What do Fed Funds Futures Tell Us? Are they a Short?
Do Fed Funds futures really tell us what the Fed will do?
The answer to that question is a resounding “no”! Fed Funds futures
contracts are simply trading vehicles in which hedgers, but mostly
speculators, buy and sell according to their market outlook. Although it
can be argued that the Fed has been looking to the financial markets
for policy guidance, in the end, they are the decision makers. Fed Fund
futures market participants are merely making educated guesses as to
what the Fed might do. Accordingly, the current value of the Fed Funds
futures contracts reflects market participants’ expectation of future
overnight lending rates, it does not reflect the actual probabilities of
changes in monetary policy based on the opinions of Federal Open Market
Committee (FOMC) members (AKA the decision makers). While most traders
of Fed Funds futures are highly sophisticated, it is important to
recognize they can be, and often are, wrong.
Specifically, the Fed Funds futures are derivative contracts written
with the FOMC’s target overnight bank lending rate as the underlying
“asset” (I use that term loosely in this instance). Accordingly,
contract expiration months are based on scheduled Fed Meetings, as
opposed to the typical quarterly expiration in financial futures. Not
unlike any other futures contract, Fed Funds futures contracts can be
bought or sold in any order as a speculative tool to bet on, or hedge,
expectations of changes in the Federal Reserve’s target interest rate.
In a bare bones example, if you think the FOMC will be increasing
interest rates you would sell the Fed Funds futures; if you believed the
Fed will lower rates you would be a buyer. This might sound
counterintuitive, but in reality, the price of an interest rate product
moves inversely to rates. Thus, if interest rates rise, then bonds,
notes, and even Fed Funds futures contracts fall; and vice, verse. The
CME Group provides a highly valuable resource to traders that are
interested in dissecting the Fed Funds futures markets known as
“FedWatch”. By navigating to the CMEGroup.com website and searching for
FedWatch, you should reveal a wealth of knowledge including the prices
of several Fed Funds futures contracts with various expiration months;
but more importantly what they mean in regards to probability of a rate
hike, in the collective opinion of traders, at a particular point in the
future.
Despite the fact that the FOMC has only raised interest rates once since
2008, the Fed Funds futures rates fluctuate on a daily basis based on
expectations of the next move. In my opinion, there appears to be a
low-risk opportunity in getting bearish Fed Funds futures with
expiration dates extending into late 2016 to early 2017. Keep in mind,
the more distant the expiration, the higher the volatility will be.
Nevertheless, these contracts move relatively slow and are margined low
at less than $1,000. Looking at the December 2016 Fed Funds futures
contract currently trading at 99.485, the market is pricing in an
overnight lending rate of about 0.515%. (100 – 99.485). The current
target rate is between .25% and .50%, so the market is essentially
predicting a single quarter-point rate hike by December and partially
pricing in one more. According to the CME, the probability of any rate
hike all by December is about 61%. It wasn’t that long ago that Fed
Funds futures and most market analysts were calling for four rate hikes
in 2016. Accordingly, we believe there is plenty of room for the market
to change its mind (pricing in more rate hikes). If not, the upside in
the Fed Funds futures contract is probably limited because for the
contract to move higher, the market would have to price in no rate cuts
at all in 2016; and for things to get really hairy for the trade,
negative interest rates would need to be a possibility - that seems
highly unlikely.
To reiterate, the Fed Funds futures simply tell us what the market
believes the overnight bank lending rate will be at a particular time in
the future. However, between now and expiration it is quite possible to
see dramatic changes to outlook. In other words, it is a snapshot of
today’s thoughts but two weeks from now we might see completely
different expectations blooming from the Fed Funds futures market.
Ultimately, nobody can predict the Fed. Not even Fed members know what
the committee will be thinking or doing several months from now.
*There is substantial risk of loss in trading commodity futures,
options, ETFs. Seasonal tendencies are already priced into market
values.
