FT Explainer: Interpreting Fed funds futures

12/13/16, 6(22 PM

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US Interest Rates

FT Explainer: Interpreting
Fed funds futures
Why markets are not overwhelmingly
signalling a US rate rise

NOVEMBER 24, 2015

by: Robin Wigglesworth

The US rate rise (http://ig.ft.com/sites/when-rates-ris

e/) drumbeat grows ever louder, and almost every
economist has by now circled December 16 in their
diary with bright red ink. But interest rate futures
imply there is still a 25 per cent chance that the
Federal Reserve will stay on hold. Why the apparent
discrepancy (http://next.ft.com/content/93cf76bc-8e
9e-11e5-a549-b89a1dfede9b)?
Virtually every financial market is affected directly or
indirectly by the US central banks benchmark interest
rate, the Fed funds rate. But the easiest way to see
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FT Explainer: Interpreting Fed funds futures

12/13/16, 6(22 PM

what investors expect policymakers to do is to track

the Fed funds futures, contracts that are settled at a
price determined by where the Feds interest rate is in
the month of expiry.
Simply put, the price is 100 minus the effective Fed
funds rate at the time. The December contract
currently trades at 99.78, so that implies that investors
predict an interest rate of 0.22 per cent, but crucially
and complicating the calculations that is the
average over the month. Next year, the Fed funds
future for December 2016 is trading at 99.19, which
implies an average Fed funds rate of 0.81 per cent in
that month.
According to Bloomberg, the Fed funds futures market
currently implies that there is a 74 per cent chance of
the central bank lifting interest rates next month,
while the Chicago Mercantile Exchange (http://www.c
megroup.com/trading/interest-rates/countdown-to-fo
mc.html) reckons that there is a 73.6 per cent chance,
based on the same contracts. Here is a chart that
shows the rising expectations from Bloomberg data.

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FT Explainer: Interpreting Fed funds futures

12/13/16, 6(22 PM

However, those numbers are misleadingly clean, given

the complex underlying calculations, and both
Bloomberg and the CMEs estimates arguably
underplay the likelihood markets really assign to the
chances of lift-off in December.
Part of the problem is that the Fed moved to an
interest rate corridor in the wake of the financial crisis.
Rather than targeting a single Fed funds rate by
tweaking the amount of money in the system the
traditional way of easing or tightening monetary policy
the US central bank in 2008 moved to a range of 0
per cent to 0.25 per cent.
As the chart below shows, the effective Fed funds rate
has traded within this corridor since then, and
averaged around 13.2 basis points roughly midway
between the two points since 2009.

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FT Explainer: Interpreting Fed funds futures

12/13/16, 6(22 PM

The interest rate rise probability calculation depends

on whether the Fed goes back to a specific target, or
as is far more likely it simply lifts its corridor target
by 25bp. If so, where the effective Fed funds rate
settles is pivotal for estimating what probability is
implied by the relevant contracts.
The Fed will set the new range with the help of two
new tools, the overnight reverse repo programme (ON
RRP) and the interest on overnight excess reserves
(IOER). The former will serve as an interest rate floor,
while policymakers hope the latter will act as a
magnet, dragging the effective Fed funds rate
upwards, off the RRP.
How traders respond to the two rates is crucial for
estimating the probability of an increase implied by
futures.
For example, if the effective Fed funds rate ends up
closer to the lower end of the central banks range then
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FT Explainer: Interpreting Fed funds futures

12/13/16, 6(22 PM

the likelihood of a rate rise implied by Fed funds

futures contracts is, in fact, much higher. If the
effective Fed funds rate goes to 37.5bp, then the
probability is about 70 per cent, as Bloombergs
calculations imply. But if it is dragged higher by the
Feds IOER tool then the likelihood implied is lower,
points out George Pearkes, an analyst at Bespoke
Investment Group.
Its all about the math, he says. The Fed has
signalled many times recently that they are ready to
raise rates, so its hard to argue that markets havent
been warned.
Indeed,
judging by
other
markets
investors
are wellprepared
for a
December
lift-off. The
two-year
Treasury
yield
climbed to
a five-year
high of
0.94 per
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FT Explainer: Interpreting Fed funds futures

12/13/16, 6(22 PM

cent on Monday, the dollar has risen to a seven-month

high of $1.06 against the euro, and the eurodollar
futures another widely watched gauge of interest
rate expectations implies a near-certain Fed rate
rise next month.
On the whole, the most likely explanation for the Fed
funds markets still-notable implied possibility of the
Fed holding fire is that the vast majority of traders are
in fact girded for interest rate lift-off in December, but
simply expect that the Fed funds future will be on the
lower end of the new range.
As Michael Cloherty, head of rates strategy at RBC,
says: Were at the point where it would be a
catastrophe for the Fed not to go in December.
Print a single copy of this article for personal use.
Contact us if you wish to print more to distribute to
others. The Financial Times Ltd.

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