Stocks and Commodities Magazine

Can Fed Fund Futures Help Forecast Fed Decisions?

What are Fed Funds Futures contracts? Can they be used to predict future Fed moves?

The Fed Funds futures are derivative contracts written with the Federal Open Market Committee’s target overnight bank lending rate as the underlying asset. Accordingly, contract expiration months are based on scheduled Fed Meetings, as opposed to the typical quarterly expiration in financial futures. Not unlike any other futures contract, Fed Funds futures contracts can be bought or sold in any order as a speculative tool to bet on, or hedge, expectations of changes in the Federal Reserve’s target interest rate.

In a bare bones example, if you think the FOMC will be increasing interest rates you would sell the Fed Funds futures; if you believed the Fed will lower rates you would be a buyer. This might sound counterintuitive, but in reality the price of an interest rate product moves inversely to rates. Thus, if interest rates rise bonds, notes, and even Fed Funds futures contracts fall; and vice, versa.

The Fed Funds futures contracts are quoted similar to a discount bond. In essence, they are valued relative to 100.00 minus basis points, where 100.00 is equal to an interest rate of zero. For example, at the time of this writing the January 2015 Fed Funds futures contract was trading at 99.9150. This implies that the market believes, in that moment, that the Fed Funds interest rate will be 0.085% at the time this futures contract expires. This is figured by subtracting 99.9150 from 100.00.

Many speculators look to the Fed Funds futures market for answers as to when the Fed might be taking action next. While most traders in Fed Funds futures are high sophisticated and are likely buying and selling these futures contracts after diligent consideration, it is important to understand that they might be wrong. Simply put, the Fed Funds futures market gives us a glimpse into the expectations of other traders but it does not tell us with certainty what the future will bring.

 

Read more about Fed Funds Futures contracts in the December 2014 issue of Stocks & Commodities Magazine.

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