BondSquawk

By Rom Badilla, CFA – Bondsquawk.com

June 23, 2010

Later today, the Federal Reserve will announce its decision on monetary policy after the conclusion of its FOMC meeting. The announcement should be a snoozer as the Federal Funds rate is expected to remain unchanged at 0.25 percent. What may be interest is if the Fed changes its language significantly from their last meeting as signs of a weakening economy have emerged recently. The European debt crisis continues to linger as well as high unemployment for the U.S. economy. Private sector non farm payrolls disappointed earlier this month and weekly initial jobless claims hover near levels that is conducive to job destruction and more layoffs. Add weak retail sales and private sector spending appears to be slowing

I am interested to see if Kansas City Fed President, Thomas Hoenig dissents again. Hoenig has been hawkish in rates since earlier this year, calling for a rise in short term interest rates to temper inflation expectations. Hoenig withdrawing his call for higher rates would fuel the disinflation/deflation fires even further and Treasury bonds would rally significantly. While I expect for him maintain his last position and to dissent again, I would not be surprised if he changes stance due to signs of easing inflation expectations.

Last week, the Philladelphia Fed Business Outlook Survey Index declined to a reading of 8 from a prior reading of 21.4 which disappointed surveys of 20.0. When looking beyond the headline Philly Fed numbers, the prices paid component dropped significantly from a May reading of 35.5 to 10. Comparatively, the last monthly drop of greater than 20 occurred in November 2008 as the prices paid component declined from 8.6 to -20.4. In the month prior to that, the component dropped 21 points from 29.5 in September 2008.

If we chart the prices paid component to the Treasury breakeven rate which is the yield differential between the fixed coupon 10-Year Treasury and 10-Year Treasury Inflation Protected Securities (aka TIPS) and is a gauge for market inflation expectations, we can see a correlation between the two. The two exhibits a 0.79 correlation where a reading of 1.0 suggests a direct step for step relationship and -1.0 indicates an inverse relationship. A reading of zero suggests no relationship at all. A decline in the prices paid component reading suggests falling inflation expectations and even lower bond yields.

Philly Fed Prices Paid and Inflation Expectations

As you can see, the prices paid component has diverged from recent inflation expectations. A linear regression between the two with prices paid as the independent variable (not shown), suggests that the breakeven rate/inflation expectations should be lower. The breakeven rate closed yesterday around 2.0 percent and if assume the relationship to hold between the two variables, the breakeven rate should decline another 20 to 30 basis points. Given that the 10-Year is currently at 3.10-3.15 and we assume all else is still equal, this points to a 10-Year Treasury yield of of sub-three percent, reaching or even surpassing recent lows.

To sum up, the FOMC meeting should be a non-event in terms of action. Focus should be on the language. Furthermore, a telling sign on the prospects for the economy and the bond market could fall on the shoulders of the lone dissenter who has been calling for higher rates. A change in his position could signal major concerns by the Fed of declining economic growth and subsequent downward pressures on prices.