Market Outlook - BNP PARIBAS - Investment Services India

This section is classified as non-objective researchUS: Unemployment Targeting – What ItMeans for Rates• Fed officials started hinting that goingforward the policy outlook may be linked to theunemployment rate (UER), possibly inconjunction with an inflation target, as a prerequisitefor monetary tightening.• Given the anaemic pace of improvement inthe jobs market, if the FOMC did indeedannounce, say, 7% UER as its target, then itcould take anywhere from 2.5 to 5 years to getthere. With the Fed on hold for that long,Treasuries in the front end would rallymassively.• STRATEGY: If/as UER targeting becomesmore likely, position for the new policy with thefollowing trades: i) outright longs in the frontend up to 5yrs; ii) sell the fly (buy the belly) inTreasury 2s5s10s; iii) put on a 5s30s steepener.What’s all the hoopla about setting targets?The growing chatter from Fed officials about forwardguidance, in the form of unemployment and/orinflation targeting, begs the following questions. If theunemployment rate (UER) does, indeed, have toreach say 7% (the level identified by the Fed'sEvans) as a necessary condition for the Fed totighten monetary policy, what does it mean forTreasury rates? And what does it mean,not when itreaches that level but rather if/when the FOMCannounces its decision to move ahead with this newapproach, possibly as early as at the NovemberFOMC meeting?This may be obvious, but we will state it nonetheless:Treasuries in the front end would rally and do so in abig way. Why? Because at the current anaemic paceof declines we saw since UER reached its peak, itwould take about 3-3.5 years for it to drop to 7%. Ifwe use other periods (see Chart 1), the pace ofimprovement is different, but even in the mostoptimistic scenario similar to the 1992-94 period, itwill likely take close to 2.5 years to get there (seeTable 1). Recall that the Fed pointed out at theirAugust meeting that they envision an environmentthat warrants "exceptionally low levels for the federalfunds rate at least through mid-2013". Now comparethat with the explicit UER target: No matter whichepisode we use from the past for comparison, wecould safely say that it will be well past mid-2013Chart 1: The Employment Story – Always aSlow Turning Ship12108642090 92 94 96 98 00 02 04 06 08 10Table 1: How Many Months Would It Take toBring UER down by 2%?1992-1994 1996-2000 2003-207 2009 to dateNo ofmonths 28 60 49 3812108642Chart 2: UER and Inflation – Not EntirelyDivorced from Each OtherCore Inflation YoY (%, RHS, Inverted)096 98 00 02 04 06 08 10ource: Bloomberg, BNP ParibasUnemployment Rate (%)before the UER dips to the 7% area. So, whateverthe market fancied as the horizon for rate hikes in thewake of the August FOMC statement, that's going topale in comparison with the re-pricing that UERtargeting will cause.How much would rates rally?Let us get a bit more specific. Tsy rates in the 2-5yarea should drop precipitously in response, with thecurve flattening in this sector. If you were comfortable0123456Bulent Baygun 20 October 2011Market Mover20www.GlobalMarkets.bnpparibas.com