keep mortgage rates pinned lower, it certainly is a historic dynamic the Fed wants to get back to. The move lower for Fed funds and higher for short-term interest rates is definitely a development which will be supportive of the U.S. Dollar. In fact just as Fed Funds have technically been in a downtrend on the chart over the past 8-months - see Figure 1 -- the U.S. Dollar has been in an up-trend on its 1-year chart - see Figure 2. (Higher interest rates equate to a stronger dollar).

Figure 2. U.S. Dollar Index

U.S. Treasuries or the "long-end" of the yield curve on the other hand is telling us a different story. Essentially the long end of the yield curve is telling us that for global investors it is "risk on" with scared money continuing to flow into U.S. Treasuries - see Figure 3.

Figure 3. 30-year Treasury Bond Future

What is different this time about that scenario is the majority of the FOMC board members are no longer in "risk on" mode themselves. With prominent Fed members downgrading the likelihood of more quantitative easing, even in the face of a near-panic in Europe, and Fed Fund futures pointed lower, despite private sector funds bidding up treasuries, the proverbial corner for U.S. interest rates to turn may not be so far off after all.

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