How Futures Markets View Rate Hikes

With each coming day, the Federal Reserve raising “rates” from the range of “0 – 0.25%” to “0.25% – 0.50%” on December 16th seems more and more probable. But those with billions of dollars on the line typically don’t like to make big bets on what seems likely. No, hedge funds, prop traders, and banks depending on the cost of money try for a bit more certainty.

Enter the Fed Funds futures contract, which allows those who care about such things to hedge their exposure to a hike in “rates.” Wait, isn’t that what 30 year bond futures are for? Or 10 yr notes? Or Eurodollars? Well, yes… But also no.

Remember, an interest rate hike comes in a few parts. Part one is the hike in the Fed Funds target rate, which is what the Fed essentially asks US banks to charge each other for borrowing money from each other through the federal reserve system. Part two is all the rest of the financial system taking that cue (either directly because the cost of their money went up, or indirectly because they can now charge more) and raising rates on the money they loan out.

Now here’s where it gets tricky, because while the financial system takes its cue from the fed funds rate, they won’t necessarily adjust all of their interest rates up/down by that same amount. Long term rates might stay the same, short term rates rise more than that or any combo in between. Which is all a very long winded way of saying there are some who need more granularity than the 30 yr bond or Eurodollars futures can offer. There’s those who need to have a direct hedge on the fed funds rate itself.

Fed Fund Futures 

Here are the contract specs via the CME Group website.

Fed Futures Contract Specs

Like the EuroDollar, the contract is quoted as 100 minus the interest rate, meaning the current December 2015 contract at 99.780 allows hedgers/speculators “lock in” a rate of 0.22% as if that’s was the average rate charged by banks loaning each other money through the federal reserve system.

There’s a 79% chance? 

Like a sports gambling system, you’ll notice in the months/weeks/days leading up to an FOMC meeting, article after article quoting a probability of the interest rates going up, like the over under of a football game. These articles aren’t actually using the price of the fed funds contract,  but the CME FedWatch Tool. At the moment, the tool shows the probability of a December rate hike at 79.1%.

CME Fed WatchtoolChart Courtesy: CME FedWatch Tool

Where do they get that number from a futures price of 99.78? Behold the equation the CME uses to determine such a number in a month where there is a fed meeting.

Equation for CME Watch Tool

This is more complicated than it looks – as it is really just taking the difference in the expected fed funds rate between the start and end of the month and dividing it by the assumed hike amount (25bps). For example, if the inferred rate from them fed funds futures was 1% at the start of the month and 1.25% at the end of, the difference would be 25bps (0.25%). Divide that’s by 25bps and you get 1 (25/25) or 100% chance of a 25bps rate hike.

Now, this is the inferred probability of a rate hike as expected by traders of the Fed Funds futures, but that’s a mouthful for reporters, who usually just throws out the percentage probability without providing context.

Volume

One might think that with media crazed focus on Janet Yellen, the fed, and raising interest rates, the fed funds contract would be as popular as the Emini S&P. But it turns out, it’s one of the least traded interest rate futures contracts. The Open Interest of fed funds in January stands at 203,000 whereas the 30 year note stands at around 507,000, suggesting there could be room for traders to grow in this space. With much anticipation on raising interest rates over the next couple of years, it will be interesting to see if this contract grows in interest (pun intended) as well.

Future Expectations

So where do traders see the Fed Funds rate going over the next few years? Up, up, and (not that far) away. You can see from the futures curve below that the price of Fed Funds futures contract is moving out over the next 36 months. Using this curve, it looks as though that by By November 2018, the rate is expected to rise to 1.73% (100 – 98.27).

30 Day Fed FundsData Courtesy: Barchart

Whether or not that happens or not is left to be seen. In the meantime, be on the lookout for an upcoming infographic on interest rates. Sign up here, to receive the latest posts and infographics delivered right to your inbox.

One comment

  1. This is a bit misleading and you start with a pretty big mistake. The Fed funds target currently is 0-25 bps. It is not 25. The expectation is for a 25-bp increase would would make the target between 25-50 or 37.5.

    Now the December meeting is mid-month so the Dec. FF contract should only include a 50% effect of an anticipated rate increase. (It is best to look at January to avoid additional math). The CME tool has a problem because it was not changed to address the Fed’s decision to set a range (it should include chances of a change to 37.5, 62..5, 85.5 etc. The 21% likelihood of rates of 25 bp in the model is an indication of a move because currently rates are set 0-25. You should add half of that to the other figure to come up with a more accurate prediction. With the Dec. Fed meeting coming at mid-month, a Fed Funds rate of 99.75 in the Dec. contract represents a near 100% chance of a 25 bp move.

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Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, RCM's own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.