What are Fed Funds Futures Telling Us About Rate-Hike Timing?

Monetary activism is a relatively new dynamic that has played an integral role in the market economy over the past quarter century.  For the sake of stimulating an economy in a downturn, a government’s central bank cuts interest rates and pumps in the liquidity.

Since the Great Recession of 2008, the U.S. Federal Reserve has sliced interest rates 10 times  and as of December, 2008 the Federal Reserve Rate “Fed funds” have been cut to a range of zero to 0.25%; bringing the U.S. to the zero-rate policies that Japan used for years in its own fight against deflation.  Six years of a zero rate interest rate policy and we’ve finally started to see some green shoots.  Our economy is not anywhere close to “escape velocity” – as judged by our GDP. However, the Fed is now increasingly more comfortable with job growth, PMI figures, that the market can surely adjust to a few symbolic rate increases and perhaps even begin to heal on our own.

There’s been an increasingly amount of “interest rate lift-off rhetoric” cross the newswires and while there’s a lot of opinion, it isn’t yet clear whether liftoff will commence in June, September, or even later.  Regardless of timing, Fed officials continue to warn of a disconnect between the market’s perceived policy path and the most likely FOMC course. Fed Chairs Williams and Bullard in particular have suggested that the market is too dovish on its outlook on rates.

Last Tuesday, before Yellen’s testimony, Fed Fund futures were implying a 40 basis point rise by year’s end with a 60% chance of a 50bps point rise.  One day after Yellen’s “interpreted as dovish speech”; Fed Fund futures quickly lowered expectations implying just a 36.5bps rise, with a 22% chance of “lift off” commencing in June.

As of Monday, with the BLS report standing ahead of us, the market is pricing similarly to last Wednesday – a 20% chance for a 25 basis point (bps) hike in June. As outlook accumulates about when the Federal Reserve will finally lift its target (from 0 - .25%) for the federal funds rate, trading in financial futures markets offer a window into the odds that markets put on the next Fed move.

Futures and options contracts based on the Fed Funds rate are traded at the CME Group. http://www.cmegroup.com/trading/interest-rates/stir/30-day-federal-fund.html . The contracts are priced on the basis of 100 minus the average effective federal funds rate for the stated delivery month.  For example, a published price of 99.885 for the March 2015 futures contract, would infer the markets expected rate of .1150bps (basis points) for that month (100 – 99.885 = .115% effective fed funds interest rate).

To calculate the probabilities of a quarter-point rate hike in June, you would take the current June, 2015 futures price of 99.835 and subtract it from 100 giving you an effective rate of .165%.  Next, you would subtract the .165% from the current rate of .115% leaving you with a difference of .05 % (.165 - .115 = .05). To find the probability of a .25% increase, you would then take your difference of .05bps and divide by .25 which would equal a 20% chance of a 25bps rate hike by June.  (.05 /.25 = .20%).

To evaluate where the market expects rates to go by the end of 2015, we look at the Fed funds January, 2016 contract which is currently trading at 99.41.  Next, calculate the Fed funds rate that is implied by the price of this futures contract by subtracting the futures price from 100 (100 – 99.41 = .59%).  Using the 99.41 futures price, the market expects the Fed fund rate to be .59% or slightly over one-half percent or, .475% (or, .475bps) more than the current rate of .115%

In the above scenario, a half-percentage-point rate hike is fully priced into the market price but not into the probability.  In order to determine the chances of a half-percentage-point hike, divide the difference between the real rate and the implied rate (.59bps - .115bps = .4750bps) by 0.50.  For January that works out to a 95% chance of a .50% hike between today and the end of December, 2015.  To estimate the chances of a three-quarters-percentage point hike, divide by .75%.  That converts into a 63% probability.

Of course, focusing one's gaze further down the path is easier said than done, especially when global central bank divergence may lob numerous obstacles into our direction. Whether manifested through monetary policy or economic growth trajectory, central bank divergence can lead to unexpected and occasionally unwelcome investment outcomes, particularly over short periods.

U.S. economic news hasn’t been horrible but continues to both mildly and consistently undershoot expectations. This would include misses from personal spending, wholesale inventories, retail sales, PPI, and industrial production countered by employment gains, personal income, and global PMIs.