The Fed meets this week and will deliver its monetary policy decision on Wednesday. Most investors, including myself, do not expect a rate hike for a variety of reasons. Sub-target inflation, lackluster wage growth, easing by foreign central banks, and global deflationary trends top the list.
Recently the market’s expectations for interest rate hikes have been more accurate than listening to the Federal Reserve members’ projections and speeches. On latter, it’s become an annoyance to hear these members so frequently espousing their individual views, injecting uncertainty into the market with a syringe. Why do they feel compelled to do this? Color me confused.
Anyway, markets and their unique ability for price discovery can help us figure out how major market participants are collectively viewing the likelihood of a rate hike, both now and in future months. In fact, we could go so far as to create our own market based “dot plot” to assess market expectations for not just the initial hike, but the trajectory of future rate hikes, a much more important consideration for both the economy and investors.
The key here is to look at the Fed funds futures. Understanding these instruments and their pricing can give you a window into the market’s view, as spoken by investor dollars.
Fed fund futures allow banks, fixed income portfolio managers and others to hedge against unexpected shifts in short-term rates. As a byproduct, they also facilitate speculative risk taking. Players in this market are essentially betting on what the average federal fund rate will be during a particular month.
Pricing for these contracts is simple once you understand what you’re looking at. Contracts vary by month are priced at 100 minus the expected Fed funds rate. If the price of a particular month’s contract is 99, then traders expect the average federal funds effective rate during that month to be 1% (100 - 99).
By comparing the price of Fed funds futures contracts for different months, we can determine how the market expects the federal funds rate to move over time.
As an example, let’s say that the current federal funds target rate is 1%, there is a Fed meeting later in the month, and next month’s Fed funds futures are trading at 98.78.
In this case the federal funds futures rate implied by next month’s contract is 1.22% (100 - 98.78). This would imply that market participants have priced in a very strong likelihood of a Fed rate hike of 25 basis points.
On the other hand, if the price of next month’s contract was 99.025, it would imply an average effective federal funds rate of 0.975% (100 - 99.025). Since the implied rate is only 2.5 basis points away from the current rate, market participants see a very low likelihood of a change in rates at the upcoming meeting, with a bias towards a rate cut.
Moving on, we can use Fed funds futures pricing to determine the probability of an upcoming rate hike (or cut). These calculations become a bit more complex as a result of the nature of the futures contracts and the timing/cadence of future FOMC meetings. I can provide the details if any subscribers are interested, but thankfully, the CME Group does this for us.
The charts below come from the CME Group’s FedWatch tool. They are using the Fed funds futures to determine the probability of a rate hike based on the approach discussed above.
This first chart shows the October contract’s implied probability of a rate hike. Please note that in reading these charts the interest rates denoted under each column refer to the upper end of quarter point ranges. Right now even though rates are “at zero,” the federal funds target range is 0 - 0.25%. So in the chart below, the 93.1% probability of a 0.25 rate is saying that there is a 93.1% probability of no rate hike. Conversely there is a 6.9% probability of a quarter point hike (to a range of 0.25 - 0.50).
So as you can see, the market (particularly big institutions that are active in this market) do not expect a rate hike to occur on Wednesday.
Now what about the December meeting?
Below you can see that the probability of a rate hike in December is higher, but that no rate hike is still the highest probability outcome.
And for good measure, here is the current January FOMC meeting implied probabilities. No rate hike is still the favored outcome, but it’s more of a coin toss at this point.
Using these inferred probabilities derived from Fed funds futures pricing, we can extrapolate a rough expected value for the federal funds rate over time. Aggregating the data for the upcoming eight FOMC meetings, which takes us through September of 2016, leaves us with the following chart.
This demonstrates that currently, the market as a whole expects the Fed to raise rates at a very gradual pace. Generally speaking, rates in the middle of next year are only expected to be a quarter point higher than they are now. This is a good sign, as a slow process of normalization is the best outcome for both the economy and financial markets.
Keep in mind that like any other frequently traded asset, Fed fund futures can change quickly as new developments arise. A steepening of the curve in the above chart would imply the market's assessment changing to reflect the anticipation of a series of quick rate hikes. If that were to happen there is a good likelihood the market will sell off in response, on the assumption that those rate hikes will drastically slow the economy in coming months.
Wrapping things up, it’s interesting to compare the market expectations above with the Fed’s most recent dot plot (below). For those that aren’t aware, the dot plot reflects each FOMC member’s expected target for the federal funds rate over time.
Notice below that for 2016, most FOMC participants expect an appropriate federal funds rate to be between 1 and 2%. This is significantly higher than the 0.5% rate that the market is expecting. Who will be right? We'll find out soon enough, but my money's on the market.
The preceding content was an excerpt from Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
