Today’sTrading Lesson From TradingMarkets
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Brice
Forecasting Rates
Months Into The Future Using Eurodollars
By Loren Fleckenstein
In an earlier lesson, I described
how to use the federal funds futures contract to forecast changes in the
federal funds interest rate, the most powerful weapon in the Federal
Reserve’s monetary arsenal. The contract works well for assessing market
expectations for near-term changes in this key interest rate. But for
handicapping rates months into the future, professionals look to eurodollar
futures.
If you haven’t done so already,
check out my lesson
Forecasting The Fed With Fed Funds Futures. In summary, the fed funds
rate set by the Federal Open Market Committee determines the overnight
lending rate that banks charge each other for loans of excess reserves.
Lowering the rate stimulates bank lending and, thus, economic activity —
raising the rate accomplishes the opposite.
When trying to get a handle on the
probable rate-setting outcome of an upcoming FOMC, one uses the fed funds
futures contract. However, open interest and volume in the fed funds
contracts fall to meager levels for contracts expiring in the months further
out. This makes pricing too volatile to render statistically reliable
forecast data.
Eurodollar contracts, however,
have ample open interest. In fact, eurodollar futures are the most actively
traded contracts in the world. At the time I’m writing this lesson, there
are 3.3 million eurodollar contracts outstanding vs. 45,400 fed funds
contracts. Thanks to this enormous liquidity, we can trust that the daily
settlement prices in eurodollar contracts accurately reflect the market’s
assumptions about the future level of the fed funds rate.
Eurodollars are U.S. currency held in non-U.S. banks, European or
otherwise. For example, U.S. dollars deposited in a Hong Kong bank are
eurodollars. Thanks to the dollar’s status as the world reserve currency,
eurodollars are commonly used to settle international transactions.
When you want to forecast the
likely fed funds rate that will prevail after the next FOMC meeting, you
calculate the implied yield of the fed
funds futures contract for that or the following month (depending on factors
detailed in my previous lesson). When you want to forecast the fed funds
rate for some time many months in the future, you look at an
adjusted implied yield of the eurodollar
contract for that point in time.
There’s a fed funds contract for
every month in the year. In other words, the September fed funds contract
represents the market’s best guess at the prevailing fed funds rate for that
month. Eurodollar contracts span quarters, except for near-term months,
which also have open contracts. So the adjusted implied yield of the
December eurodollar contract would represent the market’s consensus forecast
for the fed funds rate in the month that the contract expires.Â
The ticker symbol for the
eurodollar contract is ED, followed by the letter designating the expiration
month of the contract and the number designating the contract year. March is
represented by the letter H, June by M, September by U and December by Z.
The year symbol is simply the last digit of the year. For instance, the year
2001 would be 1. So the March 2001 contract would have the ticker EDH1.
Adjusting The
Implied Yield
Okay, I’ve said that we must
adjust the implied yield of the eurodollar contract in order to divine the
market’s fed funds rate consensus for the contract quarter. What are we
adjusting for? Loans of foreign-deposited dollars carry a higher interest
rate than loans of dollars deposited in U.S. banks. We need to factor out
this premium to get at the implied yield
reflecting the fed funds rate assumption priced into the contract.Â
To do so, we turn to the London
Interbank Offered Rate, better known as LIBOR. The LIBOR represents the rate
that creditworthy international banks charge each other for loans of
eurodollars. The spread between the three-month LIBOR and fed funds rate
represents the premium that we want to subtract from the implied yield of
the eurodollar contract.
Let’s say that the LIBOR stands at
6.66%, a spread of 16 basis points above the fed funds rate of 6.50% at the
time I’m writing this lesson. We’re interested the market’s assessment of
where the fed funds interest rate will stand in the quarter ending March
2001. Assume that the March 2001 eurodollar contract settled at 93.33. That
gives an implied yield of 6.67% (100 – 93.33). Now subtract the LIBOR-fed
funds spread of 16 basis points. This adjusts the implied yield to 6.51%. So
the market is pricing in only one basis point of tightening. In other words,
the market assumes a very high probability that the Federal Reserve will not
raise rates between now and March 2001.
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.