Fed Fund Futures: Predicting the Fed

Issue 81

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Today’s Bullets:

• Fed Fund Futures

• Implied Rates & Probabilities

• Futures vs. The Dot Plot

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Inspirational Tweet:

The latest CPI and unemployment numbers are in, and now we have a Fed meeting next week. Then another one in November, and one more in December, for a total of three before year end.

So, will the Fed raise or lower rates at the next meeting? And what about the other two?

At times like this, we often hear rumblings about the Fed Funds Futures as a predictor.

But what are the Fed Funds Futures, what are they saying, and, perhaps most importantly, are they the best predictor of Fed policy? Can they, in fact, help us navigate through the fog and clarify the landscape of cuts and hikes ahead?

If talk about the Fed and Futures confuse you and still leaves you in the fog, have no fear.

(wow that’s a lot of f’s, but let’s add some more, shall we?)

Let’s unfurl the factors that Fed Funds Futures infer.

Ok that’s enuf.

Let’s get on with it, nice and easy, as always, shall we? So, grab a cup of coffee and settle in for some Fed fun with The Informationist today.

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🎯 Fed Fund Futures

At the heart of it, futures are simply a bet on the future price of an underlying security or commodity, or, well…rate of interest on an instrument.

In this case, the futures predict the Fed Funds Rate (the overnight rate) at a specified future month. The futures contracts are traded on the Chicago Mercantile Exchange (aka, the CME or Merc) and can be traded in various maturities, ranging from overnight to one year. 

But why? Are they just a bet, like an over/under line on a football game?

Well, yes and no, because while you can use the futures to simply speculate, many investors use these contracts to hedge exposures they may have that would be impacted by changes in the benchmark interest rate.

For instance, if they are long US Treasuries, they may want to use Fed Fund Futures to protect themselves against a rise in rates (which would negatively impact their USTs).

They would thereby lose money (on a mark to market) on their UST holdings, but profit in the Fed Funds Futures contract.

As far as actual trading the futures, here's how pricing works:

100 Minus the Expected Rate: Fed Fund Futures are quoted as 100 minus the expected Federal funds rate average for the month. For example, if the futures are priced at 95.50, the market's expectation is that the Fed Funds rate will average 4.50% for that month (100 - 95.50 = 4.50).

Contract Value: Each contract has a face value of $5,000,000, but the amount exchanged is based on the average Fed Funds rate for the month. The closer the actual average rate is to the futures price prediction, the more valuable the contract becomes to its holder.

Profit or Loss: For example, suppose you buy a Fed Fund Futures contract expecting the rate to be 4.50% (so, priced at 95.50). If the actual rate ends up being 4.40%, the futures price would move to 95.60. For every 0.01 change, there's a $41.67 profit or loss for the contract holder. So, if you bought the contract at 95.50 and it moved to 95.60, you would make $416.70 (0.10 x $41.67) because the actual rate was lower than you expected, making your contract more valuable.

But why $41.67 per bp (.01%)?

Remember, for a Fed Fund Futures contract, a 0.01% change in the interest rate represents a daily interest difference of $500 on its $5 million principal.

When considering this change over an average month and accounting for money market conventions (360 days per year), this translates to a $41.67 profit or loss for each 0.01% shift in the contract's rate.

Does this mean anyone can buy or sell the contract?

Well, it seems reasonable that a retail investor could stomach up to a 50bp (.5%) loss, or -$2,083.50 on a single $5M contract.

That said, you'll need a futures trading account with a broker that offers access to the futures markets, as well as personal approval by your broker (filling out an application that assesses your trading experience, knowledge of the risks involved, and financial situation), and finally, futures trading requires margin, so you'll need to have enough capital to meet the initial margin requirements of the contracts you wish to trade.

Now that we understand how Fed Fund Futures are traded, what are the prices telling us today?

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🔍 Implied Rates & Probabilities

Knowing that the prices of the futures show expected rates, we can then extrapolate the probability of a cut or hike from that.

Here’s how: