To gauge interest rate movements around the FOMC meeting on September 18, it might be useful to look back to the situation in 1998 where the FOMC started cutting rates at itsSeptember meeting from a peak of 5.50%. The following quote from the September 1998 Minutes illustratesthe similarities between the situation back then and now:
Although the domestic economy is weaker than in 1998, the situation currently facing the FOMC has many parallels to the situation back then. In particular, the FOMC also today faces global financial market turmoil and high uncertainty about the impact on economic growth. Hence, we think the interest rate movements around the Fed cuts in late 1998 represent a useful benchmark for movements in USD interest rates in the coming months.
Charts A and B on the front page display the Federal Funds target rate and 2Y and 10Y USD bond yields, respectively, around the Fed cuts in 1998. Interest rates started falling well ahead of Fed's rate cuts. They continued declining after Fed's first rate cut before stabilising at a higher level around the time of the third rate cut. In other words, bond yields were 'over-shooting'.
Another instance of 'over-shooting' occurred in 1995-96 when the Fed also cut the Federal funds target three times before going on hold. Charts C and D display how 2Y and 10Y bond yields evolved duringthis period. Bond yields trended down between the first and third rate cut, before shooting up in the months fol-lowing the third rate cut in January.
In the cases referred to above, when the Fed starts cutting interest rates, markets often anticipate it as the beginning of a longer sequence of rate cuts. This behaviour is merely a reflection of the extrapolative nature of financial markets. However, in cases with only a short sequence of rate cuts, this naturally leads to over-shooting. As market expectations align with actual Fed policy, this overshooting is reversed.
'Overshooting' to reappear
Based on the similarities between the situation now and in 1998, we think the 'overshooting' scenario could be repeated over the coming months. Ifour Fed call of two 25bp rate cuts at the September and the October meetings carries through, bond yields would probably rise as markets currently price in a more dovish Fed path. Consistent with this, our recent Interest Rate Forecast from September 3 implied lower USD rates at the 1M horizon and higher USD rates at the 3M horizon.
The risk to our 'overshooting' scenario for USD rates is that stronger evidence of an impact from the finan-cial crisis to the broader economy starts to emerge. For example, if last Friday's weak Non-Farm Payrollsfigure turns out not to be a temporary dip, then bond yields might well extendthe recent downward trend. However, we expect the US labour market to recover from this very weak reading, see 'US: Weak job mar-ket in August' and the 'overshooting' scenario remains our central expectation.
The first two columns in the table below shows average spreads between 10Y/2Y bond yields and the Fed-eral Funds target rate in a five-day window leading up to the first Fed cuts in 1995 and 1998. The last col-umn displays current market levels for these spreads. Using these time windows prior to the first Fed cuts in 1995 and 1998 as benchmarks, it appears that current spreads appear low. In other words, bond yields appear low relative to the 1995 and 1998 benchmarks. The bottom line is that bond yields might be over-shooting at present.
Note: The first two columns of the table report average spreads in percentage points. The last columnreports current spreads using the following bond yields. 10Y: 4.3372Y: 3.878by Danske Bank