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Fed May Lower Rates Three Times on Housing Woes, Options Show

By Daniel Kruger

March 19 (Bloomberg) -- Options traders are starting to say the Federal Reserve may cut interest rates three times this year as the housing slump threatens the economy''s growth.

Options on Federal Fund futures at the Chicago Board of Trade show a 24 percent likelihood the central bank will lower its target rate for overnight loans to 4.5 percent from the current 5.25 percent. Just seven weeks ago, options prices suggested no chance of that large a reduction this year.

Traders in options anticipate lower borrowing costs than economists or futures contracts, the most widely used barometer of Fed policy, amid increasing concerns about mortgage defaults. Futures show rates will fall to 4.75 percent by year-end and economists expect 5 percent, according to the median in a Bloomberg survey 73 forecasters from March 1 to March 7.

``The fear is it spills into the economy, it spills into the banking system and creates a credit crisis,'''' said David Robin, an interest-rate strategist in New York who helps manage options trading for institutional clients at Fimat USA LLC, a unit of Societe Generale Group.

Options, among the cheapest way to bet on rates, may provide a more accurate picture than futures, according to a 2005 study the Federal Reserve Bank of Cleveland.

The Chicago Board of Trade first listed options on the fed funds futures contract in 2003 and began offering contracts in July that allow bets on the Fed''s target rate for loans between banks. The so-called binary options pay $1,000 if an investor bets correctly on the Fed''s interest-rate decision at regularly scheduled meetings. Investors get nothing if they bet incorrectly.

`The Only Place''

``The only place professionals look at is the options,'''' said Stan Jonas, managing director at Dutchbook LLC, a New York- based hedge fund. ``There are three things that can happen. It goes up, and down, and stays the same. When you look at the futures contract, you assume that one of the three can''t happen.''''

All the economists surveyed by Bloomberg are forecasting that the Fed will hold interest rates at 5.25 percent when policy makers gather March 21. The central bank has kept the target rate unchanged for five consecutive meetings since August after 17 straight increases starting in June 2004.

Investors see a higher likelihood the Fed will cut rates later this year, based on falling yields for Treasuries, the haven in times of market turmoil.

Yields on benchmark 10-year Treasury notes dropped 4 basis points, or 0.04 percentage point, last week to 4.55 percent, according to Cantor Fitzgerald LP.

Pendulum Swings

Former Federal Reserve Chairman Alan Greenspan roiled markets last month by predicting a one-in-three chance of a U.S. recession this year and said on March 15 that he expects the fallout from subprime-mortgage defaults to spread to other parts of the economy, especially if home prices decline.

``In the past three weeks we''ve seen a complete swing in the pendulum'''' in Fed expectations, said William O''Donnell, U.S. government bond strategist at UBS Securities LLC in Stamford, Connecticut, one of 21 primary dealers that trade directly with the central bank. ``They may have to cut rates soon.''''

Fed Chairman Ben S. Bernanke, may not have enough leeway to remove the central bank''s bias for tightening rates at the March 21 policy meeting after a report on March 16 showed consumer prices rose 0.4 percent in February, said Jan Hatzius, chief U.S. economist in New York at Goldman Sachs Group Inc.

``The market is treating the Fed''s stance as something that will change'''' later in the year, said Hatzius, who expects the central bank to lower its target rate to 4.5 percent by year- end.

The Fed''s target rate exceeds the yield on two-year notes, which are more sensitive to central bank policy than longer- maturity debt, by 66 basis points. The gap is near the widest in almost six years. Yields on two-year notes dropped 8 basis points to 4.59 last week.

Cleveland Fed Study

The dollar fell to the lowest level this year against the euro and dropped against the yen last week as concern increased a slowing U.S. economy is reducing the appeal of U.S. assets.

Another study by the Cleveland Fed in 2001 said that moves in futures tend to be exaggerated and don''t accurately reflect traders'' expectations for shifts in central bank policy.

``Contrary to popular belief, federal funds futures do not tell us precisely where the market thinks fed funds rates will be in the future,'''' wrote Ed Nosal, an economist at the Cleveland Fed. Nosal declined to comment.

July futures contracts suggested on Feb. 27 that there was a 70 percent chance the Fed would cut rates to 5 percent in June, up from 20 percent the prior day. Treasuries posted the biggest gains since December 2004 on Feb 27, as a plunge in Chinese shares set off concern investors will shy away from riskier assets.

Less Volatile

Some of the price swings in options have been less volatile. Options on the same futures contract showed the probability of a 5 percent Fed target rate rose to 32 percent on Feb. 27 from 16 percent the day before. The chance of a 4.75 percent rate rose to 18 percent from 5 percent. The likelihood that the Fed would hold at 5.25 percent fell to 46 percent from 72 percent, and odds that rates would increase to 5.5 percent fell from 7 percent to 3 percent.

Options ``really catch the mood of the market,'''' said Eric Liverance, a strategist with UBS in Stamford. They offer information ``you wouldn''t see in the futures at all.''''

To contact the reporter on this story: Daniel Kruger in New York at

Last Updated: March 18, 2007 11:00 EDT