"Fed watching" has mesmerized the bond markets for the past several weeks, taking control and dictating every move by dealers. Last week was no exception and, as one government dealer exclaimed, "It was the most confusing week I ever spent."
"Fed watching" can mean several things. For one, it means tracking the monetary aggregates -- the various money supply figures like MIA and MIB -- that the Fed releases each week. Watching them is important because the monetarists theorize that there should be just enough money in our system so that we can buy at current prices all the goods and services the economy is able to produce. The theory goes that if there is too much money, we have inflation. If there is not enough money -- a depression.
The regulation of the money supply is the domain of the Federal Reserve Bank. Simply put, the Fed supplies reserves to the banking system, mainly by purchasing securities from government bond dealers. The Fed drains reserves from the banking system, mainly by selling securities to government dealers.
Commercial banks need these reserves to create or expand credit.
Since banks need reserves -- which are provided by the Fed -- to create credit, it is most important to follow the amount of resrves in the banking system.
If the Fed should ease credit, they supply reserves and the funds rate moves lower. Conversely, if the Fed tightens, they drain reserves and the funds rate moves up. And that is what has been so confusing to the market in the last two weeks, for the Fed did both -- added and drained. Bond dealers were at a loss to sell or to hold bonds. If the Fed eases, rates go lower as prices rise. But if the Fed tightens, rates rise as prices decline. So you can see how "Fed watching" left the markets and dealers in complete dissaray.
Over the past six weeks, the yield on Treasury year bills has risen by 106 basis points while yield on the 10-year and 30-year Treasury bonds rose 73 and 78 basis points respectively; (a basis point is one-hundredth of a percentage point). This is a large correction and comes in in teeth of a large corporate, which will be marketed over the next 30 days. The increase in rates will probably continue over the next month.
It looks as if we are settling into a trading range or both short- and long-term securities. This would mean, for example, that 30-year Treasuries should be purchased at 10.50 percent and sold at 10.0 percent."
With all the uncertainties and with the heavy supply of issues, a good stragegy would be to keep your funds liquied and pick quality issues to purchase on continued weakness. Avoid bonds longer than 10 years. And if you feel so inclined become a "Fed watcher," too.