Thin Trading: Fed Fund Futures and Antique Watches

Wednesday, October 10, 2007 | 07:48 AM

Yesterday, Traders embraced the release of the FOMC minutes. Indices were flat up until just before the 2:00pm release, and then took off, with the Dow gaining near 1%.

The thinking behind the Fed action was clearly revealed in that release. The emphasis was on the subsequent impact of credit on the entire system. The WSJ reported:

"Federal Reserve officials worried that credit-market turmoil could reinforce slower growth at a time of "particularly high uncertainty," leading to their half-point interest-rate cut last month, minutes from the meeting show.

Without a cut, there was concern that "tightening credit conditions and an intensifying housing correction would lead to significant broader weakness in output and employment," the rate-setting Federal Open Market Committee said. The minutes, released yesterday, also showed members worried that market turmoil "might persist for some time or possibly worsen."

They offered no clues about the direction or timing of the Fed's next move."

That last sentence is quite intriguing. Understanding whether or not a rate cut is forthcoming impacts yields, stocks prices, etc.

Given the significance of the Fed's action, one would suppose that the markets which trade the Fed Futures would be, if not prescient, than at least telling about their future price action. One of the more fascinating aspects about this, however, has been the way the Fed Fund Futures have functioned over this time. They have been wildly wrong, forecasting an imminent rate cut since January 2006. I thought it might be instructive to look at why this maybe so, and what it might mean . . .

First off, Fed Fund Futures could be used to hedge positions, especially fixed income holdings. Given the traditional impact any change in rates has on a bond portfolio it makes some sense to think of the buying and selling of futures as hedges. Rather than forecasting future price action, they are offsetting risk to a given set of holdings.   

Next, consider that not all markets are alike. The currency market is broad and deep, with enormous amounts of cash exchanged every day. (Note how much faster the greenback responded to the NFP report last week, than the Fed futures did). So too are the Fixed Income markets, Equity markets, and the Commodity markets, with trillions upon trillions of dollars allocated to these asset classes. Options are some what thinner, depending upon the specific issue -- but still amount to substantial amounts of capital.

Beyond this group, markets get thinner and thinner, with less dollars changing hands, less diversity of thought about the subject matter amongst the traders. This makes these markets less reliable as "Tells" as to the future price action of their subjects. Professor Robin Hanson has noted these (amongst other issues) as elements which make markets less efficient as future discounting mechanisms. For those of you interested in these sorts of things, Chris Masse's site has all the info you could ever want on Prediction markets.

Which brings us to a fascinating article in Monday's WSJ on a subject near and dear to my heart: How Top Watchmakers Intervene in Auctions.

It seems that many of the large watch houses -- Patek Philippe, Rolex, Omega -- were anonymously bidding on their own antique and collectible watches at auctions. For these manufacturers and marketers of expensive timepieces, spending a few $100,000 to a few million on a watch was a minor advertising and marketing expense. It served a larger purpose than the actual ownership of the watches -- it made their current watches for sale seem much more valuable.

Alas, my own modest collection of antique timepieces contain no Pateks -- they never seemed to be good values, relative to the actual watches themselves . . . Now I understand why.    

Sayeth the Journal: "This is a technique of which Patek Philippe and other famous brands, as well, have availed themselves. "It's an entirely different approach to promoting a brand," says the cofounder of Antiquorum, Osvaldo Patrizzi, "Auctions are much stronger than advertising."

Which brings us back to the Fed Fund Futures. As they get closer and closer to Fed meetings, they become more accurate. They have now been adjusting to the prospect that more rate cuts this year may not be as imminent as previously believed: Prior to the the release of yesterday's minutes, the futures were downgrading the odds of another cut by the Fed at the Oct meeting. Two weeks ago, they had put the odds at almost 90%; that slid to  48% on Friday, and down to a 44% chance of a 25 bps cut as of 1:55pm yesterday.

As of the most recent reading: The fed funds futures now expect only a 36% chance of an Oct cut, down from 88% 2 weeks ago (although if they don't go in Oct, they have priced in a 92% chance of Dec cut vs 100% yesterday).

Miller Tabak's Peter Bookvar noted that "for the 1st time since mid Sept, the fed funds futures aren't pricing in a fed funds below 4.5% but implying a 100% chance of one more cut by year's end."


Markets are mostly efficient -- usually correct, but occasionally not. Markets have even set new highs as recessions were beginning: 1990, 1980, 1929; In 2000, the Nasdaq market doubled less than a year prior to the recession beginning.

This all suggests that an ongoing series of Fed cuts is far less likely to occur than has been recently expected . . . 



Behind Rate Cut, a Shift in Concern
Fed Worried Credit Woes Could Fuel Broader Pain; 'Some Inflation Risks'
WSJ, October 10, 2007; Page A3

How Top Watchmakers Intervene in Auctions
Luxury Timepieces Get Pumped Up in Bidding;
WSJ, October 8, 2007; Page A1

Auctions' Role in Watch Prices Raises Ethical Questions
WSJ, October 8, 2007

Wednesday, October 10, 2007 | 07:48 AM | Permalink | Comments (22) | TrackBack (0) add to | digg digg this! | technorati add to technorati | email email this post



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They are two parts of these stories

The derivatives as a support to prices

When looking at the net position of the speculative funds, they have as August resolutely read few fed rates cut (they are long Fed funds and long ten years TB). When looking at the fundamental data as published in September (ISM, factory orders, leading indicators) they are weak enough to sustain their views.

The cash component as a support to the real needs the Balance of payment

When looking at the speed at which foreign investors (latest ones Vietnam, Qatar) are shifting their assets away from the USA, the level of interest of indirect bidders in the TB auctions, the needs arising in many countries to support their banking industries (From Kazaktan to Russia, Central Banks are increasingly supplying additional funds to their banking system through repo’s 10 Billion USD a day)
One may wonder how much flexibility the Fed may have with the Fed funds even though they are not a driving force on the long-term interest rates.

Cronos is more pressing and more demanding.

Posted by: Philippe | Oct 10, 2007 8:53:59 AM

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