Today’s Trading Lesson From TradingMarkets
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Each night we feature a different lesson from
TM University. I hope you enjoy and profit from these.
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Brice
Forecasting The
Fed With Fed Funds Futures
By Loren Fleckenstein
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No single
institution has greater more sway over U.S. financial markets
than the Federal Reserve. And the Fed’s most powerful weapon is the federal
funds interest rate.
The fed funds rate sets the
interest charged by banks for overnight loans to other banks in need of more
cash to meet reserve requirements. The rate is decided by the Federal Open
Market Committee, which decides monetary policy of the nation’s central
bank.
By raising the rate, the FOMC
restrains bank lending downstream to businesses and consumers. This
translates into less cash to chase securities as well as stimulate the
economy. By lowering the rate, the committee makes credit cheaper. That
boosts lending activity, funneling more money into the markets and the
economy.
Obviously, it behooves us as
traders to stay alert to the likely future direction of this pivotal
interest rate. Fortunately, we have a handy, historically accurate tool for
predicting changes in the rate — the Federal Funds
Futures contract.
With a bit of arithmetic, you can
determine from the contract where the market thinks the fed funds rate is
headed. Even better, you can figure out a
probability of that forecast. For instance, on a given trading
day, the contract price might imply, say, a 75% chance of a quarter-point
increase in the fed funds rate to 6.75%.
The Chicago Board of Trade
established the fed funds market in 1988 as means for “commercials” —
banks, other companies and repo traders — to hedge against movements in the
federal funds interest rate.
The hedgers dwarf the speculators. According to the Commodities Futures
Trading Commission, commercials accounted for 32,000 of the 46,000 contracts
comprising the open interest in all fed funds futures contracts as of May
30, 2000. The remaining 14,000 contracts were held by non-commercials —
mostly locals and small speculators.
The contract trades from 8:30 a.m.
ET to 3 p.m. ET on the CBOT. It also trades overnight on the Globex
electronic network. But trading on the Globex is very light compared to
volume on the CBOT. That makes Globex pricing too volatile for use in
interest-rate forecasting.
Chicago’s fed funds pit has proven
a trustworthy oracle.
Take the seven FOMC meetings from
June 1999 through May 2000. Over this period, the committee raised the fed
funds rate from 4.75% to 6.5%. In five meetings, the FOMC raised the rate by
quarter-point increments. In another meeting, the committee left the rate
unchanged. In one meeting, the committee raised the rate a half point.
In six meetings, the fed funds
contract price implied the correct outcome, with an implied confidence level
of 70% or higher in the forecast, a week ahead of the FOMC’s decision. The
implied probability rose as the meeting day neared.
The only Fed decision that gave
the Chicago handicappers some trouble came on Nov. 16, 1999, when the FOMC
raised the fed funds target by 25 basis points. A week earlier, the November
futures contract put the odds of a quarter-point hike at a rather hesitant
55%. The clouds cleared over the pit a few days later. By Nov. 15, the
probability implied in the November contract had climbed to 80%.
This level of forecast accuracy
isn’t surprising. Under Fed Chairman Alan Greenspan, the nation’s money
chiefs have tried to prepare the financial markets in advance of
interest-rate decisions. As decision times draw near, they tend to drop
broad hints telegraphing their intentions, particularly when rate increases
are at hand.
When we talk about the fed funds
rate set by the Fed, we’re really talking about a target rate. The actual
rates on interbank loans oscillate around the target from day to day but
average out to match bogey over time. Each monthly fed funds contract
amounts to a bet on the average effective fed funds rate for that month, as
reported by the Federal Reserve Bank of New York.
You can find end-of-day closing
futures prices at the CBOT Web site. For the fed funds contract, go to
www.cbot.com/mplex/quotes, go
to “Futures Settlement Prices,” then select “Financials.”
TradingMarkets.com members can
pull up charts as well as quotes on the fed funds futures as well as any
other futures contract. Go to the Futures section of the Web site. Click on
the Futures tab near the top of the
page. Then hit the Launch Futures Charts
button. That will bring up your quote and chart display. Just enter the
ticker symbol for the contract that interests you.
Ticker symbols for futures
typically consist of a letter pair designating the market (wheat, crude oil,
bonds, etc.) followed by a letter designating the contract month and a
number designating the year. Market designation for the fed fund futures
contract is FF, followed by the letter and number designating the month of
the contract that interests you. Here are the month symbols for the CBOT-traded
contract: January F; February G; March H; April J; May K; June M; July N;
August Q; September U; October V; November X; December Z. The year symbol is
simply the last digit of the year. For instance, the year 2000 would be 0.
For example, the ticker for the
August 2000 fed funds futures contract would be FFQ0. The ticker for the
January 2001 contract would be FFQ1.
The price for fed funds futures is
based on settlement at 100 minus the effective average fed funds rate. So
futures prices move inversely with changes in the expected fed funds
interest rate in the settlement month.
Now, let’s run through an example
of how to use the contract to forecast the probability of a rate change by
the Federal Open Market Committee. I’ll use closing prices throughout this
lesson.
Implied Rate
Let’s say today’s date is June 13,
2000. The federal funds target rate stands at 6.50%.You want to know the
probability that the FOMC will raise the rate by 25 basis points at its June
28 meeting.
The Fed will not meet again until
Aug. 22. This makes the July contract perfect for forecasting the June 28
meeting as there is no scheduled meeting in July to affect our calculations.
Your first step, then, is to
figure out the average effective fed funds interest rate for the month of
July as implied in the July contract price. The July futures closed at
93.420 on that day. Subtract the contract price from 100 to obtain the
implied rate, which in this case comes to 6.58%.
Probability
Just by eyeballing the implied
rate of 6.58%, we can tell that the market on June 13 expected the FOMC to
leave the target rate unchanged at 6.50% at the June 22 meeting. Otherwise,
the July contract would have priced in an implied rate much closer to 6.75%,
the target rate if the Fed were to tighten by its usual increment of 25
basis points per meeting.
With one more calculation, you can
assign a percentage probability to the likelihood of a rate hike. The
implied rate of 6.58% is eight basis points above the current target. In
other words, the market has only priced in eight points of a 25 basis point
hike. To obtain a probability, just divide the tightening priced into the
contract by the possible rate hike.
So divide eight by 25. The
resulting quotient of 0.32 indicates a 32% probability that the FOMC will
raise the fed funds target by 25 basis, or a 68% probability that the
committee will stand pat.
Weighted
Average
Unfortunately, not all rate
decisions meetings come at the end of the month with no FOMC meetings set
for the following month. If you lack a “clean” month after the expected rate
decision, you’ll need to use the contract for same month in which the
decision occurs.
As a result, you must use a
weighted average that blends the old rate with the new rate that you are
forecasting. The FOMC meeting on May 16, 2000 is a good example. The meeting
fell square in the middle of the month, and the committee convened again in
June, ruling out the June contract for forecasting the May 16 rate decision.
Performing a May forecast will
help us deal with another scenario. On May 16, as we know now, the Fed
departed from its usual approach of raising rates by quarter-point moves and
jumped the fed funds target by a half point.
Let’s assume today’s date is April
28. On that day, the May fed funds futures contract closed at 93.790, giving
you an implied interest rate of 6.21%.
At the time, the target rate stood at 6.00%.
So you saw that the market had
priced in an increase of 21 basis points.
Write down that number. We’ll come back to it near the end of this exercise.
Now the question is, how many
basis points needed to be priced in to forecast an increase of 50 basis
points?
May has 31 days. Assume that the
6.00% target prevailed every day of the month up to and including the day of
the FOMC meeting. We include the meeting day because the bulk of the
contract trades occur early in the day before the rate decision is
announced.
So you will compute a weighted
average that assigns the first 16 days of the month to the old rate of 6.00%
and the remaining 15 days to the new rate of 6.50%.
Divide the number of days in the
first part of the month by total days in the month. Then multiply the
quotient by the old rate.
(16/31) * 6 = 3.097
Next divide the number of
remaining days in the month by total days in the month. Then multiply the
quotient by the forecast rate.
(15/31) * 6.5 = 3.145
Now add the two products together
to obtain an implied average effective rate of
6.24% for the month of May.
This weighted average implied rate
represents the implied rate of the May contract if the market fully priced
in a target rate increase of 50 basis points. In other words, the contract
must price in 24 basis points above the target rate to yield a 100%
probability of a half-point rate increase on May 16.
Last Step
As we determined earlier, the May
contract closed at 93.790 on April 28, yielding an implied rate of 6.21%, or
21 basis points above the target rate of 6.00%.
There’s 24 basis points required
to price in a half-point increase. The contract has actually priced in 21
basis points. Twenty-one divided by 24 equals 0.875, or 87.5%. As of April
28, your calculation shows that the fed fund futures market discounted an
87.5% probability that the FOMC would raise the fed funds target by 50 basis
points on May 16. As we know, the FOMC later proved the market right.
A Final Word
This technique works best when
forecasting forthcoming rate decisions, not decisions several months or more
into the future. Obviously, the further you project into the future, the
more unforeseen developments can intervene and disappoint your forecast.
Another problem stems from trading
volume in the fed funds futures contract. Open interest drops off sharply
for contracts expiring in months further out. You need substantial trading
volume before trying to draw conclusions from any security’s price. So these
contracts tell you little about the market’s built-in assumptions on
interest rates.
In a future lesson, I will show
you a way to use the market for Eurodollars,
U.S. dollars held in banks outside the United States, to get a fix on
how the financial markets are handicapping the fed funds rate in the more
distant future.