Bond Trading on the Fed's Decision

The Federal Reserve released a statement at the conclusion of the FOMC meeting and as widely expected reduced the Federal Funds rate by 25 basis points to 2 percent. The statement cites the weakness in the economy and the various forces acting in concert to restrain growth. The statement specifically notes that the Committee believes that the substantial easing which they have already put in place will act to set the economy back on a path to moderate growth. The Committee omitted the sentence which had been in previous statements that stated that the economy faced severe downside risks.

Regarding the inflation outlook, the Committee expressed measured concern about the inflation outlook and a slightly elevated level of inflation expectations. However, they did note that they anticipate that inflation pressures will moderate as energy prices and other commodity prices recede and as pressures on resource utilization ease.

I think there are several trading conclusions which we can derive from the statement. In the near term it is appropriate to reestablish steepening trades as the statement was not indicative of an overly hawkish Fed. The Treasury will sell $15 billion 10 year notes and $6 billion Long Bonds next week. The most recent round of supply from the Treasury has been digested and distributed. So the safest course of action is the traditional one. Sell whatever the Treasury sells next and cover your short in the auction. The curve has experienced a huge retracement and into supply I think it is safe to buy 2 year or 5 year paper and sell 10 year and 30 year paper.

Longer term, the FOMC statement means that the market will become data dependent and somewhat range bound. I think that one can assume that the range for the benchmark 10 year note will be 3.90 percent to 3.70 percent. The market will fluctuate within that range as perceptions about inflation and the economy shift. And given that the FOMC thinks that the substantial ease already in the system will stabilize the economy and promote moderate growth, I think that one set of bullish numbers will not be enough to put the central bank on course for a new round of ease. It will take an accumulation of data to do that.

In the current environment I think that means a sharply deteriorating labor market ( four week moving average of initial claims above 400k and unemployment rate heading for mid 5 percent area) and solid evidence that consumer spending is slumping substantially.

I also think that absent a clear trend in the data and the FOMC’s more temperate stance the market should sell off harder on bad for bonds data than it would rally on more sanguine data.

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