MBS Live Day Ahead: Today's Fed Announcement is More Complicated Than Normal

In the day just passed, the bond market managed to add a 2nd day to a friendly correction--a small counterattack against the much larger corrective sell-off that dominated last week's trading (and yes... that weakness was, itself, a counterattack against a MUCH larger downtrend in rates throughout 2019).  There were no meaningful reactions to economic data and traders were largely preoccupied with making sense of yesterday's repo market drama.  The best recap of the issue I've seen is this Reuters story.  

In the day ahead, all eyes are on the afternoon's Fed announcement.  It's multifaceted to say the least.  In just the past few days, Fed Funds Futures suggest the rate cut probability has dropped dramatically--from over a 90% chance last week to a 62% chance today.  But Fed Funds Futures are severely undershooting the actual probability, as I've been warning about all week.  Here is a snippet from our friends at BMO Capital Markets that puts it even more plainly:

The market-implied odds of a cut are as close to 100% as money markets can get. What we’re puzzled by is some public probability tracking indicating that market-implied odds are so far disjointed from this reality, with some closely watched tools showing as low as 54% this morning. We’re puzzled what methodology is being used to get these figures, as the October ’19 fed funds futures contract is trading at 1.89%, i.e., precisely 25 bp below Friday’s fed funds print. If this were off by a bp or two, this would be reflecting the uncertainty of where EFFR will trade in the target range after the funding squeeze, rather than lack of confidence that Powell is going to ease.

In other words, Fed Fund Futures are bets on where the EFFECTIVE Fed Funds Rate (as opposed to the TARGET rate, which is what they set at their meetings) will be at the end of any given month.  And the effective rate got a bit jacked up over the past 2 days due to the repo market snafu linked above.  Said another way, futures were reflecting the uncertain impacts of overnight funding markets on the effective rate and were NOT reflecting an adjustment in the Fed's rate cut probabilities.  

Simply put, the rate cut has been and continues to be a done deal as far as markets are concerned.  And the complexity surrounding today's Fed events has to do with forward guidance and the rate cut outlook.  We can also expect Powell to answer several questions regarding yesterday's funding market drama.  Recall that he already sort of did that in several recent press conferences by saying the declining reserve balance held at the Fed by banks was a key factor in the decision to stop balance sheet normalization and the possible reintroduction of QE in the future.  Bottom line: don't be surprised if another round of QE becomes a hot topic today.

The announcement and economic projections are at 2pm ET and Powell's press conference begins at 2:30pm ET with prepared remarks.