Economists predict rate increase in June- Is that the market consensus as well?

The best way to obtain consensus is to read the federal funds futures contracts. These contracts trade out 10 months – one contract for each month. The price quoted is 100 minus ‘effective fed funds’, which represents the market’s expectations of the overnight fed funds rate. Using these contracts, one can place a probability of when and how much the Federal Reserve’s Federal Open Market Committee (FOMC) will move rates

 
 

The best way to obtain consensus is to read the federal funds futures contracts. These contracts trade out 10 months - one contract for each month. The price quoted is 100 minus 'effective fed funds', which represents the market's expectations of the overnight fed funds rate. Using these contracts, one can place a probability of when and how much the Federal Reserve's Federal Open Market Committee (FOMC) will move rates.

There are three outcomes of an FOMC meeting: it can raise, lower or maintain the target fed funds rate. However, the market is concerned with only two outcomes; simply put, will the FOMC raise the fed funds rate or not? If the FOMC changes the fed funds rate, is the amount just as likely to be 25 basis points (b.p.), 50 b.p., 75 b.p., or 100 b.p.?

Take the July fed funds contract as of May 10, 2004, as an example: the price is 98.77, resulting in an implied rate of 1.23 percent. The contract is trading at 23 b.p. higher than the current fed funds target rate of 1.00 percent. If we take the 23 b.p. and divide it by the Fed's anticipated 25 b.p. move (contracts trade under the assumption that a minimum move is 25 b.p.), we conclude that, by July, there is a 92 percent probability that the Fed will increase rates by 25 b.p. and an 8 percent probability that rates will remain unchanged.

Now, examine the August contract; and follow closely! The August contract is trading at 98.55, for an implied rate of 1.45 percent. The difference between 1.45 percent and 1.00 percent (the current rate) is 45 b.p. Accordingly, the market foretells a 100 percent probability that the Fed will move rates up by 25 b.p., and an 80 percent probability [(45 b.p. -25 b.p.)/25 b.p.] that the Fed will move rates up by 50 b.p. by August.

The answer to your question is that the market sides with economists and that it believes there is a 100 percent chance the Fed will move rates up to 1.25 percent by August. The last available contract tells us that the market has priced in, with 100 percent probability, that the Fed will increase rates to 2 percent by December 2004 (the contracts are currently trading at an implied rate of 2.06 percent.)

There's just one problem. Lately, the contracts have been wrong as often as they have been right. With market sentiment changing on a dime, it is common to see the contracts swinging wildly to extremes; leaving the economists and us for wont of a crystal ball.

 

 

 

May 10, 2004


Comments

 
 
 
  • I thought this article and the futures contracts rate formula was very interesting and probably as good of an indicator as anything regarding the probability of Fed rate movements.
    Anonymous
     
     
     
  • How do you determine the implied rate from the amount that the future contract is trading at? Or what is the correlation between the trading price and Fed funds rate? Is their a formula or something?
    Anonymous
     
     
     
  • I have been doing my own research regarding rise rates and how this will effect certain types of investments. My crystal balls says 25 on June 30th.
    Anonymous
     
     
     
  • Emily is an insightful observer of the economy and its impact on credit unions
    Anonymous
     
     
     
  • Emily is an insightful observer of the economy and its impact on credit unions
    Anonymous