What Do Falling Fed Funds Futures Tell Us?

 | Mar 02, 2017 | 2:00 PM EST
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(This commentary originally appeared on Real Money Pro at 12:05 p.m. ET today. Click here to learn about this dynamic market information service for active traders.)

Not that long ago, market analysts and commentators spent most of their time combing over comments made by Federal Reserve members in hopes of gaining an edge in regard to the next change in monetary policy.

Ironically, the joke was on us.

Nearly a decade of talking, writing and fawning over the Fed resulted in a mere two interest rate hikes, and at the precise moment the Fed appears to be poised to begin taking meaningful action, market participants simply don't care anymore. There are bigger and better stories to focus on. After all, changes in fiscal policy are expected to trump (pun intended) any anchor a few quarter-point rate hikes might be on economic growth. Nevertheless, rate hikes are around the corner and we shouldn't completely ignore their implications.

What Is the Fed Funds Rate?

Before we can talk about the fed funds rate, and the futures contracts written against them, let's define exactly what we are talking about. The federal funds rate is the interest rate at which depository institutions such as banks and credit unions lend reserve balances to other depository institutions overnight. This is also known as the overnight rate. Through monetary policy by the Federal Reserve, this rate is manipulated to hover at a targeted rate of interest.

What Are Fed Funds Rate Futures?

Fed fund futures contracts, on the other hand, are contracts using the fed funds interest rate as the underlying instrument. The contract is priced similarly to a discount bond in that the implied interest rate can be derived by shifting the decimal two places to the left, then subtracting the current price from 100. For instance, if the fed funds futures contract is trading at 99.25, the corresponding fed funds rate is 0.75% (100-0.9925). Also, the price of the fed funds futures contract trades inversely to interest rates; as the fed funds rate increases, the fed funds futures contract declines and vice versa.

Speculators buy and sell these futures contracts in hopes of profiting from accurate predictions in price changes. The price of the fed fund futures contracts reacts to these trades in real time. Thus, if most market participants believe the Fed will increase interest rates, they sell fed funds futures contracts to reflect that view.

Ironically, analysts and commentators spend a substantial amount of time discussing the probability of an interest rate hike based on action in the fed funds futures; yet those probabilities are nothing more than the accumulation of market participant opinions. In many cases, those market participants are highly sophisticated, but in many other cases, they are not. In other words, we are fooling ourselves if we believe the fed funds futures contracts are offering us some sort of insight into the future. Instead, it is a highly active form of market polling, but fed funds futures traders and, therefore, markets can be wrong. In fact, not unlike any other speculative market, prices often overshoot the sustainable reality only to quickly revert back to a more logical price point.

Fed Funds Futures Contracts

What Are Fed Funds Futures Markets Telling Us?

Fed chatter early this week has triggered a sharp slide in the fed funds futures market. The move has changed the perceived odds of a March rate hike dramatically. As we've discussed, market expectations of a rate hike don't necessarily translate into reality, but at this time the market believes the probability of a March rate hike is nearing 75% versus Tuesday's odds of 35%. In short, in the eyes of fed funds traders, the odds have more than doubled! Given the dramatic change in animal spirits in the economy and the equity markets, the Fed would be foolish to bypass this opportunity to take a step toward normalizing interest rates in March while the focus is on something else. Thus, it is likely to be on the same page as the market going into the March meeting. However, the Fed's path becomes murky as the year wears on.

The December 2017 fed funds futures contract is pricing in a roughly 30% chance of two rate hikes by the December meeting, a 30% chance of three rate hikes in the same timeframe and a 15% chance of four rate hikes. In other words, the market has already priced in a 75% chance of two hikes or more. If you are an investor attempting to structure your portfolio around future moves by the Fed, it is important to realize that the financial markets have already priced in two rate hikes and have partially priced in four. Thus, most of the implications of such changes in monetary policy are already accounted for.

Likewise, if you are willing to speculate directly on the Fed's actions by trading in the fed funds futures market, you've probably missed the "easy" money on the short side of the market. We wouldn't want to be a buyer of this market going into what is almost certainly going to be a multiyear rate hike campaign, but it probably won't pay much to be short either. Unless you believe the Fed will raise rates four times before December, which is only partially priced in, a short position from current levels makes little sense. Even if the Fed does raise rates four times, the path between here and there will be a rocky ride for those short the fed funds futures. We tend to like the idea of waiting for a bounce into the 98.90-ish area to turn bearish again. Knowing how fed funds futures tend to have emotional swings, such prices are relatively likely to be seen again.

Conclusion

Despite the intently hawkish rhetoric coming from Fed members, they've proven to be extremely slow when it comes to pulling the trigger. Keep in mind that the fed funds futures markets are simply a gauge of what traders believe the Fed will do, not a sure-fire predictor at what will actually unfold. Our guess is that the Fed will take the March meeting as an opportunity to bump the overnight rate higher, but what happens between now and December is far from settled. We suspect the market will retract some of its ambitious expectations as traders are forced to cope with political fights such as the debt ceiling, tax policy details and other budget battles.

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